City Journal Autumn 2014

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Autumn 2014
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By Nicole Gelinas

After The Fall: Saving Capitalism From Wall Street--and Washington

Eye on the News

Nicole Gelinas
Gotham’s Capital Chance
New York is missing a once-in-a-generation opportunity to seize a competitive advantage.
13 July 2010

New York and London have long competed to be the global capital of global capital. With plenty of business to go around, the competition has usually been friendly; now, as the West’s financial industry shrinks, it could become fierce. London is already stumbling in this race, giving New York a golden opportunity to pull ahead. But instead, our politicians are sacrificing growth to higher taxes and bad regulations, just as London is.

The global finance industry awakened in the 1980s and soared in the 1990s. Wall Street and its British equivalent, the City of London, reaped an outsize share of the rewards, thanks to their strong legal and regulatory systems, their quality of life, and the global dominance of the English language. Between 1995 and 2004, the United States and Britain each nearly quadrupled its financial-services exports, but the City held the lead, winning Britain 23.8 percent of the global market against America’s 19.7 percent. It wasn’t just because London’s time zone was more convenient for many clients or because of the United Kingdom’s easier visa rules for foreign workers. The City benefited from American missteps, some dating back decades.

London’s dominance in global debt and credit derivatives, for example, stemmed in part from an error that America made nearly 50 years ago. In the early 1960s, Washington, worried about speculative flows of foreign funds, slapped a 15 percent surcharge on the interest income that investors earned from American bonds issued by foreign firms. London saw this as an invitation to create a flexible market in dollar-denominated bonds—and thus honed a lasting proficiency in debt (and eventually in related derivatives).

London also excelled at attracting global financiers with its tax policy. A shipping-era provision allowed British residents to escape taxes on their worldwide income if they didn’t plan to live in Britain forever; Americans had no such perk. In 1998, the new Labour government’s chancellor of the exchequer, future prime minister Gordon Brown, added to that advantage, writes former banker Philip Augar in Reckless: The Rise and Fall of the City. To encourage tech entrepreneurs, Labour slashed the top long-term capital-gains tax from 40 to 10 percent—and because asset managers often take their profits as a share of the investment gains they achieve for clients, this tax cut attracted international fund managers to London. The Bush administration followed suit three years later, cutting America’s capital-gains rate from 20 to 15 percent.

More recently, though, London has reversed its welcoming attitude. In 2007, Brown pushed the top capital-gains rate up to 18 percent. Earlier this year, Britain hiked top income taxes from 40 to 45 percent (the effective rate is now 51 percent) and imposed a $45,000 annual surcharge on long-term foreign residents. Last month, the new Conservative government proposed to hike the top capital-gains rate again, to 28 percent. The Conservatives will also eliminate some deductions for wealthy earners. A couple earning $300,000 will see a tax hike ranging from $2,700 to $3,150 annually, the accounting firm Deloitte estimates.

Uncertainty about financial regulation could also drive financiers from London. True, Britain is taking a fairly mild approach, largely transferring responsibilities among regulators and telling them to do a better job next time. But a one-time tax on big banks’ bonuses earlier this year must have City executives wondering whether the government will come back for more if it thinks that the public is still angry enough at the fat cats. The European Parliament could harm London’s fund-management business if it carries out its threats to micromanage hedge funds and private-equity funds and to set up protectionist barriers against asset managers that don’t follow the new rules. And the European Union’s strict new limits on cash bonuses, which will give banks less flexibility to compete globally, could also hit London’s independent asset managers, depending on British regulators’ interpretation of the rules.

This across-the-pond turmoil is an invitation for national, state, and city leaders to plaster an OPEN FOR BUSINESS sign on New York. Helping Gotham pull ahead of London should be easy. Congress could pass a reasonable financial-regulation bill—revising existing laws so that old borrowing, trading, and bankruptcy rules apply consistently to companies and instruments. President Obama could dangle tempting bait before financiers by promising not to raise income or investment taxes. New York State and City could make the same pledge and follow it up by cutting their budgets and future retirement obligations to government workers, which would let them make good on their tax promise without allowing the infrastructure that supports quality of life to deteriorate further.

Instead, we’re throwing our advantage away. The Dodd-Frank financial-regulation bill on which the Senate will vote this week won’t unleash healthy competition on Wall Street; instead, it will preserve “too-big-to-fail” institutions’ immunity from market discipline. When the Bush tax cuts expire next year, the top federal income-tax rate will climb from 35 to 39.6 percent, and capital-gains taxes will increase to at least 20 percent; two years later, wealthier earners will face an additional 3.8 percent investment-income tax.

New York State is raising taxes, too. Last year, Albany hiked the top income and capital-gains tax rate from 6.85 percent to 8.97 percent—and though the increase is set to expire next year, it will surely become a permanent fixture unless the state gets its finances under control. This year, Governor David Paterson floated new tax grabs to help fund a $9 billion deficit, including a provision that would tax the New York capital-gains income of out-of-state asset managers and a restriction on charitable deductions for wealthy earners. Though Paterson has backed down from the first of these proposals (since Mayor Michael Bloomberg called it “the best thing to happen to Connecticut”), the State Assembly has already passed both, and Paterson has not explicitly said that he’ll veto the deal when the Senate follows suit. By 2013, the wealthiest New Yorkers—exactly the people the city and state should be trying to attract—could easily be paying more than 50 percent of their income to federal, state, and local taxes.

In the coming decades, moreover, London and New York may have to scramble for a shrinking share of the global capital markets. Hong Kong and Singapore are quickly gaining as global financial centers in their own right; China, India, Eastern Europe, and some nations in Africa are developing more sophisticated domestic markets to raise funds closer to home; Paris and Frankfurt are eyeing London’s crisis-hit financial businesses and seeking to lure away some of their high-end jobs. Gotham should capitalize on its advantage while it can. Why, instead of becoming a refuge for global financiers, is it joining London in driving them away?

Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of After The Fall.

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