Tax rates around the world generally don’t get much coverage or consideration in Forex thought and discussion. This is unfortunate and a bit of a blind spot for traders, but there are two quite good reasons for this:
First, changes in the tax system of a given country are usually not a surprise, since they are discussed a lot in the local press, the government and maybe even as part of a political campaign. That means the market has plenty of time to price the effect in – though, of course, that pricing in is a market move that traders ought to be aware of.
Secondly, tax changes are relatively rare, as a country only has major changes in the tax code happen once or twice in a decade. So it’s not something that’s on a trader’s daily checklist before trading. And because it’s a subject that people generally don’t pay attention to, few talk or write about it.
Common sense and complexity
Regardless of that, taxes are a major driving force in underlying markets. Conventional wisdom is that taxes have a negative correlation with economic growth; if taxes go up, then the economy will slow, and vice versa.
There are, of course, exceptions to any conventional wisdom rule (looking at you, Chile in 2010 and you Kansas under Walker). But the interplay between taxation and currency markets is a lot more sophisticated.
Tax policy is a complex system in itself, and changes will have different effects on the economy and financial markets. Raising the capital gains tax is not the same as raising sales taxes. Cutting repatriation taxes is not the same as cutting excise taxes. And so on.
More importantly, some of these tax policies can have counterintuitive effects on the market, that can catch traders off guard. For example, the government passes a law raising the top marginal tax rate. Conventional wisdom says this will lead to slower economic growth in the long term, so the currency should weaken, right?
Well, investors might decide to take profits now while taxes are still low, drawing assets from businesses into cash – raising the value of the currency as bond yields fall. And where will they put this money?
If the capital gains tax hasn’t been raised in conjunction, a good place to invest would be the stock market, drawing investor appetite and strengthening the currency in the short term. A trader might think this is the market “pricing in” the tax policy, and then get caught off guard again as the currency value drops to the underlying economic value.
Taxes also influence other economic indicators. Japan made an illustration of this with their proposed increase in sales tax, delaying it for years because it would have a negative impact on consumer demand. Lower consumer demand would translate into lower inflation, strengthening the currency.
The expectation of a higher tax load can lead investors to cut back their investment in a country, reducing demand for the currency, and even start withdrawing their money, creating downward pressure on the currency. This is especially relevant in countries with high FDI, such as emerging markets, which often attract investors based on relatively low taxation and high-interest rates.
Because investors are always trying to get in ahead of the action, the market might move on rumors or even electoral polls of candidates that have a dissimilar tax outlook. Rarely is tax policy in smaller, emerging countries, discussed in mainstream press, even during elections.
The bottom line is that Forex traders ought to keep an ear to the ground for tax policy talks in the countries whose currencies they are trading.