A Graduated System of Benefits

October 29, 2017

My kids will learn that they are the sons and daughters of charity parents.

Two weeks ago, I wrote about the measurement of the poverty rate in America. Why is our standard different than the one adopted by all other developed countries? What efforts have we made to alleviate poverty, and have those programs helped or hurt the poor?

Qualifications for benefits under various programs rely primarily on paid income. As a person exceeds certain thresholds of income, benefits are reduced or stopped entirely. Regardless of how we define a reduction in benefits, it feels like a tax to the recipients. Under these programs, the poor pay the highest tax – 100%. $1 earned above a certain threshold results in a $1 reduction in benefits. There is a very real incentive to hide reported income.

As I showed earlier, the poverty standard adopted by the U.S. undercounts the number of poor. On the other hand, income earned in the underground economy is not counted and results in an overcount of the poor.

We may associate “underground” with “illegal” but it includes both legal and illegal activities. A better synonym would be “unreported.” Workers in the unreported economy may include the kid down the block who mows our lawn, the guy who repaired our fence, the woman who walks our dog when we work late.

Almost all of us are part of the unreported economy whether we realize it or not. Recent estimates of the size of this shadow economy in the U.S. are from 7% to 11%. In dollar amounts, that’s $1.4 trillion to over $2 trillion. In less developed economies, it can be as much as 25%.

The tragedy of current programs is that they often discourage recipients from getting more work, or better paid work. The loss of Medicaid benefits dissuades a single mom with children from taking on employment unless she can find an employer who provides health insurance for her and her children. Many don’t.

Income above a certain threshold may disqualify someone from housing benefits. Under a Section 8 housing program, a low-income person pays 30% of their monthly income for housing (Section 8 FAQs). HUD, a Federal agency, and state agencies pay the rest of the rent. Section 8 housing is in short supply. The amount of paperwork and inspections required by HUD dissuades many real estate owners from enrolling their properties in the program.

These programs would improve by paying benefits on a graduated scale rather than using a qualifying threshold. Under the current system, a person making less than half the area’s median income, let’s say $24,000, gets housing assistance and other benefits. If they make above that, they may receive nothing under some Federal and state programs. That is the equivalent of a 100% – or higher – tax.

This graduated scale should apply to everyone. That includes the richest people on the planet like Bill Gates and Warren Buffett, who would also be eligible for housing vouchers, food stamps, for supplemental income and Medical benefits. As income increased, benefits would be gradually decreased. Bill Gates would be eligible for housing assistance, but his monthly benefit would be $0. For many of us, there would be no incentive to apply.

A graduated scale would help eliminate the quiet shame that some people experience when they receive public assistance. Like it or not, there is a stigma attached to being poor and receiving benefits.

A person with a disability can receive Social Security and Medicare. They can be quick to point out the fact. They are not on SSI, a program for low-income people. They are on Social Security. They paid into the insurance system. They got hurt. They are collecting on the insurance payments they made during a lifetime of work. Because they are disabled, they are on Medicare, not Medicaid. Medicaid is for poor people. If they are poor, it is only because they became disabled.

If I am a worker with a family to support and I make $11 per hour, or about $450 a week, my family is qualified to receive housing, food, medical and other assistance programs. I may be experienced in a few construction trades, but my tools were stolen last year. Perhaps I don’t have reliable transportation. I could make more money if I could get some tools or a more reliable car, but I can barely take care of my family. How can I get ahead?

A concrete contractor offers me a job paying $20 an hour for a project that will last the summer months for sure. However, the winter months may be a bit lean. The additional income will put me over the income threshold and my family will lose most of the benefits.

If I calculate the benefit my family currently receives in addition to my current $11 per hour wage as a janitor, I am receiving the equivalent of about $20 an hour. Even though I prefer to take the new job, I should continue to work at my current job for the sake of my family. Perhaps I can find a few jobs on the side, or “under the table,” but these are sporadic.

If I continue to stay out of the construction trades, my skills will atrophy. My self-confidence will erode. My kids will learn that they are the sons and daughters of charity parents.

The example above is all too common. If we had a gradual system of benefit awards, such a worker would be more inclined to take that better paying job. With a higher income, they might be able to get a loan for more reliable transportation. Their family might be able to afford more housing choices.

Who benefits under the current system? Whenever a poorly performing system stays in place, there is usually a small group of people who benefit under that system. They don’t want it to change.

Am I being a bit too cynical? No. It is Realpolitik. The practical benefits for one group of people outweigh any moral considerations by that group. In a later blog, I’ll look at who benefits from the current system.

Sacred Cow

October 22, 2017

Moo. One of the sacred cows of tax law has been the mortgage interest deduction. There is talk that the proposed Tax Reform law will erase this deduction. Who benefits from the deduction? Before I look at that, here’s some groundwork.

Two months ago the IRS released aggregated income tax data for 2015. Pew Research analyzed the data and produced this  chart of who pays how much in individual income taxes.   I took the liberty of marking up  their chart.


The Tax Reform bill that is being tortured to death in the back rooms of Congress proposes to double the standard deduction, making the first $50K that a couple earns tax-free. About 50% of tax returns will pay little or no federal income tax. That leaves the other half to pick up the tab for the 5% of taxes paid by the lower half of incomes. 1% of tax returns paid 40% of taxes in 2015 and they will argue that they are already paying their fair share.

As the Congress tries to craft a Tax Reform bill, one of the hot button topics is the mortgage interest deduction. According to IRS analysis of 2015 tax data, 33 million returns, about 20% of total returns, took the mortgage interest deduction totaling $304 billion, averaging over $9000, or $770 a month. The annual cost to the Treasury is about $70 billion in taxes not paid.

The bulk of this tax giveaway goes to wealthy families, but the program is popular among middle class families in expensive housing markets, particularly on the east and west coasts. The Tax Reform package proposes to double the standard deduction.  For many married couples, this would exclude another $25K of their income. This $25K is far more than the $9K average mortgage interest deduction.  However, there will be about 8 million returns, mostly wealthier Americans, who will pay more.  Those 8 million will certainly raise a campaign of alarm and outrage as they try to convince the vast majority of Americans that this reform is so un-American. Those in the real estate sector will claim that this will cripple a recovering homebuilding sector and prevent many American families from owning a home.  It won’t.  Each sector of the economy wants to preserve their tax carve outs because their business model has come to depend on it.

Notice that the analysis included effective, not marginal, tax rates. What is the difference? The effective rate is the net tax divided by adjusted gross income. It is the average tax paid for all the income received. For those who use tax preparation software, the program calculates the effective rate and prints it out on the summary page.

The marginal rate is the highest tax rate paid on the last dollar. When we hear someone complain that they are in the 33% tax bracket, for example, we think that the person pays 33% on all their income. They don’t. A two-earner family making $130K, filing jointly, two deductions, would be in the 25% bracket in 2017, but their effective tax rate is 12.89%, almost half of the marginal rate. (Dinky Town calculator)

Why is this important? Let’s return to the difference between effective and marginal tax rates. Let’s say our hypothetical couple making $130K wants to buy a new house for $300K. After $60K down, they will pay about $7800 per year in interest for the first 20 years of a 30-year mortgage (Zillow mortgage calculator). What they tell themselves is that they are “saving” over $160 per month, almost $2000 per year, because they are in the 25% tax bracket.

What is the fallacy? The couple assumes that the first dollars they earn buy the groceries, buy clothes for the kids, or make the car payment. It’s the last money earned, the money that is taxed at a 25% rate, that they will use to pay the mortgage. It’s sounds silly, but it’s effectively what we do when we use the marginal rate to analyze costs. Real estate salespeople sometimes use this technique to upsell a couple into a more expensive house, one that earns the salesperson a higher commission. If our couple uses the effective tax rate of less than 13%, the savings on that monthly mortgage payment is only $83. Many financial decisions are made “at the margin” but this is not one of them.

Also on the cutting board is a reduction in the amount of pre-tax contributions a person can make to a 401K retirement program.  Higher income earners would be trading in that tax break for lower tax rates, but the finance industry is sure to balk.  They make billions of dollars in administrative and trading fees for these retirement programs. In addition to the taxpayers who receive the benefits directly, tax breaks have protectors who benefit indirectly from the break. Together, this minority fights for their interests.

Soon after the last tax reform was passed in 1986, members of Congress began adding tax exclusions. Republicans may be able to pass a reform bill under a Budget Reconciliation rule in the Senate, which requires only a 50-vote threshold. Their slim majority in the Senate and a lack of cooperation from Democrats means that passage of a reform bill is vulnerable to just a few Republican defections. This is how health care repeal or reform was defeated earlier.  It can happen again.

The Poor and the Not Poor

October 15, 2017

No worries. Among the 25 OECD countries, Americans have historically had the lowest percentage of their financial assets in cash and savings deposits. After the financial crisis, we became the second lowest, just ahead of Chile. The percentage for the most recent available year (2015) was 13.5%.

In the heady optimism of the dot-com boom in 1999-2000, Americans had less than 10% of their assets in cash and savings. In the long downturn from 2000 – 2003, Americans bumped up their percentage in safe assets to almost 13%. As the economy recovered, that need for safety declined slightly but not to the levels of the 1990s. The financial crisis in 2008 caused Americans to reach for safety. Safe assets rose to 14.3% of total financial assets and we have still not recovered the level of confidence we once had.

You can click on this OECD link to see a comparison of current percentages. On the bottom right below the chart you can drag the year slider and look at some historical data.

Below the chart on the left is a category labeled “Perspectives.” Select “Total” to see total financial assets, which does not include home equity. Americans have the second highest total, just below Switzerland.

On the other hand, the U.S. has a comparatively high poverty rate of 17.5% using the OECD standard,  a simple measure that an economist would use.The poverty threshold is half the median income.

The U.S. publishes a poverty rate that is several percent lower because it uses a complex definition first set in 1963 when families spent an estimated 1/3 of their income on food. The complexity of the definition hints that politicians had a hand in crafting the definition but it is attributed to one person in the Social Security Administration, who based her standard on a combination of foods that the Department of Agriculture thought would meet minimum nutritional needs. The history of this standard and its many revisions is an interesting read.

The threshold is set at three times the cost of this 1960s era minimum food diet. Efficiencies in food production over the past 50 years have dramatically lowered food costs for U.S. families. In 1978, the BLS estimated that the average family spent only 18% of their income on food. In 2014, it was a bit more than 14% (BLS).

Using food costs as the basis for measuring poverty has enabled politicians in this country to claim success in lowering poverty over the past half century. In 1978, the calculation of the U.S. poverty threshold produced one that was slightly more than the OECD standard. Today, the U.S. threshold is 16% less than the OECD standard.

Let’s look at a family of four making $28K in 2016. They were above the official U.S. poverty threshold of $24,300 for a family of four. By the OECD definition, that American family was below half of the median $59K in income and would be counted as poor.

Housing costs are higher in urban areas, where half of the U.S. population lives. That family of four living in Chicago might pay $15000 per year for a 2 BR apartment in Chicago. Further south in the same state, Springfield, IL, they might pay $11,000. That $4000 difference in housing cost is not calculated into the poverty rate that the U.S. publishes. In effect, poverty is undercounted in urban areas and overcounted in rural areas.

The simplicity of the OECD standard better captures poverty among both urban and rural low-income families because it is based on median income. So why doesn’t the U.S. adopt this much clearer standard? We can turn to the last sentence of the previous paragraph for a clue. Politicians in rural areas want a standard that overcounts poverty in their districts. A higher headcount of poverty equals more subsidies for their constituents. When this standard was set, rural areas in the southern states were primarily Democratic and Democrats dominated the Congress under a Democratic President, Lyndon Johnson. Those politicians wanted the adoption of a food based standard that overcounted those voters.

Today, most rural areas are predominantly Republican and the standard works to the advantage of Republicans and the disadvantage of Democrats. As a rule of thumb, whenever we see excessive complexity in rule-making, there’s usually a very sound political reason for that obfuscation. Former President John Adams lamented this unfortunate characteristic of lawmaking in the crafting of the Constitution itself.

The intentional lack of clarity in lawmaking ensures that any nation’s population will be at odds with each other. A small and smart part of the population makes money from conflict and confusion. People argue on Facebook; Facebook makes money. Trump did what? There’s a video. Got to see that, right? Click bam boom, Google makes money by placing some ads next to the video.  Controversy is profitable. Politics as carnival show.

Crown Publishing, a division of Random House, publishes both the fringe right author Ann Coulter, and the way out on the left author and MSNBC host, Rachel Maddow. Worried that the liberals are taking over the country? Frightened that the conservatives will destroy the very institutions that have made America the greatest nation on earth?  Crown has something for you.

On the other hand, the record low volatility of the stock and bond markets in the past year have made it difficult for financial firms who depend on controversy to make a good profit.  Active fund managers have struggled to outperform their benchmark indexes.  The volume of derivatives and other products that insure against volatility have fallen.  People are not worried enough.  That’s the problem.  We need to worry about not being worried.

And those poor families?  If we lower the poverty threshold even more, we won’t have to worry about those poor people as much.

Young Beasts of Burden

October 8th, 2017

The Federal Reserve recently released their triennial survey of household income, debt and wealth. Rising asset values have lifted the fortunes of many, but younger families are struggling.  I’ll show a reliable indicator of recessions as well as some trends peeking out behind the numbers. The incomes below are denoted in inflation adjusted 2016 dollars.

The good news is that lower income workers have recently seen some income gains, which the Federal Reserve attributes to the enactment of minimum wage laws in 19 states at the start of 2017. However, single parent families have struggled with income gains, as they have for three decades. The decade from the late 1990s to the financial crisis in 2008 lifted the incomes of single parents but they have struggled during the recovery. Median incomes for this group remain below the 2007 level.


That this group needed back-to-back historic asset bubbles in order to see some income gains shows just how vulnerable they are.

Much has been written about income inequality among households. During booms, there is a growing inequality even among those in the top 10% of incomes. The median in any data set is the halfway point in the numbers, and is usually less than the average of the numbers. If the numbers are evenly distributed the median is closer to the average and the percentage of median to average is high.  When there are a lot of outliers that raise the average far above the median, as in home prices, the percentage is lower.  During boom times there is growing inequality, even among the top 10%  of incomes. (Data from survey)


The growth of inequality of income obeys a power law distribution. Think of a 1’x1’ square. The area is 1. Now double the sides to 2’x2’. The area quadruples to 4. Triple the sides to 3’x3’ and the area increases by a factor of 9. Let’s imagine that the area inside of a square is money. How fair is it that the 2’ square has four times the money that the 1’ square has? Politicians may pass tax and social insurance laws to take some of that money from the 2’ square and give it to the 1’ square.  The redistribution of income and wealth can’t change the fundamental characteristics of a power law distribution. Despite the political rhetoric, solutions are bound to be temporary.

The income figures most cited are for households but this data has only been collected since the mid- 1980s. A fall in real median income usually precedes a recession except for the latest fall in 2014 when oil prices began to slide.


Let’s turn to the data for family household income that has been collected since the mid-1950s. What is the difference between a household and a family? By the Census Bureau definition, a family household consists of at least one person who is related to the householder by blood, marriage or adoption. A fall in family income has preceded every recession except a mild one in the 1960s. Family incomes rose very slightly just before that recession, due in part to a new optimism about the presidency of JFK and the promise of tax cuts.


Because this family income data is released annually at mid-year, this indicator is usually coincident with the start of a recession. However, it has proven quite reliable in marking the start of recessions.

Non-family households are not related. This includes roommates or a childless couple living together but not married. Non-family households are generally younger and their income is less than the income of family households. Over the past three decades, the ratio of the incomes of all households to family households has declined.


Although younger people are experiencing slower growth in incomes, they will face increasing pressure to meet the demands of older generations expecting social insurance benefits like Social Security and Medicare. As the oldest Americans begin living in nursing homes in increasing numbers, they are expected to put an ever-growing burden on the Medicaid system (CMS report).  It is the Medicaid system, not Medicare, which covers nursing home costs for seniors after they have depleted their resources. Although the number of nursing homes and certified nursing home beds have declined slightly in the past decade (CMS Report page 21), Medicaid spending still increased a whopping 10% in 2015 as enrollment expanded under Obamacare.

Colorado Governor John Hickenlooper has said that many states are expecting an increase in Medicaid spending on nursing home care as the first of the large Boomer generation turns 75 at the beginning of the next decade. CMS expects total health spending to increase 5.6% per year for the next decade. The last time we had nominal GDP growth that high was in 2006, at the peak of the housing boom.

The demands of both low income families and seniors on the Medicaid system will strain both federal and state budgets.  The federal government can borrow money at will; states are constitutionally prevented from doing so.

What will drive the high growth needed to sustain the promises of the future?  New business starts are at an all-time low (CNN money). How did we get here? The financial crisis caused the failure of many small businesses, many of which are funded with a home equity loan by an entrepreneur.  Home equity loans are down 33% from their peak in early 2009. At the end of last year, the Case-Shiller home price index finally regained the value it had in 2006. In the past decade there has been no home equity growth to tap into.


Imagine a couple in their late 30s or early 40s who bought a home 10 to 15 years ago. They may have only recently recovered the value of their home when they bought it. One or both may long to start a new venture but how likely are they to take a chance? In some of the bigger metro areas where home prices grew much stronger during the boom, prices are still below their peak ten years ago.


The market has priced in a tax cut package that will lower corporate taxes. Investors are expecting a third or more of those extra profits in dividends. Investors are expecting a compromise that will enable companies like Apple to “repatriate” their foreign profits to the U.S. and for that money to be used to buy back stock or pay down debt, both of which are positive for stocks. The IMF projects 3.6% global GDP growth in 2018. There’s good cause for optimism.

Investors have not priced in the long term effects of this year’s hurricanes, the volatility of commodities, the future risk of conflict with North Korea, the risk that the debt bubble in China, particularly in real estate, could escape the careful management by the Chinese government. Add in the several fault lines in household finances that the Federal Reserve survey reveals and there is good cause to season our optimism with caution.

Individual investors surveyed by AAII are cautiously optimistic, a healthy sign, but the sentiment of actual trading by both individuals and professionals shows extreme optimism, a negative sign.  The VIX – a measure of volatility – just hit a 24-year low this past week, lower than the low readings of early 2007.  Sure, there was some froth in the housing market, investors reasoned at that time, but nothing that was really a problem.

Then, oopsy-boopsy, and stocks began a two year slide. So, don’t run with joy, Roy. Don’t go for bust, Gus. Pocket your glee, Lee. Stick with your plan, Stan. There are at least “50 Ways To Leave Your Money,”  and one of them is investing as though the future is predictable.


The Gravy Train

October 1, 2017

In the newly published “The High Cost of Good Intentions” author John Cogan relates a 230-year history of Federal entitlements, beginning with veterans’ pensions after the Revolutionary War. For 150 years the expansion of veterans’ benefits was prompted by budget surpluses brought on by high import tariffs. Each was targeted to a small number of soldiers who had died or become wounded during a war. Each program expanded into giant giveaways to any soldier or state militiaman and their wives.

Republicans expanded Civil War pensions to secure control of federal and state legislatures at the turn of the 20th century. Twenty years later, FDR and the Democratic Party used the same strategy of benefits to wrest control from Republicans.  First, the old system of service for benefits had to be curtailed. Like previous pension programs, benefits for WW1 veterans had been extended to those with non-service disabilities. Immediately after assuming office in 1933, FDR persuaded Congress to give him emergency authorization to alleviate the financial crisis. FDR eliminated almost a half-million veterans with non-service disabilities from the pension rolls and reduced pensions across the board. For the rest of the decade Congress tried to reinstate veteran’s benefits over the Presidential veto.

In 1934, the administration launched the New Deal, a series of programs to alleviate Depression-era hunger and unemployment. For 150 years, military service had been the prerequisite for federal benefits. Under FDR need, not service, became the primary requirement. An act of compassion quickly became a political tool that secured Democratic control at both the federal and state levels. Under the newly introduced Social Security program, a small amount of tax paid during the working years now entitled an older voter to federal pension benefits. No military service required.

For eighty years, benefit programs have become a political football. Two-thirds of the ten legislative increases to the Social Security program have occurred in election years. Today the total cost of entitlements is 60% of the $4.2 trillion in Federal spending.

If asked to list the federal entitlement programs, how many could we name? In addition to veteran’s benefits for service to the country, there are:
Income replacement programs like Social Security retirement and disability;
Income supplemental programs for poor families, such as the earned income tax credit (EITC), unemployment insurance, SSI and TANF;
Health insurance programs like Medicare and Medicaid, and the ACA’s health insurance subsidies;
Food assistance and price support programs like food stamps (SNAP) and child nutrition (WIC);
Business and individual loan guarantees and subsidized insurance programs including Sallie Mae education loans, FHA mortgage programs, and flood insurance subsidies.
This list does not include the many tax subsidies handed out by Congress.

I found that I could open this book at random and be both informed and entertained. Mr. Cogan combines an engaging narrative style and extensive research to construct an epic story of human need and greed, and the politics of pork.

I’ll turn to another book, “The Framer’s Coup” by Michael J. Klarman for some related backstory. At the Constitutional Convention in 1787, anti-Federalists objected to the “general welfare” clause of the proposed Constitution. What was to stop the Federal government from becoming a charity funded by taxes, they asked?

Nonsense, Constitutional delegates James Madison and Edmund Randolph countered, pointing to the enumerated powers in the Constitution as a restraint on the Federal government. Just as the anti-Federalists feared, the Court has long adopted a liberal interpretation of the Federal government’s enumerated powers. In the 1819 case of McCullough v. Maryland, Chief Justice Marshall set a precedent that the Congress could enact legislation that was “convenient or useful” to the exercise of its enumerated powers.  After that decision, then ex-President Madison admitted that if the Constitution had clearly stated the signers’ intention to firmly restrict the power of the Federal government, the Constitution would not have been ratified.

Turn the dial forward to the present. In the expansion of the welfare state during the 20th and 21st centuries, the Supreme Court has never found that the Federal government has exceeded its enumerated Constitutional powers. The most recent example was the Court’s finding that, under the enumerated power of taxation, the federal government could force people to buy health insurance under the ACA program.

The liberal interpretation of those two clauses – “convenient or useful” and “general welfare” – has unleashed the Federal government, whose agencies have become an omnipresent force in every American’s life. Each month, politicians in Washington take tax money from one set of voters and give benefits to another cohort of voters. Everyone  who receives benefits convinces themselves that they have paid into the system in some way. When it comes to tax money, it has always been better to receive than to give.

As the benefits to the receivers slowly exceed the taxes from the givers, there will be a crisis, and then some urgent half-baked legislative fix will be passed. I wish there was a better way.  Oh wait, I forgot.  There is a better way.  Paul Ryan, Speaker of the House, introduced the plan last year. Now that Republicans control the Presidency, Senate and House, they will fix the problem and avert a looming crisis of entitlements.  Silly me.  I can focus on the baseball finals now and stop worrying.