Tax Reform Winners and Losers

May 26, 2019

by Steve Stofka

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Did your head just explode? That’s how the tax code appears to many of us. This spring, many taxpayers sat down with their tax accountants and were informed that they were among the losers created by the tax reform act that went into effect for the 2018 tax year. Among the losers were employees who claim business expenses. In the western states, many in the construction trades may take a temporary job that is located a few hours from home. Instead of driving home every day, they share hotel rooms or live in campers during the work week and travel home on weekends to be with their family. Some employers pay per-diem expenses, but many smaller employers don’t. Under the old tax laws, an employee could deduct meals, lodging and ordinary living expenses away from home. Under the new law, employee business expenses are subject to a threshold that equals 2% of gross income (Note #1).

An employee with business expenses who has a family of four has discovered that they are the losers this tax filing season, the first one under the new tax law. Under the old law, that family of four used to get $12K standard deduction and $16K in personal exemptions. Now they get a $24K standard deduction and no personal exemption (Note #2). If they have employee business expenses that meet the threshold test, it may not be enough to exceed the new higher standard deduction. Some tax accountants report that their clients are shocked when they learn how much they owe in this first tax year under the new law.

In the future, some workers may be able to negotiate higher pay on these away jobs. Some will have to turn down such jobs.   

Corporate America was a big winner in the tax reform bill. In addition to lowered tax rates, low interest rates during the past decade have helped many publicly held companies buy back their own stock. The stock buybacks have accelerated this past year, with a record 25% of companies in the SP500 buying back their own stock, according to a Wall St. Journal analysis published this week. 

Don’t companies have a better use for the money? Apparently not. When companies buy back stock, they reduce the number of shares outstanding and increase the profit per share reported. In the first quarter of 2019, these buybacks lifted per-share profits by 4%. The share buybacks have distracted investors from the fact that corporate profits have flatlined since 2012.

Corporate profits flatlined during the Reagan administration in the 1980s. Investors bid up stocks on the promise that trickle-down policies and tax reform would break the cycle. Before profits did start to rise again, stock prices shook off their speculative pricing on Black Monday in October 1987. Let’s hope we don’t have a similar phenomenon this time.  

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Notes:

  1. Workplace expense deductions
  2. Tax law winners and losers.

Taxes – the Necessary Good

Taxes shall be levied according to ability to pay. – Franklin D. Roosevelt

August 19, 2018

by Steve Stofka

In the aggregate taxes are necessary and beneficial to everyone. Because Federal taxes act as a drain from the economic engine, they are different from state and local taxes. How those taxes are levied is a matter of policy debate, but they are necessary for the survival of a nation’s government and its economy. Revenue from natural resource production that is owned by a national government acts as a tax. Failing to understand that concept weakens and cracks governments around the world.

The inability to create money constrains state and local governments (Note #1). Taxes paid act as income for goods and services received from those governments. The Federal government has no such constraints. It does not need tax income as such. Rather, it must drain taxes to offset the amount of spending that it pumps into an economy. Inflation, the chief measure of extra money in an economy, rises when the Federal government doesn’t drain enough in taxes. As inflation rises, people turn to goods and service exchange that is not recorded and not taxed. The underground economy tries to offset the hidden tax of inflation.

As Venezuelans flee the runaway inflation in their country, they are running from too much spending and not enough taxation. Yes, it is counterintuitive. Venezuela owns the world’s largest reserve of oil. The net revenue from that oil competes with the taxes that a private oil company would pay to the government. The national government “owes” itself the tax revenues that it would have collected from a private company. Oil production has declined from 2.4 million barrels per day in 2008 to 1.2 million barrels in 2018 (see Note #2). Corruption and incompetence are the chief causes of the decline. Net oil revenue has declined by 95% from the bull market levels of the mid-2000s. Because the national government has not been paying their taxes, inflation has exploded the economy.

Because national politicians begin their careers in local politics, they regard a nationalized resource (NR) as a source of income, not an economic drain. That drain must be kept open through spending in oil infrastructure, training and transportation. In Venezuela, 2016 gross oil revenues were 20% of GDP and a net of less than 5% (see Note #3). Inflation taxes 100% of an economy. Because NR revenue acts as a pressure relief on inflation, that 20% portion of GDP affects 100% of the economy. A lack of understanding of the nature of a NR led to the crisis and decline of Great Britain in the 1970s, China in the 1960s and 1970s, and Zimbabwe in 2008.

How should a national government levy taxes on the taxpayers within the economy? FDR suggested “ability to pay.” For the past one hundred years we have measured ability to pay by income. Is that a good measure? French economist Thomas Piketty suggests that assets are a better measure. Local governments use this method to collect property taxes. Consider a retiree with $500K in liquid assets, who is taxed on $10K in interest and dividends earned each year. Clearly, the retiree’s assets are a better indication of his ability to pay. Should Congress abolish the income tax and tax people and corporations a multiple of what they pay in property taxes on their primary residence or business locations? Those living in high tax suburban and ex-urban areas might move toward lower-taxed urban areas. Would suburban areas actively recruit businesses to widen their tax base and lower property taxes? An intriguing thought.

Tax levies are the subject of endless debate because people cannot agree on what constitutes a fair tax. In the aggregate, the pressure reducing function of taxes benefits everyone, but is especially beneficial to those with less income. Should a national government impose a head tax on everyone? It could. That would amount to $15,000 per person this year, more than some families make. How does a national government extract tax money from its poor? It doesn’t. From 1958 – 1962, China forced taxes out of poor farmers in Mao’s Great Leap Forward (Note #4). Millions starved as a result.

Everyone should contribute equally to shared benefits, but practicality triumphs over principle. The survival of the national government becomes paramount. Some form of redistributive taxation must ensue. How to shape that redistribution? A government could take all the wealth of the ten richest people in America and still be short $3.8 trillion (Note #5). All the debate falls between total equality and total unfairness, and neither accomplishes the task of draining enough taxes out of the engine. A government could spend nothing: no defense, no research, no border or shore protection, no pension, medical or education spending. That’s a government in name only, and not for long. Other governments will want to capture control of that country’s resources.

The vast middle of the debate is an endless variety of proposals of “fairness” in both taxing and spending, a debate that has changed little since Cicero argued for his proposals in the Roman Senate in the first century B.C.E. What is not debatable is that a nation’s taxes must be roughly guided by its spending. A nation like Venezuela, which taxes half of what it spends, was headed for an economic tsunami of high inflation and inevitable collapse.

The debate is important. Just as it did in Rome two thousand years ago, consolidated party power corrupts. Because the current Presidency and House are held by the same party, we can expect a strong growth rate of net input, spending less taxes, and the data confirms the prediction. Net Federal input in the first full year of the Trump administration, April 2017 – March 2018, grew at a record-breaking annual pace of 19.6%, far above the sixty-year average of 8%. However – because Federal input has been so low this decade, the Federal government must continue this torrid pace of input in 2018 and 2019 just to reach the 8% average.

Republicans have held the House for the majority of the past three decades. Neither party agrees with the other party’s priorities, so the Republican strategy has been simple. They talk fiscal discipline and curtail Federal spending during Democratic administrations so that Republicans can spend big on their priorities when they have the Presidency. The Democrats did this for forty years when they held the House from 1954-1994 and will do so again when they have their next Congressional “run.”

To sum up: taxes are good, in general, but bad in the particular. No nation’s leader has stood on the world stage and said, “To tax or not to tax, that is the question.” For a nation and its economy, “to tax” is synonymous wtih “to be.”

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Notes:

1. Before the Civil War, each state controlled banking within its border (National Bank Act). For a deeper dive into state financing, try this Brookings Institute article.

2. A background paper on Venezuela oil (PDF). Crude oil production in the first quarter 2018 fell to 2.19 million barrels, a thirty-year low (Reuters). The Venezuela government spends more than 40% of GDP but collects only 20% in taxes (Statistica). During the 1997-2006 oil bull market, net revenues to the Venezuelan government averaged $20B per year (background paper above). Last year it was less than $1B. On August 20th, Venezuelans will lose their gasoline subsidies and pay a competitive price for gasoline (PDVSA article).

3. Gross oil revenue in 2016 was $48B, 20% of GDP of $236B (Reuters article). Exxon Mobil had a net profit of 6.5% in 2011. Venezuela would greatly benefit if the oil production was owned privately and paid 25-30% in income and other taxes.

4. Frank Dikotter was one of several historians afforded access to People’s Party records of the Great Leap Forward. He wrote an exhaustive account of human folly in Mao’s Great Famine .

5. Richest people in America  – Wikipedia 

Miscellaneous

Gold is down more than 10% in the past few months. BAR is a gold ETF launched in the past year. As an alternative to GDL and IAU, it has the lowest expense ratio at .2%. Here is a June 2018 article on the ETF.

Taxes – A Nation’s Tiller

Printing money is merely taxation in another form. – Peter Schiff

 

August 12, 2018

by Steve Stofka

The Federal government does not need taxes to fund its spending, so why does it impose them? Taxes act as a natural curb on the price pressures induced by Federal spending. Taxes can promote steady growth and allow the government to introduce more entropy into the economic system.

During World War 2, the Federal government ran deficits that were 25% of the entire economy (Note #1) and five times current deficit levels as a percent of the economy. Despite its monetary superpowers, the government imposes a wide range of taxes. Why?

Using the engine model I first introduced a few weeks ago (Note #2), taxes drain pressure from the economic system and act as a natural check on price inflation. During WW2, the government spent so much more than it taxed that it needed to impose wage and price controls to curb inflationary pressures. Does it matter how inflation is checked? Yes.

When price pressures are curbed by law, people turn to other currencies or barter. During WW2, the alternative was barter and do-it-yourself. Because neither of these is a recorded exchange of money, the government collected fewer taxes which further increased price pressure in the economic engine. After the war was over and price controls lifted, tax collections relieved the accumulated price pressures. As a percent of GDP, taxes collected were 50% more than current levels.

For the past fifty years, Federal tax collections have ranged from 10-12% of GDP, but they are not an isolated statistic. What matters is the difference between Federal spending and tax collections, or net Federal input. During the past two decades Federal input has become a growing share of GDP.

FedSpendLessTaxPctGDP

During the past sixty years, that net input has grown 8% per year. The growth rates have varied by decade but the strongest rates of input growth rates have occurred when the same party has held the Presidency and House. Neither party knows restraint. The lowest input growth has occurred when a Republican House restrains a Democratic President (Note #3).

FedNetInputGrowth

Let’s compare net Federal input to the growth of credit. As I wrote last week, the Federal government took a more dominant role in the economy in the late 1960s. By the year 2000, net Federal input grew at an annual rate of 10.3%, over one percent higher than credit growth. During all but six of those years, Democrats controlled the House and the purse. During those forty years, inequality grew.

FedNetInputCreditGrowth

During the 1990s and 2010s, government should have increased its net input to offset the lack of credit growth. To increase input, the government can increase spending, reduce taxes or a combination of both. When GDP growth is added to the chart, we can see why this decade’s GDP growth rate has been the lowest of the past six decades. It’s not rocket science; the inputs have been low.

FedNetInputCreditGrowthGDPGrowth

A universe with maximum entropy is a still universe because all the energy is uniformly distributed. At a minimum entropy, the universe exploded in the Big Bang. Too much clumping of money energy provokes rebellion. Too little clumping hampers investment and interest and condemns a nation to poverty. As an act of self-preservation, a government adopts redistributive tax policies. Among the developed nations, the U.S. is second only to France in the percent of disposable income it redistributes to its people (Note #4).

A nation can either tax its citizens directly, or add so much net input that it provokes higher inflation, which taxes people indirectly through the loss of purchasing power. Of the two alternatives, the former is the more desirable. In a democracy we can vote for those who spend our tax dollars. Inflation is both a tax and an unmanaged redistribution of money from the poor to the rich. How so? Credit is money. Higher inflation rates lead to higher interest rates which reduce access to credit for lower income households, and give households with greater assets a higher return on their savings.

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Notes:
1. Federal Income and Outlays at the Office Management and Budget, Historical Tables

2. The “engine” was first introduced in Hunt For Inflation, and continued in Hunt, Part 2 , Engine Flow , and Washington’s Role.

3. Federal spending less tax collections grew at a negative annual rate during the Clinton and Obama administrations. Both had to negotiate with a hostile Republican House in the last six years of their administrations.

4. “U.S. transfer payments constitute 28.5% of Americans’ disposable income—almost double the 15% reported by the Census Bureau. That’s a bigger share than in all large developed countries other than France, which redistributes 33.1% of its disposable income.” (WSJ – Paywall) The OECD’s computation of the GINI coefficient is based on disposable personal income, which is calculated differently in the U.S.

Miscellaneous:

Average GDP growth for the past sixty years has been 3.0%. The average inflation rate has been 3.3%. The 60-year median is 2.6%. The average inflation rate of the past two decades have been only 2.1%.

A good recap of the after effects of the financial crisis.

 

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.

TaxAnalysis2015Pew

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.

Income Distributions

February 7th, 2016

Updates on January’s employment report and CWPI are at the end of this post.  Get out your snowboards ’cause we’re going to carve the political half-pipe! (*v*)
(X-Game enthusiasts can click here)

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To Be Rich or Not To Be Rich

Every year the IRS takes a statistical snapshot of the almost 150,000,000 (150M) personal tax returns it receives.  There are some interesting tidbits contained in these tables that will put the lie to many a politician’s claim in this election season.  The IRS lists the number of returns for each of some twenty income brackets.  They also list the exemptions claimed for each of these income brackets and let’s turn to that for some interesting insights.

From Table 1.4 we learn that there were 290M exemptions claimed in the 147M tax returns filed in 2013, or almost two exemptions per return.  In 1995 (Table 1, same link as above) the number of exemptions claimed was 237M for 118M returns, exactly two exemptions per return. Exemptions are people that need to be fed, clothed, and housed.

Census Bureau surveys (CPS) over the past few decades show that households are shrinking.  Conservatives assert that median household income has stagnated simply because there are fewer people and workers in households today compared to the past.  If this were true, IRS data would show a greater decrease in exemptions over an 18 year period. We can’t say that one or the other data source is “true,” but that averaging data from the two sources probably gives a more accurate composite of income trends in the data.  Census data probably overcounts households while the IRS undercounts them.  Conservatives who advocate less government support will ignore IRS data that conflicts with their beliefs.

30% of the exemptions were claimed by tax returns with adjusted gross incomes (AGI) of less than $25,000, or less than half the median household income. (AGI is earned income and does not include much of the income received from government social programs.)  Only 2M exemptions, or 2/3 of 1%, were claimed by tax returns with an AGI of $1M or more.  Out of 315 million people in the U.S., there are only two million “fat cats” with incomes above $1,000,000.

Presidential contender Bernie Sanders tells his supporters that he is going to tax the rich to help pay for his programs.  IRS data shows just how few there are to tax to generate money for ambitious social programs. Mr. Sanders says he will get money from the big corporations.  Corporations with lots of well paid lawyers are not going to give up their money peacefully.

Instead, Mr. Sanders’ plans will rely on taxing individuals who can not erect the legal or accounting barricades employed by big corporations.  11% of exemptions were claimed by those making more than $200,000, a larger pool of potential tax money. Doctors, lawyers and other professionals will “Feel the Bern.”  It is not unusual for a middle class married couple in a high cost of living city like New York or Los Angeles to make $200K.  Mr. Sanders has his sights on you.  You are now reclassified as rich.

Here is a well-sourced analysis of the net cost to families.  Most will save money.  Unfortunately, Mr. Sanders made the political mistake of admitting that he would raise taxes, but…  No one paid attention to the “but.”  Should he win the Democratic nomination, Mr. Sanders will “feel the Bern” as Republicans use the phrase against him.  He might have used a phrase like “my plan will lower mandatory payments” to describe the combined effect of higher income taxes and no healthcare insurance payments.

The author calculates that the top 4% will spend a net $21K in extra taxes less savings on health care premiums.  The author probably overstates the effect on those at the top because he uses an average instead of a median, but we could conservatively estimate an additional $10K for those with AGIs in the $200K-$300K range.

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Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is  a reverse income tax for low income workers, who get a check from the federal goverment.  For the 2014 tax year, over 27 million returns received about $67 billion from the government for an average of $2400 per receipient (IRS).  In inflation adjusted dollars, this is up 50% from the 2000 average of $1600.  The number of receipients has expanded 50% as well, growing from 18 million to 27 million.  Although Democrats often tout their support for the poor, it is Republican congresses that are largely responsible for expanding this support for low income families.  Republicans may talk tough but are more than willing to reach out a helping hand to those who are giving it their best effort.  There is a practical political consideration as well.  An analysis of IRS data by the Brookings Institute found that, in the past fourteen years, the poor have shifted from urban areas largely controlled by Democrats to the outlying suburbs of metropolitan areas, where Republicans have more support. In short, Republicans are taking care of their voter base.

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Constant Weighted Purchasing Index (CWPI)

The manufacturing sector, about 15% of the economy, continues to contract slightly, according to the latest Purchasing Manager’s Survey from ISM.  The strong dollar and a slowdown in China have dragged exports down.   Extremely low oil prices have impacted the pricing component of the manufacturing survey, which has reached levels normally seen during a recession.

 

For some industries, like chemical products, the low oil prices have boosted their profit margins.  Most industries are reporting strong growth or at least staying busy.  Wood, food, beverage and tobacco manufacturers and producers report a sluggish start to the year, as reported to ISM.

The services sectors have weakened somewhat in the latest survey of Purchasing Managers, but are still growing, with a PMI index reading of 53.5.  Above 50 is growing; below 50 is contracting.  The weighted composite of the entire economy, the CWPI, is still growing strongly but the familiar up and down cycle of the recovery is changing.  Both exports and imports are contracting

The composite of employment and new orders in the non-manufacturing sectors has broken  below the 5 year trend.  It may turn back up again as it did in the winter of 2014, but it bears watching.

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Employment

Each month theBureau of Labor Statistics  (BLS) surveys thousands of businesses and government agencies to compute the number of private and public jobs gained or lost during the month.  The payroll processing firm ADP also tallies a change in private jobs based on paychecks generated from thousands of its client businesses.  If we subtract government jobs from the BLS total, we should get a total number of jobs that is close to what ADP tallies.  As we see in the graph below, that is the case.

Economists, policy makers and the media look at the monthly change in that total number of jobs.  This change is miniscule compared to the 121 million private jobs in the U.S.  A historical chart of that monthly change shows that BLS survey numbers are more volatile than ADP.

I find an averaging method reduces the monthly volatility.  I take the change in jobs as reported by the BLS, subtract the  change in government employment, average that result with the ADP report of jobs gained or lost, then add back in the BLS estimate of the change in government employment.  This method produces a resulting monthly change that proves more accurate in time, after the data is subsequently revised by the BLS.  Based on that methodology, jobs gains were close to 175K in January, not the 151K reported by the BLS or the 205K reported by ADP.

There was a lot to like in January’s survey.  The unemployment rate fell below 5%.  Average hourly earnings increased by 1/2%.  Manufacturing jobs added 29,000 jobs, the most since the summer of 2013.  This helped offset the far below average job gains in professional and business services.  Year-over-year growth in the core work force aged 25-54 increased further above 1%.

The bad, or not so good, news: job gains in the retail trade sector accounted for 1/3 of total job gains and were more than twice the past year’s average of retail jobs gained.  Considering that job growth in retail was near zero in December, this may turn out to be a survey glootch.  Food services were another big gainer this past month.  Neither of these sectors pays particularly well.  The jump in manufacturing jobs probably contributed the most to lift the average hourly wage.

The Labor Market Conditions Index (LMCI) is a cluster of twenty or so employment indicators compiled by the Federal Reserve.  December’s change in the monthly index was almost 3%.  In the forty year history of this index, there has NEVER been a recession when this index was positive.

We are innately poor at judging risk.  We derive indicators and other statistical tools to help us balance that innate human weakness with the strength of mathematical logic.  Still, people do not make money by NOT talking about recession.  NOT talking does not pay commissions, does not generate the buying of put options, expensive annuities, and other financial products designed to make money on the natural gut fears of investors.  Next week I’ll look at the price stability of our portfolios.

Re-pricing the Market

January 31, 2016

In the closing moments of one of the “big ape” films, the very large gorilla Mighty Joe Young saves the girl, placing her on a boat as an island in the Pacific, broken by a volcano, falls back into the sea.  The bandaged hand of the big ape reaching out of the roiling waters is the last we see of the movie’s star.

On Friday morning, the Bank of Japan (BOJ) surprised the world by cutting it’s funds rate to a negative .1% from a positive .1%, vowing to fight the deflation and lack of growth that has plagued the Japanese economy for two decades.  As the island’s economy collapses under the weight of its aging population and lack of immigration, the bank thrust its arm above the Pacific waters to save – well, the entire Japanese population.  Could be the script of another big ape movie or a Godzilla sequel.

The first estimate of fourth quarter GDP was released Friday morning and the news was not good, which meant that the news was good, get it?!  GDP growth for the last quarter was positive, not negative, but less than 1%, so traders figured that the Fed will not raise interest rates again in March.

#3 in the combination was positive earnings surprises from Microsoft and Facebook, among others. Thursday was the busiest day of the earnings season.  #4 The price of oil continued to climb above the near rock-bottom benchmark of $30.  All of these factors were the impetus for a stock market surge of 2-1/2% on Friday and helped soften a really bad start to the year.  For the month, the index fell 5%.  During the month, revisions to earnings estimates for 2016 fell about the same amount – 4.7% (Fact Set).  In short, the stock market re-priced itself.

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Taxes

As the primary season approaches and millions of Americans receive their W-2 earnings record in the mail, Americans turn their attention to the cheery subjects of incomes and income taxes.  Here’s a Heritage Foundation chart of the effective payroll tax rates and income tax rates for the five quintiles of Americans based on income.

Those in the lowest quintile making less than $25K pay a combined rate of 2.1%.  Those in the next quintile making less than about $47K pay a combined rate of 6.6%.  Those in the next higher quintile making less than $80K pay 12.2%.  The top two quintiles pay 14.7% and 21% respectively.  It is easy to understand why many in the upper quintiles feel that they are already paying their fair share of taxes.

The fault in these calculations is that they neglect the employer’s portion of the payroll tax which is paid indirectly by the employee in the form of a lower wage.  Including that portion would add another 7.5% to 8% to the lower quintiles, a bit less to the top two quintiles.  Here’s a chart showing the total payroll tax burden since the Social Security Act was passed in the 1930s.

Should the rich pay more in taxes?  Yes, says Democratic Presidential contender Bernie Sanders.  Many Americans do not realize that we are in the top 10% of global incomes, the world’s fat cats.  Should Americans pay a global fairness tax of 10% or so?  This money would then be redistributed to poorer people around the world.  That is the world that Mr. Sanders is aiming toward.

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Consumer Problem Survey

Over the past several thousand years people have developed numerous tools to predict the future.  Reading chicken bones, tea leaves and other forms of augery have given way to mathematical and statistical modeling.  The folks at Georgetown have developed a predictive tool to estimate consumer spending. Using a survey methodology researchers ask consumers what problems they have and which ones they are planning to solve in the coming months. These can be the payment of taxes, needing a new computer, iPad, or cell phone, the purchase of new home, etc.  Based on these responses, the researchers compile a Problem Driven Conumption Index (PDCI).  In the spring and early winter of 2014, the predictive index badly under-estimated retail sales.

However, the approach brings an essential understanding of the challenges American families face.  In a 2013 survey, respondents reported having many problems for which they see no solutions.  We learn that men and women have a few problems in common but confirm the axiom that each sex really does see the world differently.  The researchers are able to chart the shifting patterns of problems as we age.  This problems based approach is another statistical tool in the field of behavioral finance.

A Change Is Gonna Come

December 6, 2015

A horrible week for many families.  When we count the dead and injured in mass shootings, we often neglect to include the family and friends of each of these victims.  If we conservatively estimate 20 – 30 people affected for each victim, we can better appreciate the emotional and economic impact of these events. Shooting Tracker lists the daily mass shootings (involving four or more victims) in the U.S. in 2015.  What surprised me is that, in most cases, the shooter/assailant is unknown.

A strong November jobs report sent equities, gold and bonds soaring higher on Friday.  Markets reacted negatively on Thursday following a lackluster response from the European Central Bank(ECB) and comments by Fed chair Janet Yellen indicating that a small rate increase was in the cards at the mid-December Fed meeting.  The SP500 closed Thurday evening below November’s close.  Not just the close of November 2015, but also the monthly close of November 2014!

Overnight (early Friday morning in the U.S.), the ECB said that they would do whatever it took to support the European economy. Shortly after the cock crowed in Des Moines, the Bureau of Labor Statistics released November’s labor report, confirming an earlier ADP report of private job gains.  By the end of trading on Friday, the SP500 had jumped up 2%.  However, it  is important to step back and gain a longer term perspective.  The index is still slightly below February 2015’s close – and May’s close – and July’s close.

Extended periods of price stability – let’s call them EPPS – are infrequent.  Markets struggle constantly to find a balance of asset valuation. Optimists (bulls) pull on one end of the valuation rope.  Pessimists (bears) pull on the other end.  Every once or twice in a decade, neither bears nor bulls have a commanding influence and prices stabilize. Markets can go up or down after these leveling periods: 1976 (down), 1983 (up),  1994 (up), 2000 (down), 2007 (down), 2015 (?)

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Year End Planning

Mutual funds must pass on their capital gains and losses to investors.  Investors who have mutual funds that are not in a tax-sheltered retirement account should take the time in early December to check on pending capital gains distributions either with their tax advisor or do it themselves.  Most mutual fund companies distribute gains in mid to late December.  Your mutual fund will have a list of pending December distributions on their web site.  For those retail investors in a rush, you might just scan through the list and look for those funds that have a distribution that is 5% or more of the value of the fund, then look and see if it is one of your funds.

An EPPS tends to produce relatively small capital gains but this year some mid-cap growth funds and international funds may be declaring gains of 7 – 10% of the value of the fund.  An investor who had $50,000 in some mid-cap growth fund might see a capital gain distribution of $4,000 on their December statement.  When an investor receives the statement in January 2016, it is too late to offset this gain with a loss.  Depending on the taxpayer’s marginal tax rate, they could be on the hook to the tax man for $700 – $1200.

Let’s say an investor is anticipating a $4000 capital gain distribution in a taxable mutual fund in late December.  Most mutual fund companies list the cost basis of each fund in an investor’s account. An investor who had a cost basis that was higher than the current value of the fund could sell some shares in that fund to offset some or all of the capital gain distribution in the other fund.  This is called tax loss harvesting.  Again, remind or ask your tax advisor if you are unclear on this.

Here is an IRS FAQ sheet on capital gains and losses.  Here is an article on the various combinations of short term and long term gains and losses.

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CWPI

The latest ISM Survey of Purchasing Managers (PMI) showed that the manufacturing sector of the economy contracted in November.  October’s reading was neutral at 50.1.  November’s reading was 48.6.

The services sector, which is most of the economy, is still growing strongly.  Both new orders and employment are showing robust growth.   

However, manufacturing inventories have contracted for five months in a row.  For now, this decline is more than offset by inventory growth in the service industries.  However, the drag from the manufacturing sector is affecting the services sector.  The trough and peak pattern of growth in employment and new orders since the recession recovery in 2009 has begun to get a bit erratic.  Nothing to get too concerned about but something to watch.

The Constant Weighted Purchasing Index combines the manufacturing and service surveys and weights the various components, giving more weight to New Orders and Employment.  Both components anticipate future conditions a bit better than the equal weight methodology used by ISM, which conducts the surveys.  In addition, there is a smoothing calculation for the CWPI.

During this six year recovery, the CWPI has shown a wave-like pattern of growth.  Since the summer of 2014, growth has remained strong but there has been a leveling in the pattern as the manufacturing sector no longer contributes to the peaks of growth.

Despite the underlying growth fundamentals, there are some troubling signs.  In response to activist investors, to boost earnings numbers and maintain dividend levels, companies have bought back shares in their own company at an unprecedented level.  In some cases, companies are taking advantage of low interest rates to borrow money to make the share buybacks. (U.S. Now Spend More on Buybacks Than Factories, WSJ 5/27/15)

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Labor Report

46,000 jobs gained in construction was a highlight of November’s labor report and was about a fifth of all job gains.  Rarely do gains in construction outweigh gains in professional services or health care. This is more than twice the 21,000 average gains of the past year. The steady but slow growth in construction jobs is heartening but a long term perspective shows just how weak this sector is.

Involuntary part-timers, however, increased by more than 300,000 this past month, wiping out a quarter of the improvement over the past year.  These employees, who are working part time because they can not find full time work, have decreased by almost 800,000 over the past year.

The core work force, those aged 25-54, remains strong with annual growth above 1%.

Other notable negatives in this report are the lack of wage growth and hours worked.  Wage growth for all employees is a respectable 2.3% annual rate, but only 1.7% for production and non-supervisory employees.  This is below the core rate of inflation so that the income of ordinary workers is not keeping up with the increase in prices of the goods they buy.

Hours worked per week has declined one tenth of an hour in the past year, not heartening news at this point in what is supposed to be a recovery.  Overtime hours in the manufacturing sector has dropped 10% in the past year.

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Inflation

The core CPI is a measure of inflation that excludes the more volatile price changes of food  and energy.  While the headline CPI gets the attention, this alternative measure is one that the Federal Reserve looks at to get a sense of the underlying inflationary forces in the economy.  The target annual rate that the Fed uses is 2%.

October’s annual rate was 1.9%.  November’s rate won’t be released till mid-December. However, Ms. Yellen made it pretty clear that the Fed will raise interest rates this month, the first time since the financial crisis. I suspect that prelimary reports to the Fed on November’s reading showed no decline in this core rate.  With employment gains and inflation stable, the FOMC probably felt comfortable with a small uptick in the bench mark rate.

New Home Sales Sink

April 26, 2015

Housing

A few months ago sales of new homes per 1000 people climbed above the low water mark set during the back to back recessions of the early 1980s.  In a more normal environment, new home sales would be closer to 800,000, not 500,000.

This past week came the news that new home sales fell more than 11% in March.  The good news is that they were up more than 10% over this month last year.  The supply of new homes is still fairly thin, less than half a year of sales, so builders are unlikely to slow the pace of construction.  As new home sales were climbing this winter, sales of existing homes – 90% of all home sales – languished.  The process flipped in March as existing home sales surged, up 10% year over year.

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Long Term or Short Term

Somewhere I read that all investment or savings is a loan.  Loans are short or long term, principle assured or not.  When we deposit money in a checking or savings account, we are loaning the bank money, principle assured.  When we buy shares in an SP500 index mutual fund, we are loaning our hard earned money to “Mr. Market,” as it is sometimes called.  Principle not assured. We hope we get paid back with a decent rate of interest when we need to cash in our loan.  Most of us probably think that this type of investing is long term but, in this model, most stock and bond investments by individual investors are liquid, which is by definition short term.  Every month that a person leaves their money in a stock or bond fund, it is a decision to roll over the loan.  The value of our asset loan depends on the willingness of others to roll over their loans to that same asset market.  Occasionally many lenders to the stock and bond markets shift their concern from return on principal to return of principal and call in their loans.  When phrased this way, we come to understand the inherent fragility of our portfolios.

Because pension and sovereign wealth funds may carry a sizeable position in a market, the entirety of their position is not liquid.  Substantial changes in position will probably affect the price of the asset.  Even in a large position, however, there is a certain amount of liquidity because the fund can sell so many thousand shares of an asset without a material change in the price.  A family’s decision to leave their 401K money in a stock fund in any month, to roll over the loan, joins them at the hip with a sovereign wealth fund in Dubai or CALPERS, the California state employee pension fund.  They are all participants in the short term asset loan market.

In March 2000, at the height of the dot-com boom fifteen years ago, many investors were still loaning money to the NASDAQ market (QQQ).  This past month investors who had bought and held QQQ finally broke even on the nominal value of their loans.   The relatively small dividend payments over the years hardly compensated for the 27% loss of purchasing power during those fifteen years.  

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Taxes

Every facet of our culture seems to get a calendar month, so I guess April is tax month.  In that spirit, let’s look at some historical trends in income taxes.  In 2001, the Congressional Budget Office did an assessment of changes in Federal tax rates by income quintile for the years 1979 – 1997.   These are effective, not marginal, rates.  If someone makes $100K gross and pays $15K in Federal income tax, then their effective rate is 15%.

Effective corporate income tax rates went down for all quintiles while Social Security and Medicare taxes went up for those at all income levels.  The top 20% of incomes saw little change in their effective rates during this 19 year period, while everyone else enjoyed lower rates.  The reason why the top 20% saw little reduction was that their income grew faster than the incomes of those in the other quintiles.

The negative income tax rate for the lowest quintile was due to the adoption of the Earned Income Tax Credit and the increasing generosity of the credit given to low income families. (In 1979, a worker with three children received $1400 in 2012 dollars.  In 2012, they received $5,891, a 400% increase)

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International Currencies

This graphic from the global financial nexus Swift com shows just how much the US dollar and the Euro dominate international trade.  For those of you interested in international currency wars, you might like this Bloomberg article.

Bank analyst Dick Bove thinks that it is unlikely that the Fed will raise interest rates this year.  The U.S. dollar has gained so much strength that a raise in interest rates has too many dangerous implications for other economies and would destabilize global trade.

A well written, informative and entertaining read is James Rickards’ Currency Wars (Amazon).  The author, a former CIA agent, weaves a coherent and interesting narrative that connects a lot of information and events of the past one hundred years.

Manufacturing Muddle

December 5th, 2012

Tenaciously limping along like Chester on the western TV series “Gunsmoke.” On Monday, the Institute for Supply Management (ISM) released their November Manufacturing Index report, showing a very slight contraction.  The downward trend in manufacturing activity will continue to curtail any employment gains.  The monthly labor report from the BLS is due this Friday.

On the same day, Markit Economics and ISM released their November Manufacturing Purchasing Managers Index (PMI) report, a survey of purchasing managers at manufacturing companies.  An outlook into the near future, the survey showed a solid uptick this past month, giving some hope that the decline in manufacturing may be bottoming or turning upward.  For the first time in six months, exports increased;  new orders and employment showed a faster rate of expansion but inventories dropped a bit, showing that businesses are still cautious.

The manufacturing PMI for the Eurozone also increased but remains at recession levels.  The lackluster demand in Europe will crimp growth in the U.S. 

The effects of Superstorm Sandy continue to muddy both the analysis of existing data and forecasting near term trends but there are no strong signs of growth.

In Washington, the impasse over the fiscal cliff is not helping.  A hundred years ago the Sixteenth Amendment was passed, enabling the Federal Government to levy income taxes.  Until then, the Federal government had a rather limited say in defining “fair.”  The power to collect taxes on income began a century long debate over what is fair.  As any parent knows, each child has their own unique sense of fairness.  As children grow up to be adults, they retain this unique intuitive assessment of fairness, layering rationality on top of the child’s sense.  Thus we have as many definitions of fair as there are people in the world.  The debate will never end until the power to tax incomes is once again removed from the Federal Government, where there are just too many powerful people with too many contending definitions of fairness.  The fractiousness is hurting people and businesses.  Winston Churchill sensed something eternally and unfortunately true about us: “Americans can always be counted on to do the right thing…after they have exhausted all other possibilities.”
   

Tax Tinkering

Negotiations over a resolution to the fiscal cliff  met an impasse in the past week.  Republicans, mainly from states with low state and local taxes, would prefer to cap tax deductions for higher income taxpayers than raise the top marginal tax rate.  Democrats are strongest in those states with high state and local taxes; the higher income taxpayers in those states would really feel the tax bite if deductions for these taxes were capped at the federal level.  Both parties have become proxies for upper income earners yet neither will admit it because it doesn’t play well in middle America.  Democrats profess that their sole concern is the middle class; Republicans cite their allegiance to small business owners as the reason for their resistance to higher tax rates.

On the spending side, Democrats have not put forward any specific modifications to entitlement programs like Social Security, Medicare, Medicaid that they would consider – only that they would consider them.   Mostly they talk about preserving these programs even though no one has suggested getting rid of them.  Most of us sit in the back of this bus with a sinking feeling in our guts;  we see posturing and positioning from the Congress and the President in the front seats but the bus is not moving.
 
Some voices are calling for comprehensive tax reform as a final solution; others rightly scoff at the idea that a lame duck Congress can enact even a small bit of tax reform.   The task of tax reform is monumental – almost Sisyphean.  I have been reading a book about the last comprehensive tax reform that took place in 1986, “Showdown at Gucci Gulch”, by Jeffrey Birnbaum and Alan Murray.  The authors tell a detailed and well informed narrative of the dastardly dueling and dealing that occurs in any democracy when competing interests collide and collude in crafting a compromise.

Venture investors want low capital gains rates.  Companies whose revenues and profit depend on investments in equipment and materials want to protect tax breaks for their costs.  Unions want fringe benefits for their members to remain tax free.  Oil and gas companies want to shield their oil depletion allowances that permit them to exclude some of the taxable income they earn each year.  Insurance companies lobby to retain the tax free status of the cash build up on the life insurance policies they sell.  Realtors and home builders want to preserve the mortgage interest deduction; the Tax Policy Center reports that over 50% of the total of this deduction goes to the top 1/10th of 1% of income earners.  Charitable organizations and places of worship lobby for the preservation of the charitable deduction.

70% of taxpayers do not itemize and the vast majority of taxpayers who do itemize claim about $10 – $15K.  The top 1% of taxpayers claim on average about $120K in deductions.

Voters want results; the say they want compromise and some resolution to the political standoff that has been the status quo in Washington for the past two years.  Given the issues, interests and costs involved, finding a middle ground will be difficult.  The 1986 Tax Reform law was almost two years in the making, and soon after it was passed, Congress began to tinker with it.
 
535 elves, the members of Congress, tinker away in the workshop of the Federal Government, making thousands of tax toys for the citizens and businesses of this country; everyone wants  a toy, not a lump of coal.  It is unlikely that Congress can put together  a comprehensive tax package before January 1st.