Hedge fund legend and Bridgewater Associates founder, chairman, and co-CIO Ray Dalio continued to offer his political insights via a LinkedIn post Tuesday, this time touching on the effects of the recent Senate-approved tax reform.
“This tax migration issue is especially important to focus on now because of the expected elimination (under the new tax legislation) of the deductibility of state and local taxes (SALT) against federal income taxes,” he wrote. “The dynamic that I’m referring to is the inevitable and self-reinforcing process in which those high SALT locations that a) have big disparities in income and fiscal shortfalls and b) can neither cut their financial supports to the “have-nots” (because their conditions are already unacceptably low) nor raise taxes on the “haves” (because they will move due to tax rates) suffer from tax migration. Of course, those low SALT locations with the opposite circumstances benefit from this migration.”
Dalio then described how the dynamic works, similar to his economic cycles explanation in his 2003 paper “How the Economic Machine Works.” As SALT rates and debts rise due to shortfalls, high-income taxpayers will move from high SALT locations to low SALT locations to temporarily escape these issues. As this increasingly happens, the value of the higher SALT locations depreciates because there is now less spending in those locations, while the opposite occurs in the low SALT areas thanks to their new inhabitants.
This eventually bottoms out when the SALT ratios switch. Unfortunately, the process creates more polarity between the “haves” and the “have nots” as neighborhoods change to accommodate the “haves” while the “have nots” are essentially pushed out due to the realization that they can no longer afford to live in their neighborhoods. Dalio points to the recent gentrification of downtown Manhattan and Brooklyn as an example.
“While we are talking about the tax migration, we see such location cost arbitrage-motivated migrations happen all the time, so we should be well acquainted with them. For example, in New York City, we saw migration from the Upper East Side to Downtown and then to Brooklyn brought about by cost arbitrages,” the post reads. “Every area in the world has this sort of cost and desirability motivated migration going on constantly. Cost differences drive migrations that change the characters and costs of neighborhoods and happen in self-reinforcing ways until the cost differences change to make the newly hot neighborhoods expensive and other areas relatively cheap, so the immigration shifts to emigration.”
When estimating the impact of cutting the SALT deductions, which the tax plan seeks to accomplish, Dalio reveals that Bridgewater’s findings (although admittedly very rough and imprecise) see tremendous problems for high SALT locations such as New York, Connecticut, New Jersey, California, and Illinois while low SALT states such as Florida, Texas, Nevada, Washington, and Arizona reap equally large rewards.
“That means that it would take only a tiny percentage of the population to move to have a devastating effect on the state’s finances,” he wrote. “Our big picture perspective is that, on the margin, the tax law changes are going to be significant and bad for high SALT locations and good for low SALT locations, and are going to be good for businesses and business owners (and hopefully those who the money trickles down to), so those businesses in low SALT states will get a double whammy benefit.”
As for Bridgewater’s methodologies, the hedge fund king noted at the end of his post that there is “a large amount of research that has been done to estimate the marginal effects of tax changes on tax migration,” which the firm “used and tweaked to come up with these estimates.”
In the coming days, Dalio will reveal Bridgewater’s observations on state finances and their respective muni bond markets.