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.

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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.

An Interest-ing Debt

February 12, 2017

Republicans used to talk about the country’s debt load but such talk is so inconvenient now that they control the House, Senate and Presidency. Perhaps it was never more than a political ploy, a rhetorical fencing. Now there is talk of tax cuts and more defense spending, and a \$1 trillion dollar infrastructure spending bill. 48 states have submitted a list of over 900 “shovel-ready” projects.

House Speaker Paul Ryan used to be concerned about the country’s debt. Perhaps he has been reading that deficits don’t matter in Paul Krugman’s N.Y. Times op-ed column. For those of us burdened with common sense, debts of all kinds – even those of a strong sovereign government like the U.S. – do matter. The publicly held debt of the U.S. is now more than the country’s GDP.

In 2016, the Federal interest expense on the \$20 trillion publicly held debt was \$432 billion, an imputed interest rate of 2.1%. Central banks in the developed world have kept interest rates low, but even that artificially low amount represents 11% of total federal spending. (Treasury)  It represents almost all the money spent on Medicaid, and more than 6 times the cost of the food stamp program. (SNAP)

The latest projection from the CBO estimates that the interest expense will double in eight years, an annual increase of about 9%. The “cut spending” crowd in Washington will face off against the “raise taxes” faction at a time when a growing number of seniors are retiring and wanting the Social Security checks they have paid toward during their working years.

In the past twenty years the big shifts in federal spending as a percent of GDP are Social Security and the health care programs Medicare and Medicaid. These are not projections but historical data; a shift that the CBO anticipates will accelerate as the Boomer generation enters their senior years. Ten years ago, 6700 (see end of section)  people were reaching 65 each day. This year, over 9800 (originally 11,000, which is a projection for the year 2026) per day will cross that age threshold.

A graph of annual deficits and federal revenue shows the parallel paths that each take. The trend of the past two years is down, promising to accelerate the accumulation of debt.

More borrowing and higher interest expense each year will crowd out discretionary spending programs or force the scaling back of benefits under mandatory programs like Social Security, Medicare and Medicaid. President Trump can promise but it is up to Congress to do the hard shoveling.  They will have to bury the bodies of some special interests in order to get some reform done.

[And now for a bit of cheer.  Insert kitten video here.]

We already collect the 4th highest revenue in income taxes as a percent of GDP. Canada and Italy head the list at 14.5%.
South Africa 13.9%,
U.S. 12.0%,
Germany 11.3,
and France 10.9 all collect more than 10%. (WSJ) Those who already pay a high percentage in income taxes will lobby for a VAT tax to increase revenues. Income taxes are progressive and impact higher income households to a greater degree. Poorer households are more affected by a VAT tax.  Cue up more debate on what is a  “fair share.” Many European countries have a VAT tax and the list of exclusions to the tax are bitterly debated.

Adding even more social and financial pressure is the lower than projected returns earned by major pension funds like CALPERS. For decades, the funds assumed an 8% annual return to pay retirees benefits in the future. In the past ten years many have made 6% or less. Several years ago, CALPERS lowered the expected return to 7.5% and has recently announced that they will be gradually lowering that figure to 7%.

Each percentage point lower return equals more money that must be taken from state and local taxes and put into the pension fund to make up the difference. Afraid to call for higher taxes and lose their jobs, local politicians employ some creative accounting to avoid the expense of properly funding the pension obligations. In a 2010 report, Pew Charitable Trust analyzed the underfunding of many public pension funds like CALPERS and found a \$1 trillion gap as of 2008. (Pew Report) The slow but steady recovery since then may have helped annual returns but the inevitable crisis is coming.

In December 2009, I first noted a Financial Times Future of Finance article which quoted Raymond Baer, chairman of Swiss private bank Julius Baer. He warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”
That warning is two years overdue. Sure hope he’s wrong but … here’s the global government debt clock. The total is approaching \$70 trillion, \$20 trillion of which belongs to the U.S.  We have less than 5% of the world’s population and almost 30% of the world’s government debt.  As Homer Simpson would exclaim, “Doh!”

Correction:  Posted figure for 10 years ago was originally 9000.  Current figure was originally posted at 11,000.  Projected for the year 2026 is 11,000.)

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Market Valuation

Comments by President Trump indicating a “sooner than later” schedule for tax cuts helped lift the stock market by 1% for the week. The Shiller CAPE ratio currently stands at 28.7, just shy of the 30 reading on Black Tuesday 1929. (Graph) Since the average of this ratio is about 16, earnings have some catching up to do. Today’s reading is still a bargain compared to the 44 ratio at the height of the dot com boom. Still, the current ratio is the third highest valuation in the past century.

The Shiller Cyclically Adjusted Price Earnings (CAPE) ratio
1) averages the past ten years of inflation adjusted earnings, then
2) divides that figure into the current price of the SP500 to
3) get a P/E ratio that is a broader time sample than the conventional P/E ratio based on the last 12 months of earnings.

The prices of long-dated Treasury bonds usually move opposite to the SP500.  In the month after the election, stocks rose and bond prices went lower.  Since mid-December an ETF composite of long-dated Treasury bonds (TLT) has risen slightly.  A number of investors are wary of the expectations that underlie current stock valuations.

The casual investor might be tempted to chase those expectations.  The more prudent course is to stick with an allocation of various investments that manages the risk appropriate for one’s circumstances and goals.

VAT Tax

In a 6/4/09 WSJ op-ed, Daniel Mitchell, a senior fellow at the Cato Institute, makes a well reasoned argument that the U.S. should not adopt a VAT tax.

This tax, prevalent in the EU, is like a national sales tax, a consumption tax. The more cautious proponents of its adoption in the U.S. wisely advocate the repeal of the 16th Amendment, which gave the Federal government the power to tax incomes. With the repeal, a VAT tax would replace the income tax. Without that repeal, a VAT tax would become just another revenue source for politicians to spend in addition to the income tax, a point that Mitchell makes as well.

For those who advocate a VAT tax as a protection for American goods producing businesses, Mitchell concludes that a VAT tax will not accomplish their goals.

Mitchell’s use of OECD data to compare government spending in the US and the EU suffers a flaw common to other op-ed writers, as I pointed out in in a previous blog. The EU includes 75% of its health care spending as a government expense. Although the US spends more as a percentage of GDP than any country in the world, it reports only 45% of that expense as government spending.

Mitchell writes that in 2007, “government spending now consumes 47.1% of GDP in the EU-15, significantly higher than the 35.3% burden of government in the U.S.” Let’s look at a 2005 (the latest available) comparison (On left side of screen, click Health, then Health Statistics, then OECD Health Data 2008, then Health Expenditures) of health care costs from the OECD.

In that year, the US spent over 15% of GDP on health care and reported that 45% of that expense was public tax dollars. Whether it is called a government expenditure or a private expenditure, the majority of us carry the burden of health insurance. To properly compare burdens between the US and EU, we can add in 5% of US GDP that would be public expenditure if US workers paid their insurance premiums to the Federal government instead of a private insurance company. Add that to the 35.3% that the US reports and a more accurate comparison of government spending burden is about 40%, still lower than the EU’s 47.1%.

What is your vote? Should the US 1) leave the income tax system in place; 2) replace it with a flat tax; 3) replace it with a VAT tax; 4) replace it with a savings transaction tax. Each system has plenty to be said for and against it.