Category: tax reform

Years Past

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December 31, 2017

by Steve Stofka

This past week, I found a July 2008 Wall St. Journal used as shelf liner. On the eve of 2018, a look back has some useful reminders for a casual investor.

Journal20080703

Most of us remember the financial crisis that erupted in September 2008. What we may not remember is that the first half of that year was very volatile. In reporting about the first half, there were “warnings of the collapse of the global financial system.”

In the first six months of 2008, 703,000 jobs had been lost. The job losses continued until March of 2010 and totaled a staggering 8 million. In early July 2008, the stock market had lost 16% from its high mark in October 2007 but a balanced portfolio of 60% stocks and 40% bonds had lost only 8%. To prepare for a difficult second half of 2008, investors were cautioned to:
1) Balance
2) Diversity
3) Spend less and invest more
4) Don’t pay high investment fees
5) Don’t get greedy and chase get rich investments

The advice is timeless.

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Tax Reform

In a holiday week, thousands of residents in coastal states lined up at their local tax assessor in order to pre-pay 2018 property taxes in 2017.  Most of these residents have annual property taxes that exceed the $10,000 cap on all state and local taxes that can be deducted on 2018 Federal taxes.

The IRS said that they would not allow deductions for prepaid taxes unless the local district had assessed the tax by December 31, 2017.  We may see lawsuits over the definition of the word “assess.” When is a homeowner assessed a property tax?  When they receive a bill?  When the district announces the rate for the following year?

In their battle against the IRS, Republicans have cut the agency’s funding so much that the IRS does not have the resources to perform audits on several hundred thousand to determine the status of assessment.  The courts will likely weigh in on the question.  Come next November, voters will register their opinions.

The New York Times featured a several question calculator  to estimate the effect of the tax bill on your 2018 taxes.

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Income

Economists have noted the decades long decline in inflation-adjusted wages.  Since 1973, the share of national income going to wages and salaries has declined by 14%.

WagesSalariesPctGDI

Employee benefits as a percent of gross domestic income have grown by a third since the 1970s. Of course, a person cannot spend benefits.

BenefitsPctGDI

Even after the increase in benefits, total income is down. In 1973, 50% of Gross Domestic Income (GDI) went to wages and salaries + 7.5% to benefits for a total of 57.5%. In 2016, 42% went to wages + 10% to benefits = 52%.  Total compensation is down 10%.

As the wealth of the affluent continues to grow, the ratio of net wealth to disposable income has reached an all-time high.

WealthPctInc
It is inevitable that extreme imbalances must revert to mean.  The last two peaks preceded severe asset repricings.

Taxes, Bitcoin, and Housing

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December 24, 2017

by Steve Stofka

Merry Christmas! Because of the holidays, I’ll keep it short. A few notes on the tax bill passed this week and some odds and ends I’ve collected.

In the final version of the tax bill, the state and local tax (SALT) deduction was limited to $10,000.  This limitation will hurt those in the coastal “blue” states.  As a group, these states already pay more in Federal taxes than they receive in various Federal programs.  The limit on the SALT deduction will take even more money from blue states and give it to red states. There is a second transfer taking place intra-state.

There are several components to SALT: income, sales and property taxes. According to the Census Bureau’s American Community Survey, almost 50 million households own a home with a mortgage.  Under current tax law, they get to deduct whatever mortgage interest they pay. Rich homeowners take the bulk of the mortgage interest deduction on their million-dollar homes.  50 million households rent. They get to deduct zilch.

For decades, homeowners have been in a protected class and able to deduct their property taxes. Renters have enjoyed no such deduction.  The owner of the building gets the deduction.  Think the owner is sharing that tax largesse by lowering rents?  No. For years, renters have effectively subsidized the tax deduction for their homeowning neighbors. The new tax bill transfers some of that tax burden from renters back to homeowners, putting both types of households on a more even level.

The density of coastal populations requires more infrastructure supplied by states, cities and towns.  Unless there is a natural resource like oil that can be taxed, local jurisdictions need higher taxes to pay for the added infrastructure. Secondly, the population density leads to more competition for land and housing, which causes higher property prices.  Even if New Jersey and Colorado charged the same property tax rate, the higher home prices in New Jersey would result in higher taxes.  But the two states don’t charge the same rate.  New Jersey averages almost twice the property tax rate charged by counties and towns in Colorado.

If you would like to compare property taxes in your state, county, or zip code with others, you can click here (https://smartasset.com/taxes/new-jersey-property-tax-calculator)

Democrats have long championed a graduated income tax, and the more graduated the better. The limit on the SALT deduction effectively levies more tax on those with higher incomes. That is the core principle of a graduated tax. Isn’t that what Democrats want?

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Bitcoin Bumps

After surging more than 2000% this year, bitcoin has fallen 40% this week, but is still up more than 1400% for the year. 80% of the trading volume this year has come from Asia. Japanese men have turned from leveraged forex trading to bitcoin and other digital currencies. (WSJ article)

As an exchange of value, currencies should be stable. When they are not, they have failed, and it is invariably due to a failure of government policy. Venezuela is a current example. From 2007-2009 Zimbabwe’s currency failed, and even today, they use the U.S. dollar. Germany in the 1920s is probably the most egregious example of a failed currency.

Bitcoin is not a currency. Bitcoin is an asset but barely that. Buyers of bitcoin and other digital “currencies” are buying a share in the “greater fool” theory. Yes, the concept is brilliant. Ledger transaction chains solve many problems in international exchange. But digital transactions take too much energy to serve as a currency. In the time that it takes to validate the transfer of one bitcoin, hundreds of credit card transactions take place.

Bitcoin is not secure. A South Korean bitcoin exchange went bankrupt this month when it was hacked, and its reserves stolen. (CNN article) . Mt. Gox is the most well-known bitcoin hack victim, but there are others (Top 5 Bitcoin Hacks ).

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Housing Prices to Income Ratio

New home sales in October were 10% above estimates. The average price of a new home hit an all-time high of $400K. The median price is $316K, more than five times the median household income. Here’s a graph of that housing price/income ratio for the past thirty years.

HomePriceIncomeRatio

The ratio first broke above 4 in 1987 and steadied for the next 13 years. During the housing bubble in the 2000s, the ratio rose swiftly and crossed above 5. As the bubble popped in 2007 and millions of people defaulted on their loans, the ratio fell as fast as it rose. Since the Financial Crisis, low interest rates have helped fuel another bubble.

The recent Case-Shiller housing index was higher than expected. Home prices are going up 6% per year, twice the rate of increase in incomes.

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I’ll have more next week on long-term trends in income and inflation. Have a merry and take care of year ending stuff this week! Those with high SALT deductions might consider paying 2018 property taxes in 2017 but there is some question whether the IRS will allow the deduction. See this L.A. Times article.

Tax Reform Is Calling

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by Steve Stofka

December 17, 2016

On our journey on the sea of life, we sometimes hear the siren call of politicians who promise simple taxes. “File your taxes on a postcard” their voices echo across the waters as they invite us to their island. Our journey is long and treacherous, so we are drawn to the prospect of simple tax filing.

Some taxpayer boats weave through the sharp rocks that lay just off the sandy shores of the simple tax island. They are greeted by the politicians who give them postcards to celebrate their arrival. Many boats are caught in the turbulent waters and are swallowed up by the tax monsters lurking in the sea.  “Alas!” they wail as they curse themselves for their attraction to the politicians’ call.

So the story goes with the tax bill that Republicans hope to pass next week. I didn’t think that the bill would get this far.

Many paycheck employees will find the new tax rule simpler. Student loan interest will continue to be an “above the line” deduction from income. The child tax credit will be doubled to $2000. To satisfy Republican Sen. Marco Rubio’s demands, more of this credit will be refundable to those taxpayers who pay little or no income tax.

Those in high tax states will suffer under the new tax bill, which allows only $10,000 in combined deductions for state, local and property taxes (SALT). Deductible mortgage interest will be capped as well. Tax policy has long subsidized homeowners over renters and favored those in coastal states (NY Times article).

Many taxpayers will find it more advantageous to take the newly doubled standard deduction of $24,000.  Under the new law, 529-college funds can now be used for K-12 tuition and qualified expenses.

Caught in the rocks and turbulent waters are professionals and business owners, who have adopted “pass-through” ownership structures to legally minimize taxes under current law. This group accounts for 30% of all business income. As this Journal of Accountancy article notes, court rulings and IRS guidance can be complex and contradictory. The new tax bill only complicates the familiarity of the existing complexity.

These non-paycheck earners receive all or part of their business income through a Sub-S corporation, an LLC, or partnership. Unlike a conventional C-corporation, these businesses “pass through” their profits to the owner/partners who pay at a personal tax rate. Under the new tax bill, some of that income may be subject to a 20% exclusion from taxes.

Under the new tax bill, the tax rate for C-corps will be reduced to 21%. Depending on individual circumstances, some owner groups may find it advantageous to adopt a C-corp ownership structure.

25 million sole proprietors  account for 11% of non-farm business income. Many are low-profit or part-time businesses which will remain sole proprietors. Higher volume businesses may want to revisit their ownership strategies with their accountants.

Corporations will benefit from the reduced tax rate but the accountants for publicly held corporations are dreading the prospect that the new tax law will be signed before the new year. Under GAAP accounting rules, those corporations must estimate the effect of the tax changes and present those estimates at the next earnings announcement which are scheduled for late January or February. Number crunchers can cancel that Cabo vacation during Christmas week.

The rich benefit because they pay an outsize portion of income taxes. According to the IRS (2016 tax stats on this page) , taxpayers with adjusted gross incomes (AGI) above $500K were only .8% of the 150 million individual returns. Their AGI was 19.4% of the $10 trillion in income reported, but they paid 36.5% of the $1.4 trillion in Federal income taxes.

TaxSumByAGI2016

These high incomes will get a reduction in taxes from 39.6% to 37%. The very rich – those with an AGI above $10 million – get half of their income from capital gains, which are not affected by the new tax law. Despite promising to do so, lawmakers did not reduce or repeal the 3.8% Obamacare tax on investment income for high income taxpayers. Based on 2016 tax data, they probably could not forgo the tax revenue and keep the ten-year cost of the bill under $1.5 trillion.

In short, the new bill will create two classes of taxpayers – the postcard and non-postcard payers. Some tax preparers and accountants may worry that the new law will reduce their business. Rest assured – Congress does not know how to write tax laws that are not complex. Thank God for politics!

Numbers and Feelings

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November 5, 2017

How do numbers feel to us? Numbers are hard like rocks. Feelings are squishy. Numbers are left-brained. Feelings are right-brained. Deep in the vaults of our brains, tiny elves translate one into another. Here’s an example.

This past week, House Republicans released an initial proposal of tax reform. A feature of the plan is the limitation of state and local tax deductions (SALT) to $10,000. Under current tax law, taxpayers have been able to deduct state and local taxes without limit.

This will hurt taxpayers in high-tax blue states which are overwhelmingly Democratic. Wisconsin, a purple state, is the lone exception among the top ten states (Forbes ranking of state tax burden).

Expecting no votes from Democrats in passing a tax reform/cut bill, Republicans included few provisions in the bill that would pacify voters in Blue Democratic states. Republican congresspersons in those states are faced with a dilemma. One Republican congressperson in New Jersey, one of the top high tax states, claimed that the average SALT deduction in his district was $21,000, more than double the allowance in the tax reform proposal.

Knowing that the SALT limitation will hurt their constituents, do Republican House members vote with their party or in the interests of their constituents? Numbers can make politicians anxious.

For some taxpayers in those states, the feeling is anger. “I don’t want to pay taxes on my taxes,” one New Jersey resident growled.

That same N.J. congressperson claimed that incomes less than $200,000 were middle-class. According to this calculator based on the Census Bureau’s Current Population Survey, an income of $200K is in the 97th percentile of all incomes. Less than 3% of households have incomes greater than $200K. Hardly middle-class.

What is middle class? Some studies use the 25th – 75th percentile. Some use the 30th – 80th percentile. Using the latter definition, 2016 incomes from $24,000 to $75,000 were considered middle-class. These classifications use national data. Many coastal states have far higher incomes and living costs.

People living in some east and west coastal states feel middle class even though the income numbers do not classify them as such. Take for example, a household in Silicon Valley, where the median household income is almost $100K,  $40K more than the national median. They are rich, right?

Not so fast. The median price of a home in Santa Clara County (San Jose) is almost $1.2 million (See here ). Spending $40,000 annually for housing on an income of $95,000 feels middle class. The percentage of housing cost to income, 42%, is far higher than the 30% HUD guideline, and is more typical of poor working-class families.

Californians have counties with the highest incomes in the U.S. – and some of the poorest. The state has a median household income that is 12% higher than the national average.

CalUSHouseholdIncComp

But that’s not how it feels. That extra income is eaten up by higher housing costs, high car insurance premiums, and higher taxes at all levels. California sends about 12% more taxes to Washington than it gets back in various national programs. The additional federal taxes paid by higher income coastal states helps pay for benefits to those in lower income states, particularly those in southern states. Blue states subsidize Red states.

The Red states control the national agenda in Washington. The Republican tax proposal in its current form takes tax pebbles from the Red scale and puts them on the Blue scale. That feels spiteful.  Voters in those Blue states feel angry.

Interest groups around the country feel angry. The National Association of Home Builders claims that the SALT limit will lower home valuations, particularly in coastal states. They have promised a considerable effort and expense to defeat this version of the tax proposal.

When I recalculated my family’s 2016 taxes using the new proposal, we saved $752, a bit less than the $1200 average savings for a family of four. The monthly tax savings – the numbers – are relatively small. I feel neither angry or joyful. Those of us who are little affected by the proposal are unlikely to raise our voices in protest or support.

Angry people act. They call, they shout, they organize.

Joyful people – the CEOs of large corporations who will benefit greatly from this proposal – are not shouting. They calmly make claims that lower taxes will create more jobs, although the evidence is rather weak. They are organizing. They are calling talk shows. But most of all they are donating.

Political donations can speak more loudly than the shouts of angry people. In the political game of Rock, Scissors, Paper, cash covers a rock thrown in anger. Angry people must take up the more precise and patient tool of the scissors if they hope to best cash in a contest.

Lastly, this tax proposal further divides earners into groups. Income earners above the median will learn that this $1 is not the same as that $1 to the taxman.  According to an analysis done for the Wall St. Journal,
The $1 earned in wages and salary will be taxed more than
The $1 earned by the small manufacturer, which will be taxed more than
The $1 earned by the real estate investor, which will be taxed more than
The $1 earned by a stock or bond investor, which will be taxed more than
The $1 paid to an inheritor, who will pay $0.

Republicans criticize the identity politics practiced by Democrats. With this tax proposal, Republicans have stamped identities on the very $$$$ we earn. Those numbers don’t feel good.

 

 

It’s Only Money

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September 24, 2017

Republicans in Congress hope that they can enact comprehensive tax reform that will lower taxes for individuals and corporations. The Congressional Budget Office estimates  that, under current law and before any tax reform, the current $20 trillion deficit will grow to $30 trillion by 2026. They recommend a combination of decreased spending and increased revenue that would amount to $620 billion (in current dollars) annually, about 15% of current Federal spending of $4.2 trillion. CBO’s goal is to achieve a level of public debt to GDP that is about 40%, the 50-year average.

Lawmakers struggle to cut even 5% of spending but let’s assume that they could accomplish that and reduce spending by $210 billion. That might be the easier task. The Federal government is currently collecting 18.5% of GDP in taxes, a few tenths more than the 18.2% collected during the Reagan years. The CBO says that the dollars collected is not adequate to meet the Federal government’s current level of spending and obligations and they project that annual deficits will increase over the next decade. The 70-year average of federal revenues is 17.5% of GDP.

FedRevPctGDP

Raising an additional $410 billion, or 10% extra in revenue, will require raising taxes or increasing GDP. Republican lawmakers and some economists hold fast to a theory that reducing tax rates will increase economic growth. To raise an additional $410 billion for a total of $4 trillion dollars, and collect the 50-year average of 17.9% of GDP in tax revenue, GDP next year would need to be almost $23 trillion, a whopping 20% increase from the 2016 level of $19 trillion. No amount of tax decrease will spur that much growth. A Republican Congress will not pass a tax increase.

In a recent Senate budget committee hearing, I was surprised to learn that half of the cost of corporate taxes is borne by the workers, as estimated by the Tax Foundation. The OECD finds that corporate income taxes are most injurious to people’s incomes and is why most developed countries have lower corporate tax rates than the U.S. These countries augment their revenues with a consumption tax, most often a VAT, or value added tax. Another surprise: consumption taxes are less of a burden to a worker than higher corporate taxes.

The founding of this country was instigated by a protest over a tea tax. In the Framer’s Coup, Michael Klarman relates the bitter debates over slavery and taxes at the 1787 Constitutional Convention. 230 years later, the debate over slavery may have ended but the debates over taxes are just as ferocious.

Since last November, the stock market has priced in the probable passage of tax reform by the end of this year or early next year. Republican lawmakers have been unable to repeal Obamacare and I think they will have an equal amount of difficulty passing tax reform.

CBO budget projections restrain the freedom of lawmakers to enact their favorite theories. Lawmakers are highly motivated to answer the whoops and hollers of their voters, many of whom may not be interested in the achingly dull but necessary procedures of budget craft. The parliaments of European governments can enact sweeping legislative changes that are difficult under our federalist system. The U.S. chose a different path of checks and balances embedded in a Constitution hammered out by compromise and a suspicion of human beings given legislative power. Time and time again we are reminded that those suspicions were well founded. Voters and lawmakers may become frustrated with the procedural obstacles of crafting legislation but the U.S. Constitution is the longest living Constitution because of those obstacles.

History lesson done. Stock investing lesson: don’t count your tax reform before it hatches.

Caution: Strong Growth Ahead

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This week, the Congressional Budget Office (CBO) released their estimate of the fiscal impact of the AHCA, the draft version of the Republican health care reform plan. I’ll take a look at the CBO methodology later in this post. For those who may be tiring of the almost constant focus on the AHCA, let’s turn our attention to some economic indicators.

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CWPI (Constant Weighted Purchasing Index)

February’s survey of purchasing managers (PMI) indicated a broad base of confidence among purchasing managers in most industries. New orders in manufacturing are surging, an expansion more typical in the early stages of recovery after recession. Regardless of how one feels about Trump, there is a sense of renewal in the business community. Consumer Confidence is at record highs. Confident of finding another job, the number of employees who are quitting their jobs is at a 16 year high.

The CWPI is a composite of both the manufacturing and non-manufacturing PMI surveys and is weighted toward the two strongest indicators of future growth, employment and new orders. Since October, the composite has been rising from mild to strong growth.

CWPI201702

For most of 2016, new orders and employment were below their five year average.  Since October, they have been above that average.

EmpNewOrders201702

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Housing

The Housing Market Index released by the National Assn of Homebuilders just set a multi-year record. Housing starts are strong and single family homes under construction are the best in ten years. A popular ETF of homebuilders, XHB, is nearing a recovery high set in August 2015. 58,000 construction employees found work during a particularly warm February. Now the big picture. As a percent of the working age population, housing starts are still at multi-decade lows.

HouseStartsPctWorkPop201702

There has been an upshift toward multi-family units in some cities but, in a broad historical context, these are also near all time lows as a percent of the working age population.

MultiFamPctWorkPop201702

A primary driver of new housing construction, both single and multi-family, is the growth in new households, which is still soft. In 2016, households grew by 1%, below the 30 year average of 1.2%, and far below the 70 year average of 1.7%.

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Consumer Credit

Here’s an interesting data series from the FRED database at the Federal Reserve: the percent of people with subprime credit in each county. Click on the link and zoom in to see the data for a particular county. In New York City, Manhattan has a 16% subprime rate, less than half the 35% rate of the nearby Bronx. Give the link a few seconds to load the data and display the map.

Subprime

On July 1st, the credit rating agencies will remove tax liens and judgments from their records if liens do not include the full name, address, SSN or date of birth of the debtor. This will raise the credit scores of hundreds of thousands of subprime consumers.

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Real Estate Pricing Tool

Trulia has a heat map, by zip code, of the median home price per square foot. I will include this handy tool on the tool page.

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IRS Data

Of the 145 million returns filed, 46 million itemized deductions. Under the Republican draft of tax reform (PDF), almost all deductions would be eliminated in favor of a standard deduction that is almost twice as large as current law, $12,000 vs. $6300. (Deductions, Child Credits ). Half of capital gains, interest and dividends would not be taxed. For most filers, the dreaded 1040 tax form is only 14 lines. Publishers of tax software like Intuit are sure to lobby against such simplicity.

BetterWayTaxForm.png
Health insurance reform is the prerequisite to tax reform.  If House Speaker Paul Ryan encounters strong resistance in his own party to health insurance reform, his tax reform plan will be stymied as well.

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AHCA

This past Monday, the Congressional Budget Office released their “score” (summary report and full PDF report) of the American Health Care Act, or AHCA. Score is a euphemism for the 10 year cost estimate that the CBO customarily gives on proposed legislation.

The CBO was careful to stress the uncertainty of their estimate. A critical component is the human response to changing incentives and the tentativeness of future state legislation. With most major legislation, the CBO estimates the macroeconomic effects. They did not include such an analysis in this report and note that fact. In short, the CBO is saying “take this estimate with a grain of salt.”

The headline number was the amount of people estimated to lose their health insurance over the next ten years – a whopping 24 million. Democrats used this ballpark estimate as a defining fact as they bludgeoned the plan. How did the CBO come up with their numbers?

Medicaid is the health insurance program for low income families and individuals.  When the program was introduced in 1965, enrollment was 1/4 million.  Today, 74 million are on the program.  The federal government and states share the costs of the program; the federal share averages 57%. Under the ACA’s Medicaid expansion, low income individuals younger than 65 without children could enroll.  An increase in the income threshold enabled more people to qualify for the program.  The federal share was guaranteed to not fall below 90% of those individuals enrolled under the expansion guidelines.

Medicaid (CMS) reports that 16.3 million people were added to Medicaid under the ACA expansion program and represent almost 75% of all enrollment under ACA. California has 12% of the U.S. population, but accounts for more than 25% of additional enrollees under Medicaid expansion. (State-by-state Medicaid enrollment ) Only 31 states adopted Medicaid expansion. The CBO estimates that those 16.3 million are 50% of the total pool of individuals that would be eligible if all states adopted the expansion program. So the CBO estimate of the total pool is almost 33 million.

Undere current law, the CBO estimates that additional states will adopt expansion so that 80% of the estimated total pool, or 26.4 million, will be enrolled under Medicaid expansion by 2026.  Under the AHCA, the CBO estimates that only 30% of that eligible population of 33 million, about 10 million, will be enrolled as of 2026. 26.4 million (under ACA) – 10 million (under AHCA) equals 16 million whom the CBO estimates will lose coverage under Medicaid. Note that this is a lot of blue sky math.

To summarize the ten year loss estimate under the rollback of Medicaid expansion: 6 million current enrollees and 10 million anticipated enrollees.

Medicaid expansion accounts for 16 million fewer enrollees. Where are the remaining 8 million missing? In the non-group private market. Currently, there are 11.5 – 12 million enrolled in these individual plans, an increase of about 5 million over the 6.6 million enrollees in 2007 (Health and Human Services brief) . The CBO estimates that, in 2018 and 2019, 2 million additional enrollees would take advantage of the ACA subsidies to buy policies. That results in a potential pool of about 14 million. Under the AHCA, the CBO estimates that the non-group private insurance market will return to its former level of 6 – 7 million, a loss of about 8 million.

Voila! 16 million under Medicaid expansion + 8 million in non-group private insurance = 24 million loss.

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Side Note

How do people get their health insurance?
74 million people, about 25% of the population, are enrolled in Medicaid. Half of Medicaid enrollees are children.
55 million, about 16% of the population, are on Medicare.
Over 150 million, or 50% of the population, are enrolled in an employer group plan (Kaiser Family Foundation).
Approximately 27 million, or 9% of the population, are uninsured.

Before the ACA, almost 50 million, or 16% of the population, were classified as uninsured. About 6 million of these uninsured had high deductible insurance plans called catastrophic plans. Offered by large insurance companies, they contained exclusions for pre-existing conditions, did not cover pregnancy, or mental disease, but were adequate for many self-employed tradespeople, contractors, consultants and farmers. (Info) In late 2013, the ACA redefined catastrophic plans by specifying the minimum benefits that a catastrophic plan must offer and, in 2014, began offering these plans through the state health care exchanges.

Border Adjustment Tax

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March 5, 2017

Gary Cohn,  President Trump’s Chief Economic Advisor, says that the Border Adjustment Tax (BAT) is off the table. This is a key revenue raiser, a hidden tax, in the Republican scheme to lower corporate taxes. We will continue to hear about BAT as the fight over tax reform heats up. What is it and how will it affect American families?

First, a bit of context. Most other developed countries have a VAT, or Value Added Tax, on purchased goods and services. In the EU most VAT taxes range from 20-25%. In America, we have state and local sales taxes that might add as much as 8 – 10% to the cost of a good. A VAT is like a Federal sales tax of 20%.

Unlike a VAT tax that affects most goods and services, the BAT will affect only imported goods. Here’s an example of the BAT tax using Big-Box as an example of a large merchandiser similar to Wal-Mart.

Big-Box imports a DVD Player for $80 (Cost of Goods Sold) and sells it for $100, making $20 gross profit. It has $5 other costs which are deducted from gross profit to reach a taxable profit of $15. Let’s say that Big-Box’s effective Federal tax rate is 30% (27.1% per Congressional Research Service). $15 taxable profit x 30% = $5 (rounded) Federal Tax.  Big-Box has a net after-tax profit of $10, or 10% of the retail price.  Remember that.  Current law = 10%.

Under the BAT proposal, Big-Box could not deduct the $80 it paid for the good because it is an import. Big-Box’s gross profit is now $100. Subtracting the $5 other costs, the taxable profit is $95. Multiply that by a lower 20% corporate tax rate and the Federal tax is now  about $19, far more than the $5 using the current tax system. Big-Box paid $80 cost + $19 in tax = $99, leaving them a gain of $1, or 1%.  Current law = 10% profit.  Proposed law = 1% profit.

For Big-Box to make the $10 after-tax profit it has under the current tax system, it would  need to raise the price of the DVD player about $15.  After paying a 20% tax ($3) on the additional revenue, it will net an additional $12. So the customer now pays $115 for a DVD player that used to be $100.  No change in quality.  Just an extra $15 out of the consumer’s pocket for an imported CD player.

What if Big-Box buys the DVD player from an American supplier for $100?  Under BAT, the $100 direct cost of the DVD player would be deducted from the sale amount, giving Big-Box a tax CREDIT of $20 ($20%).  The after-tax cost of the player is now $80 direct and the same $5 indirect cost = $85. To make a $12 net profit as under the current system, Big-Box could sell the DVD player for $97 and undercut another vendor selling the same DVD player for $115.

In theory, customers would rush to the vendor selling American DVD players. BUT, there is only one DVD manufacturer in the U.S. (Ayre Acoustics) and we don’t know how many parts of their product are imported.  The transition could take years and consumers will pay more for many household goods during that time.

Some products can only be imported.  Most of the lumber used to build homes is imported from Canada.  This hidden tax will be added onto the prices of homes and remodels.  Most diamonds are imported and will bear this hidden tax.  Businesses will lobby to have their product excluded where there is no alternative to an import.  This will be a boon for lobbying firms.

Businesses, particularly durable goods manufacturers, anticipate a complexity in this new tax. Planes, cars, boats, sporting goods and appliances are made with parts from a variety of countries, including the United States. Assessing the component value of imports and exports may require a judgment call by the company, and that is subject to dispute with the IRS. This is sure to become a headache.

Should the BAT become law, customers who have benefitted from the lower prices of imported goods are sure to complain loudly at the higher prices. Retailers have opposed the scheme. Republicans are promising tax cuts for middle class households but the tax reduction won’t offset the extra cost of many household goods.

Republicans have long resisted tax increases in their effort to shrink the size of the government yoke on American families. Many have signed a pledge not to raise taxes. To avoid any appearance of raising taxes, Republican lawmakers had to hide the tax and this was the best they could do.

Side Note: Why not just add the extra $20 as an import tax, or duty? Import taxes are paid to the government by the importing company of record when the goods are received in the country. Even if an item sits in a warehouse as inventory, the import duty has been paid, creating a cash flow problem for companies. With both VAT and BAT taxes, the tax is not charged until the good or service is sold.

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IRA Contributions

Did you put off making your IRA contribution for 2016? In May 2011, I compared several “timing” scenarios of investing in an IRA for the years 1993-2009.The choices were making a contribution on:
1) July 1st, the middle of the tax year;
2) January 31st following the tax year;
3) April 15th following the tax year

The 1st option had a 2.5% advantage over the 2nd option because of the longer time frame invested. An even greater advantage was an option not on this list. Contributing an equal amount every month produced a 4% greater gain over the first option.

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Stand up or Sit Down

The Bureau of Labor Statistics published a study  of  the time workers spend standing/walking or sitting. The average worker spends 3/5th of their time standing or walking.

timestudy
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Education in the 21st Century

“Education technology is like teenage sex: everyone talks about it, nobody really knows how to do it, everyone thinks everyone else is doing it, so everyone claims they are doing it…”

That’s just one quote from this TechCrunch article on the investments needed in K-12 and higher education. The author feels that the appointment of Betsy DeVos as Secretary of Education will break up a coalition of interests that has stymied the adoption of technology in classrooms.

Readers who do not support Ms. DeVos may still find themselves in agreement with the author’s comment that “in both K-12 and higher education, technology remains supplemental to chalk-and-talk practices as old as the hills, and not much more effective from a pedagogical standpoint.”

Those who are sympathetic to teacher’s unions will bristle at this comment: “In K-12, the most promising applications of technology have been found most consistently in private and charter schools — freed from the strictures of teachers unions.”

The author discusses a new “10/90” proposal to give higher education institutions some “skin in the game.” Under an Income Share Agreement (ISA), higher education schools would contribute 10% of the amount of every federal loan. After graduation, students would make loan payments based on a fixed percentage of their income for a fixed number of years, with a clear cap on the total amount paid. The schools would recap their money ONLY if students graduated and would thus be more invested in the future of their students.

Sales Tax Collections

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January 8, 2017

The New Year begins, the 9th year of this blog that began during the financial crisis.  For two decades I had studied financial markets but the financial crisis surprised most people.  This was my attempt to organize and share my thoughts.

Sales Tax Collections

Let’s look at a data point that has been a consistent indicator of economic health – sales tax collections. This is not survey data or economic estimates but actual tax collections based on consumer purchases. For the first 3 quarters of 2016, sales tax collections are up 1.6% above the same period in 2015. (Census Bureau)    As we will see, this tepid growth rate does not compare well with the historical data of the past 25 years.  Below is a quarterly graph of sales tax collected in the 50 states.

As we can see in the graph above, the 2nd quarter (orange bar) is the highest each year, and is a good indicator of consumer activity and confidence. Since population growth is about 1%, the annual growth of sales tax collected should be above that mark to be effectively positive.

In the graph below, we can see negligible or negative growth in 2001, 2008 and 2016. In 2001 and 2008, we were already in recession, although it took the recession marking committee at the NBER almost a year to declare the beginning of those recessions.  By selecting the 2nd quarter growth rate in the historical data, we can more easily see the weakness at the start of an economic downturn.

In retrospect, 25 years of data is rather sparse.  We can only hope that this year’s lack of sales tax growth may turn out to be a warning sign only, a fluke.  Third quarter tax collections were effectively positive, but only 2% growth, and that annual growth has consistently declined in the past three years in a pattern exactly like the weakening of 2006 – 2008.

Of particular note in the graph above is the steep 10% drop in sales tax collections in the second quarter of 2009. Fom a vantage point eight years in the future, we may have forgotten the degree of fear during the winter of 2008-2009.  The American people were holding onto their money.  State budgets were crippled by the lack of sales tax collections, an important and ongoing source of revenue for state and local governments.

See end for a side note.

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Population Growth

Business Insider published a chart of 2015-2016 population data from the Census Bureau.  We can see a clear shift from the northern states to the mountain and southern states.  Retiring boomers, who want to maximize their fixed incomes, will shift from states with high state income and property taxes like New Jersey and New York, and move to states with lower taxes.

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Tax Reform

In a few weeks Republicans will control the legislative machinery, and have promised  tax reform that, after thirty years, is overdue.  One of the proposals on the bargaining table is the end of the home interest deduction, which prompted this blog post at Slate.  The author contends that the elimination of this deduction will hurt middle class homeowners, who will see the value of their homes decline by 7%.

I’ll add in some contextual data from the IRS.  In 2011, 22% of the 145 million (M) returns claimed mortgage interest totalling $321 billion. ( IRS tax stats Table 3) People making a middle class income of less than $100K claimed half of that interest – 14% of all returns.  The average interest deduction for these middle class households was $8100.

Two million returns with incomes of $500K and above claimed $46B in mortgage interest, about 15% of the total interest claimed.  For these high earners, the average deduction was $20,000.

The tax reform of 1986 eliminated the interest deduction on credit cards and cars, but lawmakers could not go the final distance and squelch the home mortgage interest deduction.  At the time, auto dealerships complained that, without the interest deduction on new car loans, their business would suffer.  Tax subsidies affect both consumers and the businesses who are indirect recipients of the subsidy. Should 78% of taxpayers subsidize the housing costs for 22% of taxpayers?   Certainly, the 22% appreciate the subsidy! The real estate industry continues to resist any tax changes that might have a negative impact on their business.  Each industry deserves a subsidy of some kind because that industry is important to the overall economy – or so the argument goes.

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The End of Capitalism – Almost

Let’s get in the wayback machine and dial in 1997.  The dot-com boom is not yet a bubble but is growing.  Cell phones are growing in acceptance but the majority of people do not have one.  A one year CD is paying more than 5%.  The unemployment rate is about the same level as today (2016).  What is very different between then and now is the number of publicly traded companies.  In 1997, there were over 9000 listed companies.  Today, there are about 6000 companies.  The 2002 Sarbanes-Oxley (SB) law has such stringent and plentiful financial reporting regulations that many companies decide not to go public, or to sell themselves to a larger company that already has the internal infrastructure in place to comply with SB regulations.  Both parties want to repeal or amend the law but cannot agree on the details.  Readers can click for more info.

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Next week I will compare the 10 year performance and risks of various portfolios.  There are some surprises there.

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Side note on Sales Tax.  The Federal Reserve charts retail sales but these are based on data samples and will not be as accurate as the actual tax collected.  When retail sales are adjusted for inflation, the year over year growth can give a number of false positives.  In the graph below, I have marked up periods that went negative without the economy going into recession.  I think that the actual tax collected may be a much more accurate predictor of economic weakness.

Capitalism and Politics

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February 21, 2016

Capitalism

Growing income inequality, and extreme disparities of wealth in a capitalist economy prompted this 2013 speech by David Simon, the writer of the HBO series “The Wire.”  Mr. Simon attributes the plight of an economic underclass to thirty years of unrestrained capitalism.

Simon confuses capitalism with politics. When the politicians and agencies in Washington amass ever more power and draw corporate lobbying money to Washington, that’s politics, not capitalism.  When taxpayers bail out big banks for making stupid bets, that is politics, not capitalism.  When large companies like Archer Daniels Midland and Exxon receive generous subsidies from taxpayers, that is politics, not capitalism.

Cronyism contaminates whatever political or economic system it infects, be it capitalism, socialism, communism or fascism.  Cronyism and factions have infected every human society from the Assyrians of 4500 years ago to the present.  Knowing how destructive these twin human traits were, James Madison, chief constructor of the U.S. Constitution, crafted a system of checks and balances to provide a legal boxing ring for the various factions to punch it out.

Simon sees the economy as a Manichean battle between capital and labor, a model first proposed by Marx.  The battle is more accurately described as a triangle of capital, labor and political power.  Capital and labor are the two productive components of the economy, vying for legal favors from politicians. Capital and labor must push and shove for a more advantageous place in a courtier’s line before the political princes and princesses, kings and queens in the capitols of the world.

With much of the productive capacity of the world weakened or destroyed by World War 2, most of the world’s capital flowed to the U.S., which became the economic engine of the world.  With little global competition, workers in the U.S. had strong bargaining power, able to win pay packages of $200,000 (in 2015 dollars) to install parts on an assembly line.  Public labor unions flexed their legal bargaining and striking power to win pension packages that paid them almost full salary for the rest of their lives.

With few challenges from the rest of the world, management at U.S. companies became undisciplined, unfocused and uncompetitive.  The big three automobile manufacturers influenced politicians who passed tariffs which protected the vehicles produced by those manufacturers.  Tariffs on imported pickups and cargo vans still insulate domestic manufacturers from competion.  Like the automobile manufacturers, aerospace companies like Lockheed cracked under the weight of inept business planning and execution.  The demands of their labor force added to the strains.  Crippled by chronic cronyism, New York slid into bankruptcy and sought a bailout from the Federal government.

In the 1950s and 60s, I grew up in a union family, in a union neighborhood in New York City.  I accepted the nepotism and bribery in the union shops where I worked.  They were a fact of life along with housing segregation and sex discrimination.  The building trades were riddled with union cronyism and “tips” to building inspectors. Repeated strikes by city workers made daily life unpleasant.  Trash piled up in the streets, mass transit didn’t work and it could take an entire day at City Hall to renew a driver’s license.

In the 1960s and 70s, whole sections of New York, Chicago, Detroit and Philadelphia were unsafe to walk in, to live in or to work in. Folks like radio and TV host Tom Hartmann and Senator Bernie Sanders find it convenient to leave out some history when they talk about the 60s and early 70s as a benchmark of fairness for working people.

In the 1970s, the problems of the past two decades were brought to a head by the oil embargo, the recession of 1973-74, wage and price controls, the Watergate scandal, and rising inflation that would near 10% by decade’s end.  In 1971, Lockheed was bailed out by the U.S. government, a precedent that would be followed by others in the coming decades.

As European countries continued to rebuild their manufacturing and financial capacities, Japanese manufacturers took advantage of a new technology, transistors, to build smaller and less expensive electronic TVs and radios.  Their automobiles posed a weak but growing challenge to the dominance of U.S. manufacturers. In 1979, the three cronies of U.S. capitalism – organized labor, capital and politics – renewed their pact when Congress bailed out the automobile manufacturer Chrysler.

In the 1980s, the financial industry, the “bookies” of capitalism, began a decades long courtship of politicians in Washington, competing with organized labor and capital for political favors. The decade began with back to back recessions, 8 – 10% interest paid on savings accounts, 9 – 10% mortgages (a deal!),  and small business loans at 14% (secured), or 21% (unsecured) interest rates.  Small business owners worked extra hard  to compensate for the high interest rates paid on business loans.

Several Social Security tax increases were passed, taking an every bigger bite out of paychecks and profits.  A lot of us muttered about taxes.  There were 10 to 15 tax brackets, none of them indexed for inflation so that most of a raise or some occasional overtime went to Uncle Sam.    For decades, fat cats had been using tax dodges – legally – to escape taxes.

Sensing a growing discontent among voters at the unfairness of the tax system, politicians deliberated for several years before passing a tax reform bill in 1986.  Although tax rates were reduced for the wealthy, they lost many of their tax shelters.  Any change impacts both the incompetent and the dishonest, but especially exposes those who are both incompetent and dishonest.  The loss of tax shelters revealed a large network of scams in the financial and real estate industries that ignited the Savings and Loan Crisis of the late 1980s and early 1990s.

Declining union membership coupled with the growing political influence of the financial industry meant that unions could no longer afford to keep up with capital in the scuffle for treats from Washington.  Politicians protest that they too are victims of the “pay to play” system of American politics but efforts to enact a system of public financing of elections have been unsuccessful.  Why?  Because the system fattens the wallets of too many politicians.  If a few do lose their gerrymandered seats, they often find jobs lobbying the very politicians who replaced them.

The task of politicians and partisans of both major parties is to first craft the problem. Is the problem 1) greedy capitalists, 2) the immoral redistribution of income, 3) an overabundance of regulation that is stifling business growth, 4) income inequality, 5) too much power concentrated in the Federal Government, 6) too much money in politics, 7) too much taxes, 8) too little taxes, 9) ineffective or inadequate Federal regulation?  Pick one, or pick several. Make up your own.  The problem is that people can not agree on the problems, much less the solutions.

The essence of capitalism is that it has one metric – the return on capital which directs the flow of capital.To the champions of capitalism, this simplicity of feedback is the virtue of capitalism.  To the detractors of capitalism, this primitive mechanism is a bane.  Socialist and communist planners insist that an elite can direct a society’s capital for the greatest good.  They offer a top-down approach in contrast to the bottom-up solution design that a capitalist system offers.  Because capitalism does not present a unified solution for a society’s problems, some people reach for socialist and communist solutions presented by the few only to find that those solutions benefit mostly the few.

Tax Tinkering

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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.