Incentives Matter; In China and in U.S. Markets

So what spooked the markets this week? In a word, China.

We sell a lot of stuff to China. If their markets tank, their companies won’t have the capital to buy our products and services.

So what spooked the Chinese market? Taxes … or at least the threat of new taxes.

Now, China's got a very different system from ours. Let's start with the fact that it's controlled by the Communist Party. But even in a quasi-communist system like China's, incentives matter. In the words of Ronald Reagan: If you tax something more, you get less of it. In this case, the Chinese Communist Party was threatening to raise taxes on China's booming capital markets. And what did that threat do? It killed off about 9 percent of that market.

To be sure, there were other issues that led to the market crash — concerns about new market regulations chief among them. But once the Communist leadership pulled back from its threat about the new tax on capital gains, the Chinese market regained about half of what it lost.

Now, the Chinese market’s still spooked. Communist leaders aren't known for keeping their word on anything, least of all what they plan to do with an economy. And markets hate uncertainty. But what gives me a bit of confidence is that Chinese capital markets, while still a small and highly regulated part of the economy, are gaining the momentum of millions of Chinese investors. In the past few months, according to the Wall Street Journal, Chinese banks have been losing deposits in almost direct proportion to the amount of money that’s been flowing into stocks. Chinese have even been selling real estate to buy stocks. That kind of popular momentum is a dangerous thing to try to block—even if you are a Communist dictatorship.

There’s another factor that makes the Chinese leadership sensitive to what happens in the market. Since the Communist government has a stake in most of the companies listed on the Chinese exchanges, they’re unlikely to purposely decapitalize listed companies. They don’t want to cut their own throats by adopting measures that would kill off capital flows to their companies. That’s another reason they reversed course on the capital tax.

So what you have in China is the strange situation where a Communist dictatorship is becoming more reliant on democratic capital markets. It’s a contradiction that I don’t think the Politburo quite knows how to handle. On Friday, for example, they balanced their reversal on capital taxes with a decision to restrict how much foreign currency Chinese firms can borrow abroad. The People's Bank of China wants Chinese companies to borrow foreign currency at home.

In other words, they’re restricting the freedom of companies to get the best deal they can so that the government can maintain control (and get a piece of the currency exchange action). So, open one place, close another.

There are so many lessons from all this, but let’s focus on the one that concerns U.S. most. If the threat to raise taxes on capital can cause a market crash in China, what could it do here? Of course, here in the States, leadership has its limits, thank God. Nobody can raise taxes willy-nilly on their own. But if our capital markets were threatened by a tax hike, you can be sure money would fly out of the market.

On Wednesday I spoke with Edward Lazear on "Your World." Dr. Lazear is the chairman of the President’s Council of Economic Advisers. Here’s what he said when I asked him whether a threat to raise taxes on capital would hurt our stock market:

"Go back to 2003, with the dividend and capital gains tax cuts, what you see is an abrupt reversal in the economy, in terms of investment in particular. Investment was going down, down, down. Then, just at the instant that those tax cuts came into play, we saw very strong increases in investment. So, just play it backwards and say, what would happen if, in 2010, we went the other way? I would be worried that we would see significant declines in investment..."

So if some bright, politician decides to take tax the capital more, how much less of it will we be left with? Who knows?

What we do know, and what was proved this week, is that market incentives go beyond borders and even ideologies. It's kind of nice to know that there are some universals in human behavior.

Let's just hope our own politicians picked up on that.

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David Asman is the host of "Forbes on FOX" which airs on the FOX News Channel, Saturdays at 11 a.m. ET.