Tax Myths

Like many people I believed in several tax myths.  Twenty years ago, my accountant helped me better understand some of the things I took for granted as true.  I had started a contracting business a few years before.

Myth: Tax rate. I believed that, because I was in a 28% tax bracket, I paid 28% of my income in taxes. 
“Too many people confuse their marginal tax rate, which is 28% in your case, with their effective tax rate,” my accountant said.  We were reviewing my corporate and personal income tax returns.  She pointed me to the Taxable Income line on my personal tax return. 
“That’s your taxable income,” she said.  Then she pointed me to the Tax line that followed.  “That’s your tax.  What is the percentage of the tax to your taxable income?” she asked. 
“About 16%,” I replied. 
“That’s your effective tax rate,” she said.

She continued, “I have other contractor clients who want to buy a new truck.  They reason that, because they can deduct the purchase from their taxable income and they are in a similar tax bracket as you, the government is effectively paying for 30% of the cost of the truck.  It sounds like a great deal to them and justifies the cost of a new truck.  I ask them whether the first dollar they make or the last dollar they make will go to the new truck payment.  This sounds puzzling at first. If the first dollar they make goes to the truck payment and that first dollar is taxed at only 10%, then the government is only picking up 10% of the cost for the new truck.  Is the extra cost of a new truck justified if the government only picks up 10%?  Do you see what my point is?  You can’t say that you buy groceries and other necessities with the first dollar you make and then say you’ll  buy the truck with the last dollar you make.”  I nodded.

“The decision whether to buy a new truck,” she said, “should be based on a number of factors: additional work capability, reliability, less down time, savings from truck repairs, to name a few.  Any tax savings is just one of those factors.  It shouldn’t be the prime factor.  Unless you pay cash for the truck, you’ll have interest charges that will add about 15% to the purchase price.  At your effective tax rate, the government is simply picking up the interest you would pay on a truck loan.”

Myth:  Capital Gains Tax. In the middle nineties, I wanted to sell some part of a mutual fund and put the money in a different mutual fund to diversify a little bit. I was a reasonably new and unsophisticated investor who had read that diversification was good.  I had held off selling any shares in the fund for about a year because I didn’t want to pay the capital gains tax on the sale.  Once again, my accountant gave me another tax lesson. 
“Many people don’t realize that when they sell a mutual fund, they often pay little in capital gains tax or they may report a loss.  For many funds, you have been paying the tax each year on any capital gains the fund has realized.” 
That surprised me. She pointed me to a form in my tax return (Schedule D).
“Here’s the capital gains your fund had this year,” she said.  That increased your taxable income and you paid tax on it.  For many people, tax considerations should not be the prime reason they buy or sell a mutual fund, especially a stock fund.  There are some bond funds and other less common investments which are not taxable and that’s a different story.”

Myth:  Tax deferred accounts. In the mid nineties, I considered whether my company should set up a 401K retirement plan but the administrative costs and restrictions were impractical for a company my size.
“For employees  the tax deferral feature and any matching employer contribution to a 401K plan are a big plus.  For small companies with just a few employees, you lose the benefit of the employer contribution because you are the employer.” 
“But what about the tax advantages?” I asked. 
“Unlike many employees whose work hours are more or less fixed,” she replied, “you can offset the tax advantage of a 401K by working a few extra hours a week.  In effect you are paying the taxes now so that you won’t have to pay them in the future.  30 years from now you won’t remember the extra hours you worked.  You will have more control of your retirement funds.  Who knows what Congress will decide to do with IRAs and 401Ks 30 years from now?” 
“But,” I asked, “I’ll be in a lower tax bracket when I’m retired and I’ll pay less taxes on the money I take out of my IRA or 401K.”
“That’s true.  But there is the matter of how a tax rate feels.  When you are 75 years old and are on a fixed income, believe me, a 10% income tax rate feels like 20% or 30%.  At a 10% tax rate, you have to take over $1100 out of your IRA or 401K to net $1000 to meet your expenses.  At that age, you are very conscious of your dwindling savings.  In your 30s, 40s and 50s, you can command more money for your labor than you can in your 60s, 70s and 80s.   You can work a little extra now in order to buy peace of mind later and hopefully avoid having to get a part time job in your 70s to make ends meet.”


The Adam Smith Institute Blog at the Christian Science Monitor carried a financial story about pensions in Hungary that had several misconceptions.  The Christian Science Monitor, while noted for its reporting in other areas, is not a financial publication.  The Washington Examiner then linked to this blog and it went around the internet as a case of “European countries taking private pensions”.  If this were the case, I knew I would find the story as a prominent feature in the Financial Times, the leading source of financial news in Europe, or in the Wall St. Journal, the leading source of financial news on this side of the Atlantic.  If this were true, then this is pretty big news to the bond market. 

At a Wall St. Journal blog, a reporter gave a more complete description of the transition which Hungary is planning.  Here is an excerpt. Emphasis added by me.

Hungarians will have until Jan. 31, 2011, to decide whether they opt to return fully to the state’s pay-as-you-go pension regime. Only the private pension fund members who wish to remain in their respective pension funds will need to express their wish. Those who don’t do that will automatically return to the state scheme.

“They have two options: they either stay or decide to return, [and] both decisions have their consequences,” [Economy Minister Gyorgy] Matolcsy said at a press conference in parliament after a government meeting.

The assets of those who decide to return to the state scheme will be kept in individual accounts and will remain inheritable by the spouse, Mr. Matolcsy said.

Hungary has a hybrid social security scheme similar to what George Bush proposed about 6 years ago.  Designed to encourage people to save for retirement, some of each person’s social security taxes could be invested in private pension funds.  The private pension fund is supposed to generate a return that will provide 30% of a retirees pension payment (Social Security check, in the U.S.) and Hungary supplies 70% of the pension payment.  Here’s the kernel of this story:  Hungary had promised to make up or “top off” a retiree’s pension, i.e. pay more than 70%, if the retirees private plan had not made the returns necessary to supply 30% of the full scheduled monthly pension payment the retiree was due.  Hungary can no longer promise to “top up” pension payments above the 70%.  What happened? 

Hungary has a large debt load.  It can borrow private pension money that a retiree chooses to turn over to the state at a net effective rate that is less than the bond market charges for Hungary’s debt.  The U.S. government borrows Social Security money at about 3 – 4%, a rate less than what the bond market usually (except for the past few years) charges the U.S. for its medium to long term debt.

Secondly, people close to or in retirement in Hungary took on more risk than they should have.  Many private pension funds lost value during the past two years and could not meet the 30% portion of the scheduled pension payment.  In a difficult economic environment, Hungary found itself “topping up” more and more private pensions. 

According to the Financial Times, France and Ireland are shifting state pension assets away from stocks and into government debt and cash.  Estonia, a prudently managed nation with no debt, has even considered reducing state contributions to private pension plans.

The question for developed countries with hybrid pension, or Social Security, schemes is how to design a system that encourages people to save for retirement but encourages prudent financial management.  If I were a Hungarian citizen and my government said they would make up any shortfall in the returns of my private pension funds, I would have rolled the dice and invested in riskier stocks that would hopefully generate big returns for me.  How could I lose when the government has promised they would make up the difference?  Then, whoops, the financial crisis hit and Hungary found that their hybrid pension system had inadvertently rewarded risky behavior. 

If I were a Hungarian citizen nearing or in retirement, I would be angry, of course.  The government had promised me that I could have my cake and eat it too and I like fairy tales and vote for the politicians who tell those tall tales.

More Sunlight

Every December it seems as though the sun will continue drifting south, never to return to the northern hemisphere.  Then in early January, the sun that used to come up over the neighbor’s chimney for the past week or so is now coming up just a tiny bit north of that chimney.  An economy can act like the winter’s sun, moping about in the doldrums until a few signs appear that things are going to get better.

In the past few months, initial claims for unemployment have fallen slowly but steadily, approaching that magic mark of 400,000, which economists regard as a milepost on the way to a healthy economy.  Another gauge of recovery are tax receipts.

Every month the Congressional Budget Office (CBO) publishes a review of the country’s finances.  In January’s review  the CBO notes that withholding taxes and other income taxes have increased over 20% in the last calendar quarter of 2010 (1st quarter of the U.S. Treasury’s fiscal year 2011 which started in October 2010).  Withholding and social security taxes make up about 80% of overall receipts to the treasury.  Below is a comparison of this past October – December with the same quarter of earlier years.

We can judge the health of local and state economies by the amount of sales tax collected.  The increased amount of witholding taxes in the past quarter is a barometer of a recovering economy.

Lending Latitudes

The horse latitudes often refer to a section of the Atlantic ocean where there was little wind for a period of time, causing sailing ships to get “stuck” in the middle of the ocean.  There are two winds that drive a developed economy like that in the U.S – the demand for loans and the willingness of banks to make those loans.

Every 3 months the Federal Reserve Board (FRB) interviews a number of bank loan officers on their lending practices, risk management of and demand for commercial, industrial, mortgage and consumer loans.  The latest October 2010 survey  shows small increases in demand for commercial and industrial loans.

In questions 11 and 12 of the survey, loan officers were asked about residential mortgages. Demand for prime mortgages remains relatively unchanged.  34 loan officers responded that they do not originate non-traditional mortgages like interest-only or no income verification.  There were so few responses to questions about sub-prime mortgages that the FRB did not list the results.  If you anticipate being in the market for a mortgage in the coming years, you can conclude that it will be difficult to find a non-traditional or sub-prime mortgage.

Loan officers surveyed saw little overall change in demand for home equity lines of credit but a quarter of them said that they had tightened slightly their lending standards for these types of loans and 12% said that they had lowered existing lines of credit.

Consumer credit was largely unchanged but there was a hopeful sign for businesses.  Over 25% of smaller banks reported that they had increased business credit card limits.  The signs were not so hopeful for those in commercial construction as 20% of officers reported that they had decreased lines of credit for their existing customers and half of respondents anticipate that their lending standards for commercial construction will remain tighter for the foreseeable future. 

For consumers and homeowners the future does not look rosy.  The survey includes a category called the “foreseeable future”, not just the next two years, when asking loan officers about their anticipated lending standards.  40% of loan officers anticipate tighter standards for residential construction and 34% foresee tighter standards for prime mortgage homeowners (62% for sub-prime holders) wanting to borrow money against the equity in their house. Over half of loan officers see the same tightening for credit card and other consumer loans. 

Big box stores like Home Depot and Lowe’s that depend on remodeling and construction dollars have seen a 10%+ increase in their stock prices the past month.  Given the current lending environment, it may be difficult for these companies to maintain the sales growth that justifies the expectations implied by such a dramatic stock price increase.  The reluctance to lend will continue to suppress growth in the consumer market which accounts for over 2/3 of this country’s GDP. 

Nasty Neighbors

In a Wall St. Journal article Dec. 31st, reporter Dan Fitzpatrick writes about an aspect of the housing crisis that hasn’t gotten a lot of attention – condos.  Residents, mostly retirees, at a 1970s built condo village in Florida are at each other’s throats because of delinquencies in homeowner (HOA) fees. 

Some residents have lost jobs and have stopped making both mortgage payments and the HOA fees as well, making it difficult for the HOA to provide adequate security and common area maintenance of the grounds, pool and clubhouse.  Some residents who have the ability to pay the mortgage and fees have simply stopped doing so.  Some non-paying owners continue to get rental income from their tenants, pocketing the money while they wait for the bank to foreclose, a process that has been delayed in some cases for two years.

Stepping out in front of the banks, the HOA has sometimes started their own bankruptcy proceeding for late fees, an agressive tactic that has prompted accusations that HOA board members were pressing bankruptcy so they could buy the condos as a bargain rental property.

A neighbor selling a house at a loss a year ago told me, “You’re not supposed to lose money in real estate” as though there was a law protecting all real estate investments.  If only it were so.