Tax Didactic

December Programming Note

2011-12-02T10:09:00.001-08:00

I will be blogging infrequently for the month of December, due to work and holiday-related obligations.

Happy Holidays! See you in January (maybe late December)

Sheppard on Earnings Stripping

2011-11-28T18:43:00.001-08:00

Our favorite tax fashionista, Lee Sheppard, has an interesting article out today. See "News Analysis: The Fashion in Interest Deduction Restrictions," Tax Notes, Nov. 28, 2011, p. 1061.

Earnings Stripping

What is earnings stripping? First, some background. Many jurisdictions, including the United States, permit taxpayers to deduct interest expense in computing net taxable income. Deductible interest reduces pre-tax income and taxes owed to the revenue authority. The deductibility of interest expense creates a difficult challenge for policy makers. The issue will be lurking below the surface as Congress begins wading into the waters of tax reform.

Deductible interest creates a "bias" for debt-heavy capital structures ("overleverage"). The deduction for interest expense artificially decreases the "real" cost of debt relative to the "real" cost of equity. Overleveraged capital structures are more likely to capsize during the "trough" of business cycles, creating turmoil and trauma for stakeholders of the overleveraged business (employees, customers, local communities, etc.).

Deductible interest also permits business owners to "strip" taxable income out of the the tax base. This "earnings stripping" or "base erosion" involves variations on a theme. Sheppard's article focuses on cross-border earnings stripping.

A corporate parent with a foreign subsidiary may be able to fund the subsidiary with "shareholder loan" capital that pays interest. With proper treaty planning, (i) the shareholder loan pays interest, (ii) the interest expense is deductible, reducing taxable income and tax liabilities in the subsidiary's jurisdiction, and (iii) low or no withholding taxes apply to the interest payment. This type of structure permits the parent to "strip" earnings out of a higher-tax jurisdiction into a lower-tax jurisdiction.

Designing an "interest strip" is not rocket science. Tax advisors can use the basic structure in domestic transactions. Assume a group of pension funds pools capital and purchases a U.S. business organized as a corporation. The pension funds capitalize an acquisition vehicle with a mix of equity capital and "shareholder loan" capital. The decision to capitalize with equity and debt is effectively "deemed" to have economic substance. The target business generates taxable income after the acquisition. But the acquisition vehicle pays deductible interest expense on its shareholder loans. The pension funds are tax-exempt entities, so pay no tax when they accrue or receive interest. Voila, an "interest strip" -- shifting tax revenue from the U.S. Treasury to the pension funds.

(In the long run, query whether foreign and domestic pension funds will be able to use their tax-advantaged status to purchase every commercial enterprise on Earth. Marx would be vindicated. The working class -- through pension funds and their investment managers -- would control the means of production.)

U.S. Rules

Congress understands that earnings stripping can be a big problem. It enacted Code section 163(j) to address the issue. Sheppard snorts at the U.S. rules: "[I]t remains ridiculously easy to strip [income out of the United States] using interest deductions, despite a statute squarely aimed at foreign-parented groups."

I won't go into section 163(j) in detail. It limits a corporation's related-party interest deductions if the corporation has too much leverage and too much interest expense. It works in some cases, but has a couple obvious shortcomings. First, it doesn't apply to my domestic example above (where a group of pension funds acquire a U.S. business and use shareholder loans to interest strip). The statute only bites if the shareholder loan capital is provided by a "related" person.

Second, the U.S. limitation does not expressly contain any transfer pricing limitation. Take a technology business. Many technology businesses are capitalized with low ratios of third-party debt to equity ("leverage ratios"). But let's assume that a foreign parent corporation purchases a U.S. target corporation and injects leverage (a shareholder loan) into the target's capital structure. Assume that external leverage ratios in the industry are very low (10% or lower). But the foreign parent capitalizes its new subsidiary with $20x of equity capital and $80x of shareholder loan capital (an 80% leverage ratio).

The U.S. earnings stripping rules do not prohibit the legal structure. And while the U.S. transfer pricing rules impose "arm's length" pricing requirements on intercompany transactions, IRS agents do no commonly focus on shareholder loans (in my experience). Unlike Sheppard, I don't fault section 163(j), so much as lax or unsophisticated U.S. tax administration.

German Rules (and Copyists)

Historically, the U.S. has exported principles of tax law and administration. But the rest of the world has caught up. Sheppard summarizes discussion at a recent International Bar Association annual meeting in Dubai. Tax professionals explored various European earnings stripping limitations. At some point, U.S. policymakers will start paying attention.

According to Sheppard, Germany was the first country to revise its earnings stripping rules. The German rules have serious teeth. The rules apply to all debt of a German affiliated group (an organschaft). The deduction for net interest expense is limited to 30 percent of EBITDA, regardless of whether the payer is related to the lender. EBITDA for this purpose is capped by the group's taxable income. (This effectively limits the benefit of timing or temporary differences to an organschaft with external or internal leverage.)

Practitioners apparently regard the limitation as "stingy." In my view, this is another example of German sensibility and efficiency. The rule is simple to describe and understand. It keys off EBITDA of a business; the financial metric that lenders and equity investors care about when financing an enterprise. The limitation may get low marks on "elegance," but it gets high marks from an administrative perspective. From a tax compliance perspective, policymakers should balance ease of administration against "technical perfection."

Italy has adopted a close variation of the German rule. The French legislature is considering a similar regime to address perceived abuse of French thin cap rules. The Dutch, Irish and Swedish are openly struggling with excessive leverage in domestic capital structures due to cross-border private equity transactions.

If you work in the international tax space or the domestic M&A space, Sheppard's article is definitely worth a quick read.

Hypocrisy and McMansions

2011-11-25T12:06:00.000-08:00

Happy Thanksgiving Weekend!

With the national economy sputtering and unemployment around 9%, many Americans will need to tighten their belts this holiday season. Meanwhile, Democrats and Republicans in Washington teamed up to serve up a big order of Hypocrisy on a silver platter.

On November 18, President Obama signed into law a bill that reinstates higher conforming loan limits for the Federal Housing Administration through 2013.

In plain English, home purchasers can now receive cheaper financing on home loans up to $729,750. The financing is "cheaper" because it's effectively guaranteed by the federal government (i.e., taxpayers). The interest rate on non-conforming jumbo loans is roughly 0.75% higher that the interest rate on conforming loans.

Hypocrisy...

Gee, isn't this a sign of progress? Team Obama was finally able to hammer out a bipartisan consensus with Republicans. The House passed the bill with a healthy 298-121 majority. Of the dissenters, 101 were Republicans and 20 were Democrats.

The main progress here was the blatant display of hypocrisy. Politicians didn't hold their noses against the stench and enact this bill in the dead of night. They transparently abandoned their "core principles" in broad daylight.

Let's start with the Democrats. The Obama administration and Congressional Democrats have relentlessly spun the following narrative:

The Great Recession was brutally difficult for lower- and middle-income Americans. But upper-income Americans emerged largely unscathed. And many of them actually profited from the economic downturn. The top 1-2% have "unclean hands" because they have not suffered the harshest effects of the economic downturn. And it is time to "spread around" some of their wealth by creating or expanding government programs funded by increased taxes on the top 1-2%.

Rhetoric aside, these tireless advocates for the middle class understand where their bread is buttered. The most expensive real estate in the United States is concentrated in Democratic strongholds on the East and West Coasts. Wealthy liberal enclaves provide enormous financial support to Democratic politicians. Note that House Democrats overwhelmingly supported the legislation.

A middle-class American cannot afford a million-dollar McMansion. She does not need a $700,000 jumbo loan, conforming or non-conforming. This legislation was nominally intended to keep an ailing real estate market on life support. But the main people hurt by a softer real estate market are the affluent real estate brokers and financial institutions that service upscale local markets. To quote tax blogger James Maule, "boo hoo" for affluent real estate brokers. Democrats howl about cuts to services for the "most vulnerable" Americans. Yet when push comes to shove, they prioritize subsidies to affluent real estate brokers by propping up home values in the wealthiest communities.

How about the Republicans? Most Republicans argue that free markets work, and that government intervention tends to cause more problems than it solves. Many Republicans have criticized government policy for exacerbating the housing bubble that burst in 2007 with such a devastating effect.

But Democrats do not have a monopoly on wealthy political donors in expensive homes. The "crony capitalism" that riled up the Occupy Wall Street crowd has deep roots on both sides of the political aisle. The main Republican advocate of the bill was John Campbell (R-Calif), whose constituents in Orange County have taken large haircuts on million-dollar homes. Republicans lose all credibility when they argue that certain sectors of the economy should remain on taxpayer-funded life support.

Republican also like to play the "certainty" card. They frequently argue that the economy is sputtering because individuals and businesses are uncertain about the future of government policy. But in this case, Republicans reversed course on a prior aspiration to scale back the federal government's role in residential housing finance. The acting director of the Federal Housing Authority bluntly criticized the legislation as "sending the wrong signal."

...and McMansions

The federal government (i.e., you and me as taxpayers) provide two main subsidies to the residential housing market. The first involves federal loan guarantees, which shift risk from private lenders to the government and, ultimately, taxpayers. Federal loan guarantees make it cheaper for homeowner to borrow money, which means that they can bid more for homes.

The second involves the deduction for home mortgage interest. Effectively, the mortgage interest deduction is a tax subsidy for home owners. Although the mortgage interest deduction is capped, it has the same overall effect as the federal loan guarantees. By reducing tax liabilities, the mortgage interest deduction frees up cash to service home mortgage principal and interest payments.

Here's the funny thing about the federal subsidies. They are nominally intended to make home ownership more accessible. But they don't make housing more affordable. On the contrary, the subsidies make housing less affordable, because they permit home buyers to qualify for bigger mortgages and pay for more expensive homes than would be possible without the subsidies.

Okay, if homes aren't more affordable, then who benefits from the subsidies? In other words, who benefits from government policies that increase the cost of housing above market rates?

Primarily the housing lobby, comprised of home builders and real estate agents. The former group (home builders) employs large numbers of union and other blue-collar workers in the construction industry. No surprise that Congress might want to direct economic subsidies to this group. In addition, local governments benefit from higher real estate prices, which translates into higher property tax revenues. Many local governments jumped on the bandwagon during the bubble years, assuming that real estate prices and property taxes would increase in perpetuity. They developed long-term budgets and entered into contractual obligations with service providers (teachers, police officers, bureaucrats) that have become unsustainable after the bubble popped.

The deduction for mortgage interest is second largest tax expenditure (estimated to cost $99 billion in 2012). Eliminating it would tend to make housing more affordable over time (by reducing the inflation-adjusted value of residential real estate). That's a bad result for many existing homeowners, but a good result for new homeowners. If political actions mirrored rhetoric, we would expect that Democrats and Republicans could agree on a plan to phase out the deduction over time. Home prices would become more affordable for the 99%. And individuals would re-allocate capital away from (subsidized) housing into more productive activities.

But political hypocrisy is just as certain as death and taxes.

Reilly and Solomon on 28% Cap

2011-11-23T15:15:00.000-08:00

I want to highlight a terrific article published by Mary Anne Reilly and Martin B. Solomon in yesterday's Tax Notes. See "Sophistry Supporting Complexity: The 28 Percent Deduction Limit," Tax Notes, Nov. 21, 2011, p. 1019.

I'm a big fan of examples in tax articles and reports. Reilly and Solomon provide good examples that illustrate something I've been saying for months. Team Obama is unable or unwilling to articulate a coherent tax policy agenda. The Obama administration sometimes articulates principles that resonate with the political left and the political right. But the principles always degrade into populist mish-mash when translated into specific legislative proposals.

Background

In September, President Obama launched his 2012 re-election campaign by proposing a $447 billion new stimulus measure (ahem, "jobs plan"). With a 9% national unemployment rate, Obama will be facing headwinds in the next election. He decided that he might be able to save one job (his own) by deflecting criticism to "obstructionist" Republicans.

We are running deficits as far as the eye can see. As partial funding for the new stimulus measure, the Obama administration proposed a 28% cap on certain deductions and exclusions. The specific proposal begins on page 137 of this PDF (page 134 of the report). The new cap is projected to raise approximately $400 billion. It's unclear how the new cap would apply if the 2001-2003 temporary individual tax discounts (the "Bush tax cuts") expire in 2012.

Howard Gleckman at Tax Vox reacted to the proposed cap as follows:

An across-the-board cap on the benefit of deductions and the like is often seen as rough justice — a way to tackle the Revenue Code’s trillion dollars in tax expenditures without fighting over each one. The theory: It is an easier political lift to curb such popular breaks as the mortgage interest deduction through a broad reduction of all subsidies than to fight the powerful housing industry head-on.

But Obama does pick and choose the preferences he wants to target. He nails all itemized deductions, all right, but he also goes after some – but not all – above the line deductions. Of the roughly two dozen write-offs available to those who take the standard deduction, Obama targets just eight, including health insurance for the self-employed, medical savings accounts, health savings accounts, and some higher education expenses.

He also reduces the benefit of two other hot-button breaks — the tax exclusions for municipal bond interest and the value of employer-sponsored health insurance. In other words, for those making more than $200,000, some muni bond interest and some of the value of their medical coverage would be taxed.

However, Obama would protect other exclusions, including those for retirement savings. Picking winners and losers this way is likely to defeat any claims of rough justice and make passing the plan that much tougher.

Sophistry, Complexity and Inequity

Reilly and Solomon criticize the 28% Cap Proposal on three grounds.

First, they argue that it represents politically-motivated sleight of hand. I'm not going to dwell on this argument. I believe that we should eliminate tax expenditures directly, not limit tax expenditures through complicated and unfair caps and floors. All variations of the 28% cap represent political expedience, not good tax policy.

Second, they argue that the "complexity created by separating the tax cost of income from the tax benefit of deductions is quite significant." Ironically, the "principles for tax reform" outlined by Obama in his recent message to Congress include "a call for simplification." The 28% Cap Proposal goes in the opposite direction. Do we want simplification? Or do we want to induce migraine headaches for tax preparers? You decide. The 28% Cap Proposal would require:

[A] computation of the tax on a new item called adjusted taxable income (ATI); a determination of another new item, the minimum marginal rate amount (MMRA); computation of tax on the greater of taxable income or the MMRA; and a computation of the "additional amount," which is the excess of the tax on ATI over the greater of the tax on taxable income or the MMRA, plus 28 percent of the excess of ATI over the greater of taxable income or the MMRA. This last number represents the additional tax generated by the new 28 percent deduction limitation.

Third, they argue that the "proposal is loaded with potential inequities and questionable tax policy." Most important, the new rules would have a cliff effect. They would be "triggered on an all-or-nothing basis when a taxpayer's adjusted gross income is above $250,000 for a joint return and $200,000 for a single taxpayer," potentially resulting "in an enormous addition to tax as a result of as little as $1 of additional income."

Reilly and Solomon provide an example of a family (the Cliff Family) with two parents and two children. The example compares the tax liabilities of the Cliff Family assuming AGI of $250,000 and $250,001, respectively. The authors hold other numbers constant to demonstrate the impact of the 28% Cap Proposal. Based on "middle of the fairway" assumptions, the authors demonstrate that $1 in additional salary income to the Cliff Family would trigger a $5,708 incremental tax liability.

The political left has vehemently argued that the "wealthiest" taxpayers are not paying their "fair share." The Obama administration has consistently defined "wealthy" taxpayers to include a family with $250,001 of taxable income. Does a $5,700 tax liability on $1 of incremental income satisfy the administration's definition of "fairness"? Is there someone on the political left creative enough to defend the "fairness" of the cliff effect? I'll stay tuned for that development.

Sacrifice Without Balance

2011-11-21T10:39:00.001-08:00

In today's post, I'd like to highlight an excerpt from Joseph Thorndike's article, "What the Civil War Can Teach Us About Tax Reform." See Tax Notes, Nov. 21, 2011, p. 944. Thorndike hits a couple points that are consistent themes on this blog. The emphasis is mine.

What can the Civil War tell us about today's debate over deficit and debt reduction? It's the notion of sacrifice that links the two eras. Then, as now, the nation faced a serious fiscal crisis. And then, as now, lawmakers struggled over how to allocate the pain incurred while solving it.
Differences abound, of course. An entitlement-driven fiscal crunch is not the same thing as a war, no matter how severe it might become. Mortal sacrifice on the battlefield is not the same as economic sacrifice from a paycheck.
Still, the notion of shared sacrifice unites those episodes. Clearly, solving today's fiscal problems will be painful, requiring higher taxes and lower spending. The necessary changes won't be pleasant for anyone -- and they will be deeply painful for some, especially those who depend on key social programs.
But today's lawmakers have failed to acknowledge that broad-based sacrifice will be necessary to solve the nation's fiscal problems. No one in either party is willing to talk about meaningful entitlement reform.
Lawmakers are also not being honest about taxes. If higher revenues are going to be part of the solution, then the extra burden will almost certainly fall on everyone. But so far, the champions of higher revenues have been unwilling to acknowledge that everyone will end up paying more. Instead, they have focused narrowly on raising taxes on those with high incomes.

I've said it before and I'll say it again. Democrats and Republicans have been complicit in deficit-spending for decades. They created entitlement programs that are structurally imbalanced and unsustainable. They designed tax expenditures that distort markets, stoking health care inflation and contributing to the real estate bubble. They manufacture drama to score points with political supporters who cannot or choose not to keep track of the bigger picture.

We cannot address these structural and tax policy challenges by increasing taxes on "millionaires and billionaires." There is no "class war" between the 1% and the 99%. If we want a bigger government and if we want to maintain federal spending on entitlements, we'll need to raise taxes on the top, middle, and bottom of the income spectrum. We may need to eliminate "sacred" tax expenditures. We may need a VAT or carbon tax. The status quo is a path towards extreme hardship for millions of Americans when the bottom falls out from under the political class.

Subsidizing Millionaires

2011-11-18T20:16:00.001-08:00

On Tuesday, Paul Caron and Peter Pappas linked to a report by Senator Tom Coburn (R-Okla). The report is entitled "Subsidies of the Rich and Famous: Federal Programs and Tax Breaks That Help Millionaires." The full report is 37 pages. It focuses on tax programs that benefit millionaires, and also spending programs that benefit millionaires.

Teslas and Golf Carts

Pappas is mildly critical of the report. The report lists several tax expenditures and summarizes the share of each tax expenditure captured by millionaires. I agree with Pappas that eligible millionaires are not doing anything "unfair." Congress enacts tax expenditures because it wants to influence economic behavior.

Take the electric vehicle credit. The Coburn report indicates that $12.5 million in electric vehicle credits were claimed by millionaires in 2009. To my knowledge, a $7,500 credit was available for the purchase of electric vehicles during the calendar year (Section 30D). The primary vehicle available for on-road transportation in 2009 was the Tesla Roadster. The base price for the Roadster is $108,000. Middle-class taxpayers were not rushing out and purchasing these vehicles. (As Paul Caron document in 2009, some upper- and middle-income taxpayers apparently claimed the credit to defray the purchase of golf carts.)

Remember, Democrats controlled Congress and the White House in 2009. They had the power to amend the Code and prevent millionaires from claiming the credit against purchases of Teslas (and golf carts). But they want to encourage an overall shift to "green" energy. The tax credits for electric vehicles are consistent with that larger policy commitment. Electric vehicles are expensive. Congress knew or should have known that millionaires would take advantage of the credits, because very few non-millionaires can drop $100,000 on an electric vehicle.

The fact that Congress designs stupid tax policy (like electric vehicle credits for millionaires) to support other policy objectives (like a transition to "green" energy) demonstrates that Congress can be stupid. This is not some kind of "loophole" for the wealthy. Congress opened a door to encourage upper-income taxpayers to purchase electric vehicles. Some upper-income taxpayers decided to walk through the open door. We don't know how many, if any, were encouraged by the credit. Tax incentives that don't change economic behavior are dollars down the drain.

On balance, the Coburn report highlights a number of these intersections between economic/social policy and tax/fiscal policy. The report demonstrates the law of unintended consequences. It doesn't make much sense to give tax credits to millionaires who purchase electric vehicles (but it's a consequence of supporting "green" energy manufacturers). It doesn't make much sense to pay unemployment or Medicare or Social Security benefits to millionaires (but it's a consequence of a political aversion to means testing for entitlements). We should be revisiting and reshaping these policies over time.

Closer Look at the Numbers

The Coburn report parrots a widely-reported data point: that 1,500 millionaires paid no income tax during 2009. To be more precise, 1,470 individual taxpayers reported AGI in excess of $1 million, but paid zero income tax.

I've seen this data point before, and it piqued my curiosity. How are these upper-income taxpayers zeroing out their federal income tax liability?

It seems likely that most of these taxpayers are making large charitable contributions. A wealthy individual may have resources to make a large cash or in-kind donation to charity and claim the amount as a miscellaneous itemized deduction (Line 40 of Form 1040).

In this respect, the Coburn report is misleading. This table in the Coburn report lists a number of "tax breaks" claimed by millionaires. The two biggest "tax breaks" are the deduction for mortgage interest ($27.7 billion from 2006-2009), and the deduction for rental expenses ($64.3 billion from 2006-2009). The report omits to mention the total charitable deductions by millionaires during the same period. I suspect that Coburn's staff included "bad tax breaks" (like mortgage interest expense) while excluding "good tax breaks" (like charitable deductions). This type of cherry-picking tends to muddy the waters -- all tax expenditures should be on the table when we start talking fundamental tax reform.

One thing is clear -- the list of "tax breaks" enumerated in the table would not zero out a millionaire's taxable income during a given year.

* * * * *

Interested readers can locate the 1,470 individual taxpayers on page 40 of this report.

Here's the breakdown among the different income groups:

	Returns	Paid Tax	No Tax

$1.0 under $1.5	8,274	8,211	63
$1.5 under $2.0	14,322	14,236	86
$2.0 under $5.0	61,918	61,535	383
$5.0 under $10.0	44,273	44,015	258
$10.0 or more	108,096	107,416	680
Total	236,883	235,413	1,470

Break Out the Dentures

2011-11-16T09:29:00.001-08:00

On Monday, the Supreme Court agreed to review the constitutionality of ObamaCare. That prompted me to sketch out the core principles of ObamaCare. Today I'll discuss the penalty regime in more detail. The penalty regime is arguably the lynchpin of the entire health care "reform" legislation. And it was designed to have no teeth, legally or economically. Call in the dentists.

Core Principles

The crux of ObamaCare is the individual mandate. The individual mandate requires most individuals and families to obtain "minimum essential" health coverage. The individual mandate is critical, because ObamaCare requires insurance companies to provide coverage to older, sicker individuals (i.e., individuals with "pre-existing conditions"). And it prohibits insurance companies from charging higher premiums to sicker individuals (within age bands).

Because ObamaCare will "expand" insurance coverage to older, sicker individuals, it will increase costs to existing participants in health insurance schemes. The costs of older, sicker participants will get transmitted to other participants, increasing premiums. To neutralize this cost spike, Congress needed to persuade/coerce more younger, healthier individuals to purchase coverage.

ObamaCare employs a "carrot" and "stick" approach to persuade/coerce the uninsured to purchase health insurance. The "carrot" involves tax subsidies for low- and middle-income households who purchase coverage through state exchanges. The "stick" involves a penalty regime applicable to individuals and families who do not obtain qualifying health coverage.

Toothless Penalties

I summarized the penalty regime on Monday. The penalty is the greater of a flat dollar amount per individual taxpayer that rises to $695 in 2016 and is indexed by inflation thereafter (with caps for children and families) or a percentage of the taxpayer's household income that rises to 2.5 percent for 2016 and subsequent years (also capped). See examples here.

Based on a CBO/JCT report, Congress assumed that approximately 1% of the population would be subject to penalties after ObamaCare is fully implemented. CBO/JCT estimates that approximately 21 million individuals will continue to be uninsured. However, only 4 million of them have sufficient household income to be dinged by the penalty regime.

Let's step back for a moment. A "penalty" is a punishment for some action or omission. If you drive faster than the speed limit, you get a speeding ticket and pay fines. If you don't have minimum essential coverage, you are supposed to pay a penalty (as described above). But Congress assumed that roughly 80% of the individuals who do not comply will be exempt from penalties. They are not deemed economically capable of compliance, so they are not punished for non-compliance. Does it make any sense to establish a penalty regime that provides an 80% exemption rate?

Ultimately, the penalty regime is window dressing to support deeply flawed legislation. Congress did not want the penalties to have teeth, legally or economically.

No Legal Bite

Democrats in Congress preach a "free lunch" gospel to low- and middle-income voters. The Democratic Gospel of Free Lunch says that the federal government can (i) create or expand social welfare programs, and (ii) "pay" for the costs by increasing taxes on the "wealthy." They want to balance a pyramid on its tip. Longer term, it's an unsustainable strategy. A pyramid won't balance on its tip, and we're heading towards the fiscal abyss. Shorter term, the Democratic Gospel is an effective way to rally support and votes.

Republicans argued that ObamaCare could only be financed through across-the-board tax increases. Democrats were sensitive to this charge for ideological and practical reasons. ObamaCare needed to provide benefits to low- and middle-class voters without increasing their taxes. President Obama vocally and publicly argued that the penalty for non-compliance with the individual mandate was not a "tax." Democratic leaders feared that a rigorous penalty regime would be viewed as a de facto tax on the uninsured (generally low- and middle-income households). The ObamaCare penalty regime was designed to have no legal bite.

The penalty regime will be administered by the IRS. Now, along with auditing tax returns, the IRS will need to track whether individuals and families maintained health coverage each month during the calendar year. Congress might as well have required the IRS to develop and launch a new Mars Rover. It's inconceivable that the IRS will be able to develop a system that (i) tracks whether 360 million Americans have health coverage each month, (ii) flags all non-compliant individuals on a timely basis, (iii) filters out the 16 million Americans who are expected to be exempt from penalties, (iv) provides timely notice of penalty to the 4 million Americans who are expected to owe penalties, (v) provides an efficient dispute resolution mechanism (for errors), and (vi) collects penalties on a timely basis. Congress is okay with IRS dysfunction. In this case, a dysfunctional administrator is consistent with the Democratic Gospel.

If the IRS somehow determines that an individual is non-compliant and owes penalties, the IRS is not permitted to file liens or levies to collect the penalties. In other words, the IRS can only "collect" the penalty out of refunds owed to the taxpayer in question. A taxpayer can "opt out" of the penalty regime by underpaying estimated taxes during the course of the year. Any individual with positive tax liability for a given calendar year will not be required to "pay" anything. Presumably, cumulative "penalties" will carry forward into successive tax years until cumulative refunds are offset against the penalties. Again, there is a huge timing disconnect; the IRS typically issues refunds before examining tax returns. Will the IRS system be able to "match" non-compliant taxpayers and their "penalties" before refunds go out the door?

No Economic Bite

The ObamaCare penalty regime also lacks economic bite. Let's assume miraculous administration (i.e., the IRS timely assesses and collects "penalties" out of tax refund amounts). In 2016, the penalty for a non-compliant individual will be approximately $700. The projected average cost of an individual employer-sponsored insurance policy is approximately $8,300.

(Remember, subsidies under ObamaCare will encourage more people to purchase health insurance. As demand for insurance rises, insurance premiums will increase. Plus, insurance companies will be required to cover more older and sicker individuals, spreading higher costs to other participants.)

Go back to my post from Monday. Let's say I'm a young, single, uninsured Gambler with no dependents. I make enough money to cover rent, car loan payments, school loan payments and recreational opportunities. Even with subsidies under ObamaCare, I can't afford an $8,300 annual policy. I can easily afford a $700 penalty. Plus, I've heard that insurance companies must offer me coverage at any time, irrespective of my health status (no discrimination for "pre-existing conditions"). I can cruise along for the time being without health coverage. If I get very sick or seriously injured, I'll enroll in a health insurance scheme through one of the state exchanges.

The drafters of ObamaCare understood the perverse economic incentives. They could have given the mandate some economic bite, simply by linking penalties to average insurance premiums on the taxpayer's resident state exchange. But again, a rigorous penalty regime would be inconsistent with the Gospel of Free Lunch. Democratic leaders were not attempting to create a penalty regime with teeth. They just needed to put some lipstick on a pig.

Kenny Rogers vs ObamaCare

2011-11-14T13:28:00.001-08:00

As widely expected, the Supreme Court has agreed to address several constitutional issues arising from the Patient Protection and Affordable Care Act (a/k/a ObamaCare).

Individual Mandate

Most of the public scrutiny of ObamaCare focuses on the constitutionality of the "individual mandate." The individual mandate requires individuals and families to purchase "minimal essential" health insurance. Individuals and families that fail to comply are subject to penalties. No penalties apply to very low-income taxpayers. Certain individuals are exempt from the mandate and penalty regime (e.g., illegal immigrants).

The penalty is the greater of a flat dollar amount per individual taxpayer that rises to $695 in 2016 and is indexed by inflation thereafter (with caps for children and families) or a percentage of the taxpayer's household income that rises to 2.5 percent for 2016 and subsequent years (also capped). See examples here.

Ghost Penalties

True to form, Congress designed a complicated penalty regime that isn't projected to raise much revenue. The Congressional Budget Office and Joint Committee on Taxation estimated that approximately 21 million non-elderly residents will be uninsured in 2016, but that a substantial majority of them will not be subject to the penalty. CBO/JCT projected $4 billion in annual revenue from the penalty from 2017 to 2019.

As the CBO/JCT numbers illustrate, Congress designed the penalties to lack teeth. Approximately 50 million individuals were uninsured in 2010. Roughly 40% of that pool (21 million) will remain uninsured after implementation of ObamaCare. Not so hot. Of the remaining uninsured (21 million), only 3.9 million (20%) have sufficient taxable income to be dinged for penalties.

These numbers are astonishing. Congress assumed that, by 2016, nearly 99% of the population would not be subject to penalties. (We're projected to have approximately 320 million Americans in 2016.) We don't have the assumptions underlying those assumptions. Congress must have concluded that the uninsured would either purchase insurance to avoid penalties, or use new tax subsidies to fund premiums (irrespective of the penalties). More on this "carrot" and "stick" approach below.

You've Got to Know When to Hold 'Em...

Why did Congress impose a "mandate" that individuals and families purchase minimal essential coverage?

Let's step back. Approximately 50 million individuals were uninsured in 2010. Many of those individuals made a conscious or unconscious economic decision not to purchase health coverage. In other words, they had sufficient discretionary income to purchase health coverage, but they chose to spend money on goods or services other than health insurance. These individuals were effectively "gambling" that they would not become sick or injured. Many of the Gamblers were young and healthy individuals who are unlikely to become sick on an actuarial basis.

Congress wanted to coerce these Gamblers to participate in the private health insurance market for reasons discussed here by Princeton economic professor Uwe Reinhardt.

In layman's terms, private insurance depends on a large "pool" of younger, healthier individuals whose premiums are used to pay the health care expenses of older, sicker individuals. If younger, healthier individuals become Gamblers (stop paying premiums), the costs of older, sicker individuals are spread among a smaller "pool." This increases the average premiums charged to the remaining members of the pool, encouraging even more younger, healthier individuals to become Gamblers. If enough young, healthy individuals become Gamblers, a private insurance scheme can face a "death spiral" effect.

ObamaCare created new incentives for young, healthy individuals to become Gamblers. Remember all the buzz over "pre-existing conditions"? ObamaCare requires health insurers to accept all applicants willing to pay (guaranteed issue). And it requires that health insurers charge the same premiums, regardless of the health status of the applicant (community rating). See Reinhardt for more. The key point is that guaranteed issue and community rating tend to increase the cost of insurance for younger, healthier individuals, because insurers cannot exclude older, sicker individuals, and they cannot modulate premiums to reflect health status.

Let's imagine a young, healthy individual in his or her early 20s (a Gambler). Our Gambler graduated from high school or college and landed a job in a service industry that pays decent wages but offers no health benefits. Our Gambler has no dependents, and prefers to allocate his or her disposable income to rent, car loan payments, school loan payments, vacations, beer and "medicinal" marijuana rather than purchasing health insurance. Under ObamaCare, our Gambler can coast along as an uninsured, spending the "premium savings," until stricken by accident or injury. If hit by accident or injury, our Gambler calls up a health insurer and starts paying premiums. The health insurer cannot reject our Gambler based on a "pre-existing condition." And it cannot charge higher premiums based on the health status of our Gambler.

Our Gambler presents a big problem for the drafters of ObamaCare. The mandate and penalty regime are supposedly the "stick" that discourage rampant gambling. They are supposed to backstop the "carrot" of tax subsidies.

...And When to Fold 'Em

ObamaCare arguably involves more "carrot" than "stick." Gamblers not impressed by the penalty regime will receive tax subsidies if they participate in the private insurance market. Specifically, ObamaCare provides for refundable tax credits that individuals and families can use to help cover the cost of health insurance premiums paid to a state exchange.

State exchanges are intended to improve the transparency and competitiveness of health insurance markets, thus lowering costs. The mechanics are fairly open-ended and complicated. In theory, an uninsured individual should be able to browse a "menu" of standardized insurance plans from different carriers through an exchange. The exchange concept raises various issues beyond the scope of this post. The tip of the iceberg: why create 50 government-regulated state exchanges rather than trying to create a competitive national health insurance market?

Congress assumed that virtually nobody would pay penalties. The penalty regime is expected to generate annual revenue of $4 billion for several years after implementation. In contrast, the CBO has estimated that the "exchange subsidies and related spending" would cost more than $100 billion annually during that period (see PDF p. 16).

Big picture, it appears that Congress believed that the tax subsidies and a more accessible "menu" of insurance options (the state exchanges) would encourage Gamblers to fold 'em. I'm surprised by the CBO numbers. Remember, Congress expected that ObamaCare would move approximately 30 million uninsured out of Gambler status into the system. In the 2016-2020 period, the average tax subsidy per uninsured is projected at roughly $3,800. $3,800 sounds very low relative to the cost of individual health insurance.

Break Out the Dentures

The Supreme Court is poised to examine the constitutionality of the individual mandate and penalty regime. The penalty regime was designed to have no teeth, legally or economically. We live in strange times. The constitutionality of ObamaCare hinges on a mechanism that Congress did not intend to have any teeth. Anybody have a good dentist? More to come in my next post.

If You Talk the Talk...

2011-11-11T07:05:00.001-08:00

On Wednesday, I examined a Monday post by James Maule. See The Tax and Spending Stalemate: Can It Destroy the Nation?, MauledAgain (Nov. 7, 2011).

Maule blamed Republicans for the legislative gridlock surrounding competing infrastructure proposals. The Democrats are pushing a $60 billion spending measure, "funded" by tax surcharges on "millionaires and billionaires." The Republicans are pushing a $40 billion spending measure, "funded" by unused outlays for other programs.

Maule was nominally venting about our crumbling infrastructure and jobs crisis. In substance, he was channeling the anxiety of the political left. If Maule were serious about infrastructure spending and economic stimulus, he would have lectured the Democrats for rejecting the $40 billion measure. A compromise starts with common ground. As between $60 billion and $40 billion in spending, $40 billion is the "common ground."

I'm sure that Maule is genuinely concerned about the current unemployment crisis. As such, I'm guessing that he'll be disturbed by a recent setback to energy infrastructure development.

On Thursday, Team Obama delayed the proposed Keystone XL oil pipeline until after the 2012 election.

The proposed Keystone XL Project (click here for map) consists of a 1,700-mile crude oil pipeline and related facilities that would primarily be used to transport [oil] from an oil supply hub in Alberta, Canada to delivery points in Oklahoma and Texas. The proposed Project would also be capable of transporting U.S. crude oil to those delivery points. The proposed project could transport up to 830,000 barrels per day and is estimated to cost $7 billion.

The announcement marked a sharp reversal by Team Obama. The State Department had previously supported the pipeline on national security grounds. Obviously, importing oil from Canada reduces our dependence on Middle Eastern oil imports. The $7 billion project would upgrade the nation's energy infrastructure; a Democratic priority until yesterday. It was expected to created tens of thousands of jobs during the midst of a national unemployment crisis. And it was funded with private capital, thus avoiding Congressional gridlock entirely.

Unfortunately, the end run around Congress ran into the brick wall of regulatory delay. Environmental activists were particularly hostile to the Keystone XL project, because the pipeline would transport oil from Canadian tar sands. (Never mind that Canada could route the oil from tar sands to the Pacific coast for export to Asia.) As noted by the LA Times, the decision exposes Team Obama "to the same criticism the White House has leveled at congressional Republicans regarding deficit reduction: delaying a tough call in hopes that the politics will be better after next November's election."

The building trade unions, whose members have been disproportionately hurt by the Great Recession, condemned the decision:

Terry O'Sullivan, general president of the Laborers' International Union of North America, said the move would "inflict a potentially fatal delay to a project that is not just a pipeline, but is a lifeline for thousands of desperate working men and women. The administration chose to support environmentalists over jobs—job-killers win, American workers lose."

Mr. O'Sullivan's comments are right on the mark. The political left talks the talk about infrastructure and jobs. But they don't walk the walk, as evidenced by the flip flop on the Keystone XL project. It boils down to a question of priorities. We're in the midst of a national unemployment crisis. Do we want a government that responds flexibly to balance environmental, labor and other considerations while fostering public and private infrastructure spending? Or do we want a government that prioritizes environmental or other regulatory considerations above infrastructure upgrades and job creation?

A cynic might take a hard look at the Keystone XL decision and allege that Team Obama is trying "to do everything they can to drag down this economy." But I'll leave that commentary to Harry Reid and left-wing academics.

Whitesnake Maule's Again

2011-11-09T14:09:00.001-08:00

I spent a couple posts last week debunking Beale's Law (see here and here). On Monday, another tax professor jumped onto the factual manipulation bandwagon. This time, left-wing blogger James Maule put himself in the spotlight. [To demonstrate the echo chamber effect, Linda Beale promptly cheered Maule's post.]

As I said last Friday:

When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics* and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.

* Okay, I should have said "facts, statistics and economic common sense."

Why am I calling out Maule for factual manipulation?

On Monday, Maule linked to this report on the latest political volley between Senate Democrats and Republicans. Maule fumed over Republican opposition to a $60 billion infrastructure proposal from Team Obama. He then scolded Republicans for a proposal to allocate $40 billion to infrastructure spending from "unspent funding for other domestic programs." In Maule's view, the Republican proposal was a non-starter because it "included provisions intended to make the nation’s air quality worse than it is, under the pretext that less regulation means better lives for, oh wait, more money for those already with plenty of it."

According to Maule:

[1] Team Obama's infrastructure proposal ($60 billion) kills two birds with one stone. It begins to address our massive deficit in infrastructure spending. And it pumps needed federal outlays into the economy, where they will support construction jobs.

[2] Republicans oppose the $60 billion spending measure for several reasons. First, it is "funded" with a surcharge on millionaires. ("Boo hoo for the wealthy," says Maule.) Second, it is too large of a government commitment. Senate Republicans have given us a middle finger, telling us that we don't deserve quality highways and bridges. (Probably a fat middle finger, swaddled in expensive rings.)

[3] Harry Reid correctly identified that the Republicans intend "to do everything they can to drag down this economy."

[4] Democrats properly rejected the $40 billion spending measure, because Republicans were just using it as a vehicle to further undermine our nation's impossibly toxic air quality. (I know that I cannot run outside on the trails of northern California without several gas masks and tanks of oxygen.)

[5] Republican partisan politics, as obvious from the above reprimand, are reprehensible. Democratic partisan politics, as obvious from the Harry Reid quote, are a necessary counterweight against those damned partisan Republicans.

Let's review how Maule's key points hold up against a dash of facts and a pinch of logic.

[1] Maule is correct that we need more long-term investment in public infrastructure. However, as I've previously discussed, infrastructure is not a holy grail of short-term job creation. Meaningful infrastructure projects require several years of development. Neither the Democratic proposal ($60 billion) nor the Republican proposal ($40 billion) would have an immediate stimulative impact on the construction industry.

The Department of Transportation has a $70 billion annual budget (rough numbers). States and municipalities spend many billions more on transport infrastructure annually. Public utilities spend many billions more on energy infrastructure annually. We don't need to spend money on infrastructure just for the sake of spending money. We should be focused on developing high-quality infrastructure using the slack in the labor market to get the highest "bang for the buck" on construction expenditures.

[2] Maule wants to increase taxes on the "wealthy," so no surprise that he favors the Democratic proposal ($60 billion in spending "funded" by a surcharge on millionaires). However, if we're going to increase taxes on the wealthy, why not use those revenues to address the existing budget deficit? The Republican proposal was also "funded" by "unused" outlays to other programs. Both sides are engaging, to some extent, in accounting gimmicks. But the Republican proposal is more fiscally responsible (although gimmicky).

Maule accuses the Republicans of espousing that we "don't deserve quality highways and bridges." He completely ignores the $40 billion Republican proposal. Or perhaps Maule believes the $20 billion difference between two measures would provide us with "quality highways and bridges."

[3] Maule criticizes Republican allegations that Democrats were pursuing a tactical agenda focused on 2012 elections. He praises Harry Reid for comments that Republicans are attempting to damage the economy.

How much more biased can someone possibly get? Let me be clear. The political left and the political right are both playing this game with an eye towards 2012. If the Democrats were serious about infrastructure spending, they could have worked with Republicans on the $40 billion measure.

[4] In point [1], Maule argues that the $60 billion Democratic proposal could address our under-investment in infrastructure and provide stimulus the construction industry. He criticizes Republicans for arguing that $60 billion is "too big" a number. Then he criticizes Republicans for a $40 billion spending measure (presumably "too small" for Maule).

But if infrastructure spending is good for the economy, shouldn't the Democrats be working with the Republicans on a bipartisan $40 billion package? Why should they resist all spending just because they want to spend a higher number? Maule reminds me of schoolkids on the playground. Apparently, if the Democrats don't get their way, they should pack up their toys and go home.

Maule gripes about the regulatory conditions affixed to the Republican bill. I'm highly confident that he hasn't perused the actual bill (S.1786). The Republicans were mainly trying to streamline the regulatory process applicable to the very same infrastructure projects that are funded by the bill.

[5] Yes, partisan politics are obnoxious. As a political independent, nothing is more frustrating than empty posturing over budgetary gimmicks and class warfare tax policies. However, the political left has no monopoly on virtue. When you start quoting Harry Reid, you confirm that you are a card-carrying cheerleader for Team Obama.

What's with the title of this post? I realized that I've spent the past several posts debunking Linda Beale and James Maule. My friends on the political left are probably thinking, "here he goes again." So I dedicate this one to you:

Here I go again on my own
Going down the only road I've ever known
Like a drifter, I was born to walk alone
And I've made up my mind
I ain't wasting no more time

Inequality and U.S. Economic Hegemony

2011-11-07T16:47:00.000-08:00

In my last two posts, I've discussed Beale's Law (see here and here). Beale's Law posits that pre-tax income inequality has an "inverse" relationship to top tax rates. Today's post explores the more complex reality underlying the increased economic inequality in the United States.

The Decline of U.S. Economic Hegemony

The political left has convinced itself that inequality of income and wealth is primarily a function of tax rates. The narrative is easy to promote through soundbite politics. It stokes our base emotions (envy) and offers a simple government remedy to economic inequality.

The left clings to this narrative for a several reasons. The narrative is simple and politically expedient. It offers an excuse for failed left-wing policy initiatives that were supposedly enacted to improve equality of opportunity. (If past initiatives have failed to address inequality, why should we trust the same policymakers to implement "new and improved" policies to address inequality?) Most important, the narrative permits left-wing politicians to bury their collective heads in the sand. A simple narrative that 'tax policy drives inequality' fails to acknowledge the decline of U.S. economic hegemony over the last 50 years.

During the second half of the 20th century, the United States had the world's largest, strongest and most stable economy. We had an educated workforce, a developed energy and transport infrastructure, and stable government institutions. Following World War II, we experienced an economic surge associated with the Baby Boom generation. We supported our major trading partners during a period of post-war economic redevelopment. Capital markets activity was largely domestic. Through the 1970s, we ran consistent trade surpluses. From an economic perspective, we were the 'only game in town.'

Fast forward to 2011. The U.S. is now a player on a crowded and competitive international stage. We have no structural advantage relative to our major trading partners (the EU, Canada, Japan and Australia). Developing countries have better educated workforces, and armies of low-skilled workers that cost less than their U.S. counterparts. We have no discernible energy policy, and our dependence on oil imports drives chronic trade deficits. Technology has diminished the economic significance of geography, while promoting the relevance of talent. Financial capital markets are globally integrated. Global capital flows to the most profitable opportunities.

With that historical context, we can isolate on the major causes of U.S. economic inequality:

- On a macro level, the U.S. has been dragged into intense economic competition with its major trading partners and developing economies. We are no longer the 'only game in town.'

- On a micro level, the low-skilled U.S. worker has become far less valuable than his or her counterpart in the mid-20th century. Developing economies have large pools of low-skilled workers, and multinational businesses can access those low-skilled workers at lower costs than U.S. workers.

- Conversely, the best educated and most talented U.S. entrepreneurs have become more valuable than their counterparts in the mid-20th century. Technology has concentrated returns to talent and genius.

- Moreover, the byzantine U.S. regulatory system has created a "lock out" effect. In large sectors of the U.S. economy, only the largest businesses can thrive. If a business requires an army of lawyers or lobbyists to navigate regulatory, commercial or tax issues, it qualifies. The individuals that climb to the top of the pyramid generate economic premiums by "locking out" competitors. In the mid-20th century, how many CEOs depended on armies of lawyers or lobbyists?

Acknowledging the truth about economic inequality requires us to take off the blinders. We aren't going back to a period of U.S. economic hegemony. We are required to compete in markets that are ruthlessly efficient. Our low-skilled workers are at an enormous competitive disadvantage, and will continue to lose ground relative to better educated and more talented peers. The wealth gap will probably get steeper before it flattens out again. We aren't going to reverse the long-term trend by increasing top tax rates on "millionaires and billionaires."

However, all is not bleak. Our country has an extraordinary tradition of innovation and resilience. We need to acknowledge the competitive challenges facing our nation, and coalesce around strategies to align educational opportunities with a knowledge-based economy. We need to re-boot policies and institutions that worked in the mid-20th century to reflect the challenges of the early-21st century. We need to be realists, but realism is not mutually exclusive with optimism.

Higher Taxes, Lower Pre-Tax Incomes?

2011-11-04T08:49:00.001-07:00

In Wednesday's post, I debunked Beale's Law. Beale's Law reflects the pseudo-scientific economush advocated by the political left and political right. It provides that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases." Sounds like physics, right? But a close look at the numbers demonstrates that income inequality levels do not track "inversely" to the tax rate.

I'm not picking on Professor Beale. She is a bombastic advocate on behalf of the political left, which provides some counterweight to her counterparts on the political right. When it comes to data manipulation for political purposes, the right and the left are engaged in a long-running tug of war. They both abuse statistics and economic common sense to influence public opinion in the short term. It's great sport for incumbent politicians, blogging left-wing academics and Washington lobbyists. Not so great for the country in the long run.

As I said on Wednesday, this is all about political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses. But enough on data manipulation. One more question about Beale's Law while the topic is fresh.

Pre-Tax Income vs After-Tax Wealth

Beale's Law posits that income inequality is inverse to tax rates. Imagine that we plot a curve with the pre-tax incomes of the lowest-earning taxpayers on the bottom left, and the highest-earning taxpayers on the top right. Beale's Law predicts that, when top tax rates are high, the curve will "flatten out." Conversely, when top tax rates are low, the curve will "steepen up." Put another way, the difference between the pre-tax incomes of the top 400 taxpayers and the bottom 400 taxpayers should decrease as tax rates increase. And vice versa.

My last post demonstrated that Beale's Law doesn't apply in the real world. It reflects ideological and political wishful thinking, not an interpolation of real-world data. However, I remain puzzled by the logic underlying the pseudo-science. Specifically, I find it puzzling that the political left attempts to link the pre-tax income gap to the top tax rate.

The data indicate that we have a pre-tax income gap and an after-tax wealth gap in our country. I follow that increasing tax rates may "flatten" the after-tax wealth gap. If we taxed the highest-earning taxpayers at 90% marginal rates, we would diminish their ability to accumulate wealth.

In response, many of those individuals would ramp up tax sheltering activity -- shifting taxable income into non-taxable perks, relocating to lower-tax jurisdictions, etc. Longer term, such a policy would drain the wealth controlled by the richest Americans. We wouldn't necessarily observe a "redistribution" of wealth. There is no reason to expect an increase the wealth of the bottom 50% of taxpayers or bottom 400 individuals. But the curve plotting the difference between the top 400 wealthiest individuals and the bottom 400 individuals would likely flatten over time, because the wealthiest individuals would become less wealthy and/or relocate to lower-tax jurisdictions.

The fact that we could flatten the after-tax wealth gap does not mean that we could also flatten the pre-tax income gap. In 2010, LeBron James, Chris Bosh and Dwayne Wade signed $100+ million, six-year contracts with the Miami Heat basketball team. If the top tax rate were, say, 70%, would we expect that James, Bosh and Wade would have signed for less money? Or is the theory that higher tax rates at the top would support higher government spending and thus "trickle up" into higher wage rates across the board?

It's very difficult to identify any logical nexus between higher top tax rates and lower pre-tax income inequality. But no surprise -- as noted, Beale's Law is ultimately about ideological and political wishful thinking.

Beale's Law Debunked

2011-11-02T15:50:00.001-07:00

The political left and political right are engaged in a knock-down, drag-out competition. Although they seek to sway public approval numbers, the competition is not about public approval per se. They are competing to see who has the defter hand at data manipulation to suit their respective political objectives.

A post today by Linda Beale provides a suitable case study in data manipulation. Beale links to this CivilAmerican report, which presents a series of graphs plotting (i) top marginal income tax rates over the decades, and (ii) income earned by the top 10% of taxpayers and top 1% of taxpayers over roughly the same time period.

According to Beale, the graphs evidence the fact that "income inequality levels inversely track the top tax rate--as the rate increases, income inequality decreases."

Beale's argument has a intuitive appeal, which reflects the beauty of data manipulation. The use of data to support an ideological argument cloaks the argument with a pseudo-scientific legitimacy. Beale's position evokes the law of universal gravitation ("the gravitational force between two objects is proportional to the mass of each, and inversely proportional to the distance between them"). How could we possibly challenge the foundational concept of gravity? And how can we possibly challenge Beale's Law: that income inequality levels inversely track the top tax rate?

But let's take a harder look at the data in the graphs. How does Beale's Law hold up to a skeptical analysis by a political independent? (Spoiler: not so much.)

The first graph from the CivilAmerican report plots the top marginal tax rate applicable to individual taxpayers over time.

The second graph plots the percentage of total income going to the top 10% of taxpayers for a period ending in 2006.

The third graph plots the share of income reported by the top 1% between 1913 and 2007.

I don't have access to the data underlying these graphs, but let's assume that the underlying data and the graphing tools are accurate. We observe that the graphs are not exactly apples to apples -- the first graph plots data for a period ending 2010; the second graph 2006; the third graph 2007. The use of different time periods is somewhat misleading, but bigger problems emerge when examining Beale's Law against the graphical data. So we'll give a pass to the apples to oranges presentation.

The inclusion of data on the top 10% in graph 2 is outright misleading. The first graph and third graph are focused on the top 1% (rates and income). The second graph creates an inference that the top 10% benefit from the same changes in marginal tax rates as the top 1%. But taxpayers in the 90th income percentile are light years away from taxpayers in the top 0.01% and the top 0.001%. The "tippy top" of taxpayers distorts the income numbers. Meanwhile, we don't have data regarding the tax rates paid by the 90th through 99th percentiles. None of this data supports Beale's Law. The graphical presentation is a mess.

Now, on to the graphical data. If your eyes -- like mine -- have seen better days, crack out the microscope.

[1] First Decade of Income Tax (1913-1923)

The top tax rates jumped from less than 10% in 1915 to around 75% in 1917 or 1918 (first graph). That's an increase of more than 750%. The top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932.

Despite a 750% increase in the top tax rate from 1915 to 1917 or 1918, the top 1% of taxpayers reported a roughly 20% decrease in income from peak (1918-19%) to trough (1922-15%).

We only have data on the top 10% beginning in 1917. Between 1917 and 1923, the top 10% bounced from a low of 38% in 1921, to a high of 43% in 1923. The reported incomes of the top 10% were not apparently impacted by the 750% increase in top marginal rates.

The data on the top 10% doesn't support Beale's Law. However, I question the credibility of all this early data. I'm guessing that compliance/enforcement was selective and that tax shelters were widely available to the top 1%. Those issues make it very difficult to compare data from the early decades of the income tax (generally unreliable) to more current data (generally reliable).

[2] Second Two Decades (1923-1943)

As noted, the top rates stair-stepped down from roughly 72% in 1920, to 58% in 1922 or 1923, to roughly 25% from 1925 through 1932. They jumped back above 60% in 1933, and were close to 90% in 1943.

The reported income of the top 1% plummeted from its peak of 23.9% in 1928 to approximately 15% in 1931 or 1932. Top tax rates were stable, but 1932 and 1933 were the worst years of the Great Depression. Even the richest Americans are not immune from the forces of wealth destruction. (A similar trend emerged in the wake of the 2007 financial crisis.)

From 1933 through 1937, top rates climbed precipitously, but the top 1% saw their reported incomes rebound to approximately 19% of reported totals. Their reported income then began a period of gradual decline, reaching approximately 12% in 1943.

The top 10% of taxpayers reported approximately 45% of total income from 1923 through 1940. Reported income declined sharply around 1941, hitting 34% in 1943.

Lessons from the period? The top 10% were basically insensitive to the top marginal tax rates for most of the period. Beale's Law does not hold if we focus on that group. The top 1% saw income losses while rates were stable, and income gains during a period of increasing rates. In the early 1940s, Team Roosevelt increased the top rate above 90%. The top 1% began to report a lower share of total pre-tax income. However, we don't know how much of that decrease is attributable to weak compliance/enforcement and tax shelter activity by the ultra-wealthy. My guess is that tax sheltering drove much of the data for the next two decades.

[3] Third Two Decades (1943-1963)

The top tax rate was consistently in the 90% range throughout this period.

The top 1% bounced from peak income of approximately 12.5% (1944) to approximately 10% in the late-1950s and early 1960s. These data are somewhat consistent with Beale's Law. However, Beale's Law would not predict a 20% decline in reported income during a period of rate stability. Remember, Beale's Law suggest that income inequality is inverse to rates. During periods of rate stability, we'd expect to see stable levels of income inequality.

The top 10% bounced from peak income of approximately 37% (1946) to approximately 33% in the early 1950s. The reported incomes of the top 10% were very stable, which is consistent with Beale's Law. However, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses over the period. Guess who can allocate more cash to planning and implementation of tax shelters?

[4] Fourth Two Decades (1963-1983)

President Kennedy slashed the top rate from 90% to 70% in 1964. Reagan chopped the top rate to 50% in 1982.

Despite the top rate decrease, the top 1% reported approximately 10% of pre-tax income throughout the period. The trough was 8.9% in 1976. Reported income began to trend upward around the time of the Reagan tax cut.

Similar to the prior period, the reported incomes of the top 10% were very stable. Again, taxpayers in the 90th to 99th percentiles reported income gains, while the top 1% reported income losses.

Lessons from the period? Under Beale's Law, we would expect to see a jump in income inequality after Kennedy cut the top rate from 90% to 70%. Something else was going on, because the top 1% reported declining incomes through the mid-70s. I smell ... tax shelters!

[5] Fifth Two Decades (1983-2003)

From a historical perspective, this period was relatively volatile. The top rates declined from 50% in 1983 to 28% in 1988. Bucking his predecessors, Clinton raised the top rate to 40%. Bush Jr. cut the top rate to 35% in 2004.

The top 1% reported approximately 15% of pre-tax income in the mid-'80s through about 1994. From 1994 through about 1999 or 2000, the group's reported income spiked to approximately 22%. Reported incomes fell when the dot-com bubble popped (2000-2001), and then rebounded to 23.5% in 2007.

The top 10% largely tracked the top 1%. The group reported approximately 36% of total income in 1983, spiked to approximately 47% in 2000, fell for a couple years, and then rebounded to a high of approximately 50% in 2006.

Lessons from the period? Under Beale's Law, we'd expect to see a decline in income inequality after Clinton raised the top rates. In fact, income inequality continued its sharp ascent notwithstanding the tax increase. History repeats itself. The top 1% took a relative hit when the dot-com bubble popped (compare peak years of Great Depression). They rebounded before the Bush tax cuts took effect.

[6] Conclusion

Beale's Law is a pseudo-scientific assertion seemingly grounded in historical data. When we scrub the numbers, however, the theory crashes and burns. During periods that tax rates changed, we don't see "inverse" reactions in reported taxable incomes of the top 1%. During periods of relative stability, we see patterns that aren't consistent with Beale's Law. For much of the history of the income tax, the top 1% (or perhaps the top 0.01%) were able to exploit tax shelters that were unavailable to taxpayers in the 90th to 99th percentile. When loopholes were tightened, their share of reported income rebounded significantly.

Moreover, Beale's Law disregards the macroeconomic currents that cause income inequality to ebb and flow over time. In the late-'90s, for instance, we see increasing inequality despite the Clinton tax increases (no inverse relationship). The evolution of new technologies and increased fluidity of global capital markets have concentrated the rewards to talented innovators and entrepreneurs. Beale's Law, and other pseudo-science on the political left and political right, is guided by political expedience: fitting complex economic issues into a simple box for widespread consumption by the relatively unsophisticated masses.

Although I've spent too much time debunking Beale's Law, her fundamental argument misses the point. Beale anguishes over the fact that income inequality has ebbed and flowed over time. She yearns for the "good old days" when the top 1% reported a smaller percentage of total income (8.9% in 1976). But the key question is whether the top 1% are paying a fair share of taxes necessary to run the government that Americans desire. The top 1% paid approximately 37% of total income taxes in 2009. Is that enough? Too little? How much would satisfy Professor Beale? And what if we increase taxes and don't cause a dent in income inequality? What's the next step from Professor Beale's perspective?

Free Lunch Politics

2011-10-31T14:40:00.001-07:00

I've been critical of the tax and economic policies advocated by Team Obama and its cheerleaders on the political left. However, for the last 30 years, Republicans in Congress have been complicit in the debt-fueled expansion of the federal budget.

Despite their public animosity, Democrats and Republicans have each promoted a "free lunch" philosophy to the voting public. Of course, their marketing of the "free lunch" philosophy is slightly different.

Democrats target their message to middle- and lower-income taxpayers. They argue that increased taxes on "millionaires and billionaires" can finance larger entitlements and higher discretionary spending. The middle-class can enjoy a "free lunch" courtesy of income redistribution. The harsh reality -- which most Democrats won't acknowledge publicly -- is that we cannot plug the long-term budget gap through increased taxes on "millionaires and billionaires." To fund Democratic spending initiatives, we'll need higher taxes across the board. Today, the political left defines the "wealthy" as working professional families with $250,000 in taxable income. How low will they go to finance tomorrow's spending initiatives?

Republicans target their message to middle- and higher-income taxpayers. Under Team Bush, they cut taxes while increasing entitlement spending for seniors. Lower taxes, higher spending? Sounds like a "free lunch" to me. Except for that little problem with deficit financing. Today's deficit spending will increase future interest expense and impose higher tax burdens on future generations of taxpayers. I'm not suggesting that all deficit spending is problematic. But Republicans have been disingenuous by attempting to kick the can permanently down the road.

Today, Republicans oppose "tax increases" as a mechanism to reduce the federal budget deficit. Like obsequious courtesans in the House of Norquist, they conflate elimination of tax expenditures with marginal tax rate increases. But tax expenditures have the same impact on federal deficits as on-budget cash outlays. Lowering tax expenditures will increase taxes for some taxpayers, but may permit broader tax relief for all taxpayers. As Congress grapples to slow the accumulation of federal debt, Republicans should be aiming to reduce federal spending and tax expenditures.

The other problem with tax expenditures is the fact that they distort economic behavior. Tax expenditures provide government subsidies for activities that Congress wishes to encourage. Given his defense of tax expenditures, Grover Norquist must believe that members of the Ways and Means Committee are better capital allocators than the free market.

By distorting economic behavior, tax subsidies can lead to over-consumption of goods and services. For example, the exclusion from taxable income for employer-sponsored health insurance is a major contributor to the runaway inflation of health care costs. Employees with generous health care packages have no incentive to control costs. Absent a price transmission mechanism, they consume more and higher-cost health care services. The excessive demand outstrips supply for medical products and services. The supply-demand imbalance translates into higher insurance premiums for individuals and businesses.

Tax expenditures can also lead to the mis-allocation of capital. For example, the mortgage interest deduction encourages taxpayers to "stretch" and purchase a little more home than they can otherwise afford. The behavior wasn't a problem during the real estate bubble. However, it had devastating consequences on thousands -- if not millions -- of homeowners during a period of high unemployment and real estate deflation.

Finally, tax expenditures can result in tax "windfalls" for high-income taxpayers that don't need the underlying tax subsidy. Take the home mortgage interest deduction. The home mortgage interest deduction has a higher value to a high-income taxpayer that pays a top marginal rate of 35% than a lower-income taxpayer that pays a top marginal rate of 25%. The lower-income taxpayer saves $250 in tax on $1,000 in mortgage interest expense. The higher-income taxpayer saves $350 in tax on $1,000 in mortgage interest expense. But capping the benefit of the mortgage interest deduction is no solution. If a taxpayer can afford a half million dollar home -- or a million dollar home -- why are we providing a tax subsidy at all?

I'm not the first to highlight the problems with tax expenditures, and I won't be the last. We desperately need fundamental tax reform, which I define as base broadening combined with marginal tax rate reductions. The first step towards any such tax reform must include an acknowledgement by Free Lunch Republicans and Free Lunch Democrats that tax expenditures are on the chopping block.

Yahoo Evaluating Cash-Rich Split Offs

2011-10-28T08:58:00.000-07:00

The Wall Street Journal (sub. required) has reported that Yahoo Inc. is considering a disposition of its stakes in Alibaba and Yahoo Japan through cash-rich split offs. Yahoo owns a 43% stake in Alibaba, a Chinese search engine, and a 35% stake in Yahoo Japan.

The split-off transactions would make Yahoo a more attractive target for a subsequent acquisition by a private equity group or strategic investor (e.g., Microsoft). The market has speculated that Yahoo's complicated relationships with Alibaba and, to a lesser extent, Yahoo Japan, have discouraged potential suitors from offering a marriage proposal.

So what is a "split off" transaction? Why does the WSJ article describe the proposal as a "cash-rich split off" transaction? Can the tax lawyers save the day for Yahoo and its beleaguered long-term shareholders?

Spin Offs, Split Offs and Split Ups

Section 355 of the Internal Revenue Code governs "spin off" transactions, "split up" transactions and "split off" transactions.

A "spin off" occurs when a distributing corporation (let's call it "Distributing") distributes the stock of a controlled subsidiary (let's call it "Controlled") pro rata to its shareholders. Following a spin-off transaction, the shareholders of Distributing also own stock of Controlled.
A "split off" is similar to a "spin off," but with a twist. A "split off" occurs when Distributing redeems shares from one or more shareholders -- but not all shareholders -- in exchange for stock of Controlled. Following a split-off transaction, some of the historic shareholders of Distributing continue to own stock of Distributing. However, other historic shareholders own stock of Controlled. The latter group "trades" its interest in the overall Distributing business for a more direct interest in the Controlled business.
In a "split up" transaction, Distributing engages in more than one business, for example, Business A and Business B. Distributing redeems stock from some shareholders in exchange for stock in a corporation that owns Business A. Distributing redeems stock from other shareholders in exchange for a stock in a corporation that owns Business B. Distributing is like the head of the Hydra. Following a split-up transaction, Distributing has disappeared, and its former shareholders go their own separate ways with stock in Corporation A (which owns Business A) and Corporation B (which owns Business B).

Yahoo's proposed dispositions of Alibaba and Yahoo Japan would be structured as "split off" transactions. As noted, Yahoo is a shareholder of Alibaba and Yahoo Japan. If the parties implement the "split off" proposal, Alibaba and Yahoo Japan would be the distributing corporations. Alibaba and Yahoo Japan would redeem their stock currently owned by Yahoo in exchange for stock in a controlled subsidiary. Following the transactions, Yahoo would cease to own any shares in Alibaba and Yahoo Japan. Instead, it would own stock in a corporation formerly owned and controlled by Alibaba and Yahoo Japan, respectively.

To qualify under Section 355, the split-off transactions contemplated by Yahoo must satisfy a number of technical conditions. If those conditions are satisfied, the split-off transactions would be non-taxable to the distributing corporations (Alibaba and Yahoo Japan) and to its shareholders (Yahoo itself). Section 355 thus permits a corporation to "shuffle" the form of its investment in a lower-tier corporation, without triggering income tax on any appreciation in the stock of such corporation.

Cash-Rich Split Offs

Now we're getting to the real action. Yahoo may be able to exchange its stock in Alibaba and Yahoo Japan for stock of a new corporation. But what does that accomplish? The market is already penalizing Yahoo for its unwieldy legal structure, which includes large but non-controlling stakes in Alibaba and Yahoo Japan. Would a split-off transaction address the market's concerns?

For Yahoo's shareholders, I have good news and bad news.

Good News

The good news is that Yahoo could effectively "monetize" its investments in Alibaba and Yahoo Japan through a cash-rich split off. By "monetize," I mean that Yahoo could convert its stock in Alibaba and Yahoo Japan into stock of new corporations whose principal assets are cash or other liquid securities. Although each of the new corporations must be engaged in a historic (five-year) trade or business after the split-off, up to two-thirds of its assets may be composed of cash or other liquid securities.

If the parties implement cash-rich split offs:

Immediately before the split offs, Yahoo would own 43% of the stock of Alibaba and 35% of the stock of Yahoo Japan, respectively; and
Immediately after the split offs, Yahoo would own 100% of stock of two new corporations. The first corporation would have a historic (five-year) trade or business formerly conducted by Alibaba, and a bucket of cash or other liquid securities. The second corporation would have a historic (five-year) trade or business formerly conducted by Yahoo Japan, and a bucket of cash or other liquid securities.
Then Yahoo's shareholders and its pointed-headed tax lawyers would pop some champagne and haul out their dancing shoes. Well, maybe the shareholders would haul out their dancing shoes.

You might be curious whether Alibaba and Yahoo Japan could simply redeem Yahoo's shares for cash. Why does Yahoo need an army of pointed-headed tax lawyers to monetize its investments in Alibaba and Yahoo Japan? Alas, life is not so simple under current U.S. tax rules. The redemption transaction (exchange of stock for cash) would be taxable to Yahoo. Yahoo would incur U.S. tax expense and its after-tax cash proceeds would take a corresponding haircut. So bring on the tax lawyers!

Bad News

Now for the bad news. Unlike a corporation that owns 100% of a business, Yahoo owns a large, non-controlling stake in Alibaba and Yahoo Japan. Yahoo would require cooperation of the boards of directors of each company to implement a cash-rich split off transaction. Each board (including Yahoo's) would have a fiduciary duty to ensure a "value for value" exchange. It might be very difficult to negotiate a valuation that makes everybody happy. That said, if the tax savings to Yahoo were sufficiently material, Yahoo may be able to "share" some of that savings with Alibaba or Yahoo Japan to bridge any gaps in the numbers.

The parties would be required to navigate the various conditions of Section 355. For the most part, those should be manageable. The biggest hurdle would probably be Section 355(g), which was enacted in 2006 to diminish the appeal of cash-rich split offs. Section 355(g) limits the "investment assets" of a controlled corporation to two-thirds of the fair market value of all its assets. For such purposes, "investment assets" include cash and other liquid securities. To comply with the limitations of Section 355(g) any cash-rich split off would need to include material business assets of Alibaba and Yahoo Japan, respectively.

Finally, Alibaba and Yahoo Japan would need to "stuff" the controlled corporation with cash or liquid securities. Such an effort may require external financing, which may or may not be palatable to the directors of Alibaba and Yahoo Japan. The tax tail is not going to wag the dog unless the parties can round up financing to make the cash-rich split off work.

Repatriation?

Another hurdle for Yahoo would involve the repatriation of cash from its new subsidiary companies. Although I can only speculate on the transaction form, Yahoo is likely to own stock in a new foreign subsidiary following a split off from Alibaba or Yahoo Japan. As described above, the foreign subsidiary would have a historic (five-year) trade or business, and a large amount of cash and liquid securities.

If Yahoo repatriates the cash by causing its new subsidiary to pay a dividend, the dividend could be taxable to the U.S. group. Yahoo may or may not have sufficient foreign tax credits to offset the resulting U.S. tax liability. Any limits on repatriation may reduce the attractiveness of the split-off idea.

Alternatively, after the dust has settled on the split-off, Yahoo may be able to liquidate the foreign subsidiary and repatriate cash in the liquidation transaction. Such a liquidation would also be taxable to the extent of the foreign subsidiary's earnings and profits.

In either case, a portion of the distributing corporation's earnings and profits would be allocable to the controlled corporation immediately before the tax-free split off. Under the mechanical allocation rules, the new corporation may inherit a very small earnings pool from Alibaba or Yahoo Japan, respectively. If the earnings pool is small, a liquidation transaction may be a viable repatriation option for Yahoo. In any case, tax nerds and Yahoo shareholders will stay tuned for developments in the Yahoo story.

* * * * *

For more on cash-tax split offs, two articles by the ubiquitous Robert Willens are worth a read. See "Liberty Media and News Corp. Will Be Parting Ways," 114 Tax Notes 697 (Feb. 12, 2007), and "Can STI Efficiently 'Monetize' Its KO Stake," 120 Tax Notes 601 (Aug. 11, 2008). He even mentions Yahoo! in this interview (published Saturday, October 22).

Searching for the Elusive "Fair Share"

2011-10-26T16:23:00.001-07:00

On Monday, David Logan of the Tax Foundation issued a report summarizing the individual income tax data from 2009. Highlights (or lowlights, depending on your perspective):

- Nationally, average effective income tax rates were at their lowest levels since the IRS began tracking them in 1986. The average tax rate for returns with a positive liability went from 12.24% in 2008 to 11.06% in 2009.

- Incomes reported by tax returns at the high end of the income spectrum fell from 2008 to 2009, as did their share of the nation's income and income taxes paid. In 2009, the top 1% of tax returns paid 36.7% of all federal individual income taxes and earned 16.9% of adjusted gross income (AGI), compared to 2008 when those figures were 38.0% and 20.0%, respectively.

- Each year from 2005 to 2007, the top 1%'s constantly growing share of income earned and taxes paid set a record. The 2008 reversal of this trend continued in 2009. In fact, the income share for the top 1% of tax returns was lower in 2009 than in 2000, largely due to differences in capital gains.

- In 2009, as in 2008, the top 1% no longer pays a larger percentage of total income tax than the bottom 95%. This trend was exacerbated by the aforementioned precipitous drop in AGI in 2009. During 2009, the bottom 95% (AGI under $154,643) paid 41.3% of the total collected, a larger share than the 36.7% paid by the top 1% (AGI over $343,947).

- The top-earning 5% of taxpayers (AGI equal to or greater than $154,643), however, still paid far more than the bottom 95%. The top 5% earned 31.7% of the nation's adjusted gross income, but paid approximately 58.7% of federal individual income taxes.

- Since 2001, the IRS has also been presenting data on a small subset of the top 1%, the top 0.1%. In 2009, this top 0.1% filed 137,982 tax returns, reporting 7.8% of all adjusted gross income earned and paying approximately 17.1% of the nation's federal individual income taxes. The average income for a tax return in the top 0.1% was $4.4 million in 2009, while the average amount of income tax paid was $1.07 million, indicating an average effective individual income tax rate of 24.3%.

- Overall, these data on high-income tax returns appear to confirm that the continued economic stagnation had the same diminishing effect on income inequality that most recessions have, and that it occurred for the same reason: a sharp decline in income at the high end. This appears to contradict reports based upon Census data suggesting the opposite that the recession increased income inequality.

Logan's report is particularly timely, in the midst of ongoing Occupy Wall Street protests. However, that's a post for another day, if the protesters keep plugging away despite the blizzard approaching the East Coast.

For today, the data inspire several questions. President Obama and his cheerleaders on the political left want to "spread the wealth" around. They believe that "millionaires and billionaires," defined as working professional married couples with $250,000 in taxable income, aren't contributing their "fair share" to the federal government.

Three questions for the political left:

[Q1] In 2009, the top 0.1% of taxpayers paid 17.1% of all individual income taxes, the top 1% of taxpayers paid 36.7% of all individual income taxes, and the top 5% of taxpayers paid 58.7% of all individual income taxes.

What percentage of individual income taxes should be paid by each sub-group to be considered their "fair share"? The answer should be a simple percentage, for example, 25% for the top 0.1%, 45% for the top 1% and 65% for the top 5% (numbers are illustrative only, not my view).

[Q2] If we increase taxes on the top 5% as you recommend in A1, will that solve the short-term or long-term budget gaps associated with current spending projections? Or will we also be required to increase taxes on the bottom 95% of taxpayers to solve the fiscal imbalance?

[Q3] Do you really believe that increasing taxes as set forth in A1 and A2 will address the wealth imbalance between the wealthiest 1% and the remaining 99%? Note that increased taxes on the bottom 99% or bottom 95% will decrease their ability to accumulate resources and "catch up" to the top 1%.

Tax bloggers on the political left, I look forward to seeing the answers to these straightforward questions.

Reid Reminder: Electoral Paradox

2011-10-24T11:59:00.001-07:00

Last week, Senator Harry Reid (D-Nevada) reminded us why we need to "throw the bums out." During a debate over the teacher/first responder bill (S. 1723), Reid observed:

It's very clear that private-sector jobs have been doing just fine; it's the public-sector jobs where we've lost huge numbers, and that's what this legislation is all about.

Yes, he really said that. Reid went on the record and stated that the pace of job creation in the private sector is "just fine."

The last time I checked, we had a 9% headline unemployment rate, and a 16-20% effective unemployment rate. The 16-20% effective unemployment rate is an unofficial number which includes people who are too discouraged to continue seeking work. For Harry Reid, 9% headline unemployment and 16-20% effective unemployment is "just fine."

Reid's comments aren't particularly shocking. He makes airhead comments all the time. But that's no excuse. Why do we have such diminished expectations for our political leaders? We should not have to tolerate a Senate majority leader who projects such an air of incompetence. His own party should have demonstrated some common sense years ago and delegated Reid to the back benches. Let's prioritize leadership over seniority until we emerge from this period of economic malaise.

Reid apologists will argue that I'm taking his comments out of context. He was contrasting recent employment data in the private sector against similar data regarding state and local government employees. He was tilting at "obstructionist" Republicans who oppose more federal spending on state and local services. Blah blah blah. It was an airhead comment, and it projects an air of incompetence, regardless of political motivation.

I'm not just picking on the invertebrate* Harry Reid. Harry Reid is symbolic of a problem that has been festering on Capitol Hill for decades. It's not a problem with the Republican party or Democrat party; both parties share the blame for bad policies and incompetent leadership over the years. It's a structural problem baked into the U.S. electoral system itself. (*Credit to tax fashionista Lee Sheppard)

The problem is that our members of Congress are, for the most part, unaccountable for their actions as legislators. I won't digress far into PolySci 101. Suffice it to say that the deck is stacked in favor of incumbent legislators. Critically, incumbents can control or influence federal spending in their districts. Federal spending sometimes translates into permanent jobs (think military bases). Local constituents can sense where their bread is buttered, even if a given legislator is failing the country as a whole. Special interests trade campaign donations and elector muscle for direct or indirect legislative perks. Legislative districts are gerrymandered to maximize political support for one party or the other. The list goes on.

Because the deck is stacked in favor of incumbents, we get an Electoral Paradox. Depending on the poll, roughly 80 to 90 percent of Americans disapprove of Congress. Nearly 80 percent of the country believes that we're on the "wrong track." But paradoxically, local constituents continue to re-elect their incumbent members of Congress, cycle after cycle after cycle. Even in 2010, when the Tea Party energized a backlash against political incumbents from both parties, incumbents prevailed in an large majority of electoral contests. The American public is enormously disgruntled on a macro level, but doesn't hold incumbent legislators responsible on a micro level.

As a result of the Electoral Paradox, our nominal democracy has become a political oligarchy. We have a cadre of career politicians; men and women who are focused primarily on their individual re-election campaigns. Their secondary focus involves jockeying to create internal and external alliances and other legislative accoutrements (committee appointments, etc.) that support their primary focus on re-election. They are effectively neglecting the long-term interests of the country to pursue short-term agendas that "refresh" every two to six years.

We're emerging from a financial crisis that prompted the worst economic downturn since the Great Depression. The political class has attempted to pin the sole responsibility for the financial crisis on Wall Street. (To be fair, politicians on the left are more vocal advocates of this view. They also blame "de-regulation," despite the fact that the banking industry was highly regulated. But sheer volume of regulation is not the same as prudent and effective regulation.)

In reality, the financial crisis originated when the U.S. real estate bubble popped. The real estate bubble was fueled by government policies that distorted traditional lending practices. That problem was compounded by lax regulation of mortgage origination practices and feeble regulation of banks and other financial institutions. On both counts, legislators share culpability with Wall Street financial engineers. Politicians took the credit for a bubbly economy driven by the housing bubble. They scattered like cockroaches when the bubble popped and a vicious de-leveraging cycle ensued.

Congress has a responsibility to pilot the U.S. economy around financial crises. Individually and collectively, members of Congress failed to live up to that obligation. Political incumbents should acknowledge that they contributed to the financial crisis, accept responsibility, and pass the political reins to a new class of legislators. Instead, a majority of the political oligarchs have clung to power. Chuck Rangel, Henry Waxman, Barney Frank, and their senior colleagues on the political right, should not be able to look themselves in the mirror. The fact that they continue to influence legislation -- despite their abject failure as trustees of the American economy -- should make us all shudder. With some exceptions (e.g., Chris Dodd), these men and women have chosen to ride out their political careers in disgrace.

Bill Bradley on Tax Reform

2011-10-21T11:10:00.000-07:00

This year marks the 25th anniversary of the Tax Reform Act of 1986. Whether you liked it, hated it, or come down in the middle, TRA 1986 was a monumental event in the history of U.S. tax policy.

To commemorate the anniversary, the editors of Tax Notes profiled several veterans of the 1986 tax reform effort this week. Nearly all of the interviews and personal recollections are worth a quick read. However, I wanted to spend a few minutes summarizing Meg Shreve's interview with Bill Bradley.

Bill Bradley is a former Senator (D-NJ) and Democratic presidential candidate. His popularity traces back to his career as a hall of fame basketball player with the New York Knicks. He was no intellectual slouch, attending Oxford as a Rhodes Scholar after a basketball career at Princeton.

Highlights from the interview:

[1] We need to define "tax reform."

Bradley emphasized that we can't do tax reform without defining tax reform. Do we close loopholes and use all the revenue from to lower rates? Or do we close loopholes and use only some of the revenue to lower rates (with some of the revenue dedicated to deficit reduction or new programs)? Alternatively, do we shift the paradigm by lowering income tax rates and offsetting the revenue shortfall with a consumption tax or some other source of revenue (e.g., a carbon tax)?

In 1986, political leaders defined tax reform as revenue-neutral loophole closers. Republicans wanted lower rates, and Democrats wanted fewer loopholes. In a sense, the stars were aligned to permit a political consensus. The Code was riddled with loopholes that were exploited by the highest earners, and top marginal tax rates were high. By eliminating loopholes, TRA 1986 increased taxes on the individuals and businesses that exploited the loopholes. The increased tax revenue was used to "pay for" lower tax rates across the board. The result was that "the top 5 percent paid a higher percent of the income tax revenue after tax reform than before tax reform even though the rate dropped from 50 to 28 percent."

Unfortunately, defining tax reform is more difficult today. Today's "loopholes" are tax expenditures that benefit tens of millions of middle-class taxpayers. Top marginal tax rates are lower today than in 1985. Even without the rancorous climate in Washington, it would be heavy lift for political leaders to adopt the 1986 definition of tax reform.

[2] We need a president that is "full square" behind tax reform and a Treasury Secretary with the gravitas to cut a deal.

Bradley recounted President Reagan's commitment to tax reform. Reagan "gave a couple of speeches," but delegated broad authority to former Treasury Secretary James Baker to cut a deal. Reagan "made it acceptable and led the charge." Baker ultimately brokered a tax reform deal with Bradley himself.

If Bradley is correct, we aren't going to see tax reform before 2013 or 2017. Meaningful tax reform is not a priority for President Obama. His priorities range from socialized health care and "spreading the wealth around" to green jobs and hybrid vehicles that will run 120 miles on a gallon of fuel. His Treasury Secretary, Timothy Geithner, is a bookish technocrat who has struggled to tread water due to economic conditions outside his control.

Bradley did not put a grade on Obama's efforts to drive tax reform. He suggests that Obama has been evasive for political reasons ("If the answer is 'we need to close loopholes to raise revenue and we don't touch rates' -- if that's what you mean, then say it.").

[3] Tax reform is too complicated for most people and will never be a "mainstream" issue. But political leaders need to articulate the principles guiding reform.

Bradley explains that the 1986 reforms were motivated by three simple principles. First, equal incomes should pay equal taxes. Second, the income tax should be progressive (those with higher incomes should pay more). Third, the market is more efficient at capital allocation than the Ways and Means Committee.

Team Obama has struggled to articulate clear, simple principles in respect to tax policy. Obama wants to increase taxes on "millionaires and billionaires," but defines millionaires as married working professionals with taxable income of $250,000. The income tax is steeply progressive, with the top 1% of taxpayers contributing 37% of income tax revenues. But he wants to "spread the wealth around" further, without defining what constitutes a "fair share." He has caught the "Buffett Bug," and become obsessed with the effective tax rates paid by the 400 top earning individual taxpayers. He sniffs at Bradley's quaint notion that the market is better at capital allocation than legislators and bureaucrats in Washington.

No wonder that individual Americans are confused and frustrated by the rhetoric around tax reform.

Solar Trade War: Collision Ahead

2011-10-20T10:26:00.000-07:00

Back in August, before the Solyndra news broke, I discussed the bankruptcy filings of two U.S. solar manufacturers.

As I remarked in the August post:

The price of solar panels has fallen dramatically as China ramps low-cost manufacturing. That's good news for U.S. energy consumers and the environment, because the cost differential between solar power and power generation from fossil fuels is narrowing. If the trend continues, solar power will become a competitive alternative energy source without government subsidies.

Yesterday, the New York Times reported that seven of the surviving U.S. solar manufacturers have filed an anti-dumping case against the Chinese solar industry. The case seeks tariffs of more than 100% on the wholesale price of solar panel imports from China. Obviously, such an action would increase the cost of solar power development projects (by increasing the cost of solar panels). Higher-cost solar power projects would translate into higher costs for U.S. energy consumers (because the cost of renewable energy is "passed through" by utilities to consumers). Moreover, higher-cost solar panels would slow the transition in our energy infrastructure away from fossil fuels.

The result is a collision of political, economic and environmental priorities.

The U.S. solar manufacturers and many politicians will argue that this is about jobs. We need a strong manufacturing base and we have the capacity to lead the development of renewable energy technologies in the coming decades. As a leader in development, we should be able to exploit our technological advances by manufacturing solar panels "at home." If China really is dumping panels below cost to gain market share, we should enact tariffs to "level the playing field" so that U.S. manufacturers can compete with Chinese manufacturers.

All fair points; one might quibble with the details, but the broad principles hang together.

From an economic perspective, however, we might be better off permitting China to dump its solar panels on us below cost. Sure, that might cost us U.S. manufacturing jobs. But China's dumping policies would effectively be subsidizing U.S. solar development projects. To some extent, then, we'd simply be shifting jobs between industrial activities. We'd need less individuals fabricating and assembling solar panels. We'd need more individuals working on construction projects and, upon completion, operations and maintenance of solar facilities.

Big picture, why shouldn't we permit China to subsidize our solar development projects? By subsidizing our solar development, China would be reducing costs to U.S. energy consumers. Our businesses would be more competitive (due to lower energy costs), and individual consumers would have more disposable income. Let's say that a Middle Eastern country decided to "dump" oil into the U.S. market, reducing U.S. oil production and decreasing the number of U.S. oil drilling jobs. Would we view that as a negative development? Would the U.S. support an anti-dumping case against the Middle Eastern country to save American jobs? Or would the U.S. take the Middle Eastern energy subsidy and run with it?

Finally, how does the environment fit into this picture? Solar power is unequivocally "cleaner" than power generated from fossil fuels. Should environmental considerations "tip the balance" in a situation where economic and political objectives do not align? In this case, for example, does the threat of global warming and environmental catastrophe outweigh concerns about a few hundred (or few thousand) U.S. manufacturing jobs? Should we make the transition to a cleaner power generation footprint the highest priority? For politicians on the left and right, time to pick your poison. Which is the higher priority: protecting U.S. jobs; economic growth; or environmental protection?

$95 Million Pay Day

2011-10-19T14:21:00.001-07:00

Several interesting developments this week converged to prompt this post.

- On Monday, our favorite tax fashionista, Lee Sheppard, published an article discussing the relationship between income tax rates and executive compensation. Sheppard argues that Reagan-era cuts to marginal income tax rates have fueled the dramatic inflation in pre-tax compensation payments to C-suite executives. See "News Analysis: Should We Adopt a Millionaire's Surtax?" 133 Tax Notes 307 (Oct. 17, 2011).

- Sheppard mines data compiled by Catherine Mulbrandon from a November 2010 rep ort by Jon Bakija of Williams College, Adam Cole of the Treasury Department and Bradley Heim of Indiana University. The report analyzes the occupations of the top 1% on American taxpayers between 1979 and 2005.

- Sheppard focuses, in particular, on the profiles of the top 0.1% of American taxpayers. Catherine Mulbrandon presents a terrific graphic comparison of the top 1% and the top 0.1% on her website, Visualizing Economics.

- Catherine Rampell, an economics reporter at the New York Times, also discussed the report on Monday. Rampell's analysis contains some good tabular summaries of the underlying data. She gently tweaks the OWS protesters by noting that the large majority of taxpayers in the top 1% are not Wall Street financiers. They are doctors and lawyers and C-suite executives.

- Over the weekend, Kinder Morgan signed a deal to acquire El Paso Corp in a $38 billion transaction. If the transaction is completed, El Paso's current CEO will be eligible for an exit package worth $95 million. Perhaps he can purchase the Greek island of Santorini after closing the deal.

- Today, Paul Caron posted the following chart summarizing the percentage of income earned and income taxed paid across the tax brackets in 2009. Thanks to Peter Pappas for linking. (Note that the data compiled for the Bakija et al study dates to 2005, so the numbers aren't precisely apples to apples.) The average taxpayer in the top 1% earned a comfortable $343,000 in 2009. That's approximately 0.4% of the retirement package for El Paso's current CEO. The doctors and lawyers in the top 1% are no closer to the top 0.1% than the middle-class union members in the middle of the income distribution.

How does this all fit together?

Sheppard argues that American CEOs are "grotesquely overpaid," and I completely agree. According to Sheppard:

Chief executive pay has increased 500 percent in real terms since the 1981 act cut the top marginal rate to 50 percent. Average worker pay has not increased in real terms during the same period. The median chief executive of an S&P 500 company now takes home more than $9 million annually [versus $1 million in 1981, in inflation-adjusted dollars]. The average chief executive of a public company takes home $2.5 million. Research has calculated that executive pay is the equivalent of 10 percent of corporate earnings at the largest companies.

It really is outrageous. I'm a strong believer in free market economics, but executive compensation practices are symptomatic of market failure. No manager of an industrial/energy company deserves a $95 million retirement package. Bill Gates, Mark Zuckerberg ... different stories.

Consultants in the executive compensation space make a killing on "peer benchmarking." For a public company, the board of directors is responsible for hiring and compensating the CEO. Directors hire consultants to "benchmark" the compensation packages granted to CEOs at "peer" companies with somewhat comparable operations, capital structures, etc. The "benchmarking" studies are used to support ever-increasing compensation packages to CEOs. As Sheppard observes, "[n]o board wants to believe that its chief executive is merely average."

The net result is the ridiculous inflation in executive compensation that has occurred during the last 30 years. The benchmarking data contains a "one-way" bias, because boards never pay their executives less than the "average" CEO among the comps. If nobody is ever "below average," there is never a price mechanism to slow the price inflation for executive management. As CEO compensation increases, the consultants incorporate the increased compensation data into their benchmarking analyses. Year after year, the cost of an "above average" manager continues to inflate. The newest vintage of "above average" CEOs needs to be paid more than the last vintage of "above average" of CEOs.

Ironically, CEO pay seems to be the one area where business organizations seek to maximize their costs. Imagine how long a business would last if it committed to paying "above average prices" for the various inputs into its products or services. Competitive markets reward innovative enterprise that can satisfy consumer demand while lowering costs of production. I understand that CEOs play a critical strategic role within their respective businesses. They're distinguishable from commoditized widgets. Nonetheless, corporate boards are consistently failing their shareholders by acquiescing to current executive compensation trends.

(Boards have other incentives to inflate CEO pay. Frequently, CEOs install or support directors who are themselves CEOs of other public companies. This creates an obvious conflict of interest. A CEO of Company A that wears a "director hat" for Company B is more likely to support an outrageous compensation package for the CEO of Company B, because he or she knows that the compensation package will become part of the benchmarking data supporting his or her compensation as CEO of Company A.)

Sheppard discusses various options to curb the inflation of executive compensation, including surtaxes and new brackets for the highest-paid taxpayers. I don't believe that taxes created the problem, so I don't believe that taxes will solve the problem. Instead, corporate boards should adopt guidelines on the relationship between CEO compensation and the median compensation of an employee within the organization. It could be a simple formula: CEO pay for a given period may not exceed 10x or 20x of the median employee pay. It could be more complicated, with performance metrics and clawbacks. No matter how you slice it, corporate boards should begin chipping away at the market failures that are inflating CEO pay.

Government Spending: 2x Inflation

2011-10-18T12:08:00.001-07:00

On Friday, I discussed Steve Shay's recent insights on fundamental tax reform. Today, I want to circle back to some interesting numbers in Shay's article.

Shay notes that federal on-budget expenditures have grown from $807 billion (18.3 percent of GDP) in 1986 to $2.9 trillion (20 percent of GDP) in 2010. Tax expenditures were approximately $1 trillion in 2010. Thus, the sum of on-budget and "off-budget" spending in 2010 was approximately $3.9 trillion.

According to a report by the Tax Policy Center, tax expenditures were approximately $362 billion in 1985. (I can't quickly locate the numbers from 1986, which were excluded from the Tax Policy Center report.) The sum of on-budget and "off-budget" spending in 1985/1986 was approximately $1.2 trillion.

Adjusting for inflation, $1.2 trillion in 1986 dollars is $2.4 trillion in 2010 dollars. Had federal spending kept pace with inflation, the federal budget would have grown by approximately 100% between 1986 and 2010. Instead, the federal budget grew by more than 200%.

I don't have time to poke around the state data, but I'd be surprised if state expenditures grew materially slow than federal expenditures between 1986 and 2010.

Here is the question for the advocates of big government. During the past 25 years, federal spending has outpaced inflation by more than a 2 to 1 ratio. Are we all better off today as a result? Are the "most vulnerable" Americans and the middle class doing better today than their counterparts in 1986? Has the binge of federal spending increased the quality of life of the vast majority of Americans? Has the growth of federal spending increased standards of living commensurate with the resources tapped to fuel the spending?

If the answer is "yes," then how do you explain 9% unemployment? How do you explain the tea party movement and and nationwide Occupy Wall Street protests? How do you explain the frustration over the inter-generational burden that debt-fueled government spending will place on our children and grandchildren (and their children and grandchildren)? How do you explain the general public dissatisfaction with our political and business leaders?

If the answer is "no," then how do you justify demands for increased government spending? Can government spend more money to "cure" problems that are correlated with increased government spending? Government spending has increased at a 2 to 1 ratio compared to inflation over the past 25 years. Would we all be better off had spending increased at a 3 to 1 ratio? A 5 to 1 ratio? How much faster does government have to grow before before it becomes obvious to everyone that government expansion blunts the vibrancy of the private sector?

Ironically, the expansion of government spending has tracked the rising inequality of income and wealth distribution that so agitates the political left. The left does not seem to realize that bigger government creates more opportunity for business and individuals to capture economic premiums by exploiting the "regulatory state." How does a regulatory or tax attorney justify an hourly billing rate of $1,500 ($3 million/year at 2,000 hours/year)? Because he or she helps businesses and individuals navigate the regulatory state. How does a CEO justify compensation of $5 million or $10 million per year? Because he or she pays the regulatory and tax attorneys $3 million per year simply to navigate the regulatory state!

Steve Shay on Tax Reform

2011-10-14T14:27:00.001-07:00

Earlier this week, Steve Shay published an article in Tax Notes with his observations on fundamental tax reform. See "Jobs, Deficit Reduction, Revenues, and Fundamental Tax Reform," 133 Tax Notes 213 (Oct. 10, 2011).

I always pay attention to articles written by Shay and Edward Kleinbard. Both are seasoned tax professionals with experience in private practice, government and academia. Shay practiced with Ropes & Gray for 20 years before jumping to Treasury in 2009. He served for two years as Deputy Assistant Secretary for International Tax Affairs. Kleinbard practiced at Cleary Gottlieb for 30 years before serving as Chief of Staff of the Joint Committee from 2007-2009. After grinding away as tax attorneys for decades, and then bashing their heads against DC gridlock for a couple years, Shay and Kleinbard both sought refuge in the ivory tower. Shay teaches and writes from Harvard Law School; Kleinbard from the USC Law School.

As tax attorneys who represented a wide range of domestic and multinational businesses in private practice, Shay and Kleinbard bring thoughtful voices to the dialogue over U.S. tax reform. Politics aside, we need more contributions to the tax policy debate from experienced practitioners who have a more balanced view of the relationship between the private and public sectors. We get way too much loaded rhetoric from business lobbyists and "career academics" on the political left.

A few highlights from Shay's article:

[1] Shay urges policymakers (presumably aiming towards the political right) not to take revenue increases off the table while considering tax reform options. Shay does not advocate "millionaire surcharges" or the "Buffett Rule," whatever his personal view on those proposals. Shay primarily focuses on tax expenditures, and the opportunity to increase revenues "by eliminating tax expenditures and rationalizing the income tax base, as part of an overall plan to restore a sustainable fiscal policy." He's basically following along a trail blazed by Kleinbard, among others.

[2] In Shay's view, fundamental tax reform "should make the income tax code a fairer and more efficient instrument suitable for the economy of today and the future."

The objective of fundamental tax reform should be a more comprehensive income tax base that is simpler and fairer and does not make losers of domestic manufacturers and winners of video game companies with offshore intangibles.

Funny how that theme keeps surfacing in discussions of fundamental tax reform. I outline the problem of "multinational princes" and "domestic paupers" in this post (discussing a tax reform proposal by Bill Parks).

[3] Shay gently scolds President Obama for his class warfare rhetoric:

[The President] has acknowledged a need for new revenues, but limiting shared sacrifice to those with incomes of $250,000 and above is inconsistent with rationalizing many wasteful tax expenditures that benefit middle-income earners as well as the very wealthy. In exchange for job-creating stimulus, Democrats should be open to sharing sacrifice more broadly, but without sacrificing a fair distribution of overall tax burden.

Shay doesn't define a "fair distribution of the overall tax burden," but he implies that "shared sacrifice" should include tax increases on all Americans. The top 1% of taxpayers currently shoulder 37% of the total income tax burden. If deemed "fair," policymakers could aim to keep that number constant, while increasing overall revenues from the tax system. By definition, such an effort would require an increased "contribution" by the bottom 99% of taxpayers.

[4] Shay bluntly scolds Team Obama for its lack of leadership on tax reform. But let's face it, this administration has other priorities. President Obama focused on socializing health insurance during the worst economic crisis since the Great Depression. Now he's focused on his 2012 re-election despite a widespread economic malaise and 9% unemployment rate. I'd wager my $100 that Team Obama will not lead us to the Promised Land of Fundamental Tax Reform.

Get Serious about Jobs Creation

2011-10-12T13:23:00.000-07:00

As I've previously discussed, President Obama launched his 2012 campaign by proposing a $447 billion stimulus proposal, the "American Jobs Act." He may not be able to bring the unemployment rate below 9%, but his main priority is to shift blame for the sticky unemployment rate to "obstructionist" Republicans. If he can't persuade Congress to "spread the wealth around," maybe he can persuade voters to "spread the blame around" and vote Team Obama.

The new stimulus proposal is heavy on payroll tax cuts ($240 billion total) and unemployment benefits ($62 billion). It also includes $140 billion in funding for state teachers ($30 billion) and first-responders ($5 billion), school modernization ($30 billion), road construction ($50 billion), an infrastructure bank ($10 billion) and neighborhood stabilization ($15 billion).

When talking about the ways to tackle the unemployment crisis, Obama loves to pull out the "infrastructure" card. If you took him at face value, you'd think the federal government could allocate funds to "infrastructure," load the funds into an enormous Jobs Vending Machine, and order up a few hundred thousand jobs over the next 12 months. Please deposit $1 billion and punch A1 for jobs in Alabama, A2 for jobs in Alaska, A3 for jobs in Arizona...

Unfortunately, infrastructure spending does not occur with the snap of a president's fingers. Major infrastructure projects involve years of lead time and millions of dollars in up-front costs. Project managers cannot get "shovels in the ground" until they have surmounted an exhaustive list of hurdles. To name a few: developing budgets and time lines; arranging engineering studies; procuring licenses, easements, land rights; procuring other state and local permits; environmental reviews; obtaining RFPs from prime contractors and/or subcontractors; resolving potential litigation and environmental remediation; navigating state, local and federal labor regulations; arranging committed financing; and paying legal and consulting fees for each step forward in the regulatory labyrinth.

The ugly truth is that local, state and federal regulatory hurdles significantly delay the infrastructure development process. When it comes to federal spending on infrastructure, President Obama talks a good game, but hasn't backed that up with meaningful legislative or regulatory proposals to accelerate investment in public or private infrastructure. A $10 billion "infrastructure bank" is a silly drop in the bucket. Moreover, banks and other financial institutions have plenty of capital. We don't need a new government bank to fund infrastructure development.

So how can President Obama get serious about jobs creation?

First, scrap the $447 billion stimulus proposal. It's another round of political gamesmanship that distracts from the problem at hand. In the real world, we're suffering from a slow-burning unemployment crisis. President Obama and his advisers should have trouble sleeping at night, because the unemployment crisis has largely unfolded on their watch. They should wake up every morning and get worked up into a slather over fresh ideas to improve the conditions for investment, development and job creation.

Second, the crux of my proposal. The Obama administration should use its platform to blast the following message to the private sector:

Private sector businesses and developers, we want to help you accelerate the development of your capital-intensive projects.

We will be shifting all resources necessary from other administrative functions into development-support functions until we have measurably decreased the unemployment rate.

Our goal is to accelerate $250 billion [or $500 billion, stretching for the biggest number realistically possible] in capital spending into the next two years.

You bring us a credible development plan for a project involving capital investment of $250 million or more. We will twist arms and use all executive powers available to ensure that your project is "shovel ready" no later than year end 2012. We will provide federal overrides of state and local red tape, relax environmental regulations for projects that do not pose an imminent danger to human life, and mediate settlements with litigants who seek to delay the start of construction.

We acknowledge that jobs creation is driven by private investment and private enterprise. Government regulation and frivolous litigation has been an impediment to jobs creation for too long. For now, we need to address the unemployment crisis. We can revisit the overall regulatory environment after we put millions of Americans back to work.

Here's the interesting thing. Although I've been noodling on this idea for some time, someone within the administration shares my perspective. The administration recently announced that it would "fast track" 14 infrastructure projects to accelerate jobs creation. My question for administration officials is: why limit this to 14 public infrastructure projects? You have just conceded that red tape delays public infrastructure development and jobs creation. Why not extend the "fast track" principle to private development projects (infrastructure, technology capex, industrial capex, utility capex, etc.)? Sure, it's a tacit admission that liberal regulatory objectives can impede economic growth. But we're in the middle of a crisis, so let's deal with the political blowback at a later date.

Do I think that President Obama is ready to get serious about jobs creation? All evidence suggests that he is not. So I'm not holding my breath, but I'd love to be wrong on this one.

Talk is Cheap

2011-10-10T16:03:00.001-07:00

The "Occupy Wall Street" protests are a major topic of conversation these days. Thus far, I haven't been able to discern a specific "cause" motivating the protests.

Some protesters are unhappy about "corporate greed," whatever that means. Some protesters believe that the government is not sufficiently focused on "creating" jobs for grad students. Some protesters want more subsidies for green energy. Some protesters want to do yoga in the streets. Some protesters are just unhappy with authority, like the guy who decided to express his outrage by defecating on a police car. Some protesters -- the college-age types -- are along for the ride, enjoying the privileges of youth, parental support, and the spontaneity that accompanies minimal responsibility. Ahhhh ... to be 20 years old with no bills, no kids, no pets, no mortgage payments.

The political left is struggling to articulate a credible narrative for OWS. Linda Beale linked to an editorial by Paul Krugman. Krugman believes that OWS represents a mass uprising against Wall Street oligarchs who bulked up their personal fortunes at taxpayer expense while triggering the Great Recession. But that's Krugman's gripe, with no connection to anything I've heard trickling up from the protesters themselves.

I've never understood why people invest so much time and effort into protests. In law school, I lived across from a Planned Parenthood center. Every weekend, from dusk until dawn, anti-abortion protesters with billboards and hand-outs marched the street, seeking to discourage young women from entering the center to discuss contraception and abortion.

The anti-abortion protesters were exercising a Constitutional right to express their moral convictions in public. However, it always struck me as a complete waste of time. Why not use the hours spent protesting to counsel at-risk teenagers? Or to help nurture foster children or other troubled children from unfit homes? Or to volunteer in a hospital to nurture babies whose mothers were addicted to drugs or alcohol? If you are opposed to contraception and abortion, and thus favor more children in unstable home environments, why not focus your time and energy to improve the lives of existing children who lack stability, guidance and love? And then, when all children are healthy and happy, living in stable and nurturing environments, get back to protesting against Planned Parenthood?

I have the same reaction to the OWS protesters. They got their message into the media. They are exercising a Constitutional right to express their outrage over the failures of our political and business leaders. But why are they devoting so much time to empty rallies? What is shouting whining, stomping and defecating going to accomplish, besides draining local security budgets? Isn't this the same crowd that protests "cuts" to "services" for "the most vulnerable Americans"? Shouldn't the able-bodied college and grad students be volunteering their time in public schools and after-school organizations? Or helping out underprivileged children as Big Brothers and Sisters? Or assisting non-profit organizations that provide meals to seniors and other individuals with limited mobility? Or cleaning up public parks? Any of us can think of hundreds of organizations that would welcome a small army of enthusiastic volunteers with open arms.

But talk is cheap, as the saying goes. Volunteering for a non-profit organization, or a run-down public school, or a foster home, or a senior center, requires people to commit time and effort. It's a drain, physically and emotionally. Let's face it, that doesn't sound nearly as appealing as a "spontaneous" street rave, fueled by Twitter and Facebook, to stomp around and shout about the Great Unfairness of the world. If you can't join Dumbledore's Army, perhaps the hippest substitute is Krugman's Army. But the hipsters aren't making a difference, and Dumbledore probably wouldn't be impressed.

So I'll keep half an eye on the protesters, to see if they develop a coherent message before the winter hits. Meanwhile, my respect goes out to individuals like Larry Powell, whose actions speak louder than their words.

Moe Money, Moe Problems

2011-10-07T09:13:00.001-07:00

In today's Wall Street Journal, Randy Noonan offers a portrait of an American success story, Moe the Millionaire.

Moe is an insurance salesman with a minority equity interest in his employer, a mid-size insurance business organized as a C corporation for tax purposes. Moe is retirement age (around age 65, having worked in the insurance business for 40 years). His ending salary, including bonus, was $200,000. In the year he retired, Moe tagged along with a sale of the insurance business, selling his minority interest at an $850,000 gain.

Moe's net worth in the year before retirement was:

Cash in bank: $100,000. Investment in business to be sold: $950,000 [cost basis $100,000]. Value of Moe's home: $450,000 [cost basis $95,000]. Total assets: $1,500,000.*

* Noonan posits that Moe would receive $75,000 in annual pension benefits from the insurance company's defined benefit pension plan, but does not include the "value" of the pension benefit in the calculation of Moe's net worth in the year before retirement.

The year of his retirement, Moe recognized $1,050,000 in total income: $200,000 in salary and bonus; and $850,000 in capital gain from the sale of his interest in the insurance business. Noonan inquires:

Is Moe the "millionaire" that Obama wants to tax? Is it "fair" that his once-in-a-lifetime capital gain of $850,000 be taxed at top tax-bracket rates? Even assuming that the current 15% capital-gain rate would be raised to only 25% for this one-time millionaire (so that his tax rate would not be less than those "middle class" taxpayers), the tax would still be $212,500, more in tax than Moe ever made in salary and bonus in any one year.

A few observations:

[1] Big picture, Noonan is framing the correct issues. The political left believes that we should increase taxes on the "wealthy." The left sometimes defines the "wealthy" as "millionaires and billionaires" (the Buffett view). President Obama takes it further, consistently defining the "wealthy" as married couples earning $250,000 and single individuals earning $200,000 in a year.

I'm unaware of any data that suggests a high proportion of married couples earnings $250,000 (or individuals earning $200,000) are "millionaires and billionaires." I'm sure that Obama would concede that an individual's taxable income during a given year is not a proxy for his or her "wealth." And an individual's "wealth" is not necessarily reflected in his or her taxable income during a given year. I will explore this basic theme in a later post (or posts).

[2] Back to Moe the Millionaire. I believe that Noonan was mistaken in assuming a 25% tax rate on the $850,000 capital gain. President Obama wants to tax a millionaire's entire income at a 30% or higher federal effective tax rate. Tack on another 5% to reflect state income taxes, and the tax leakage on $1,050,000 in income is around $368,000. In other words, Moe would bring home around $683,000 after the payment of taxes on his retirement-year income.

When the dust settles, Moe is still a millionaire, but not by much. His liquid assets of $783,000, if invested conservatively, might yield around $40,000 annually before taxes. Almost everyone on both sides of the political would agree that this is a modest pre-tax income, even if the recipient is a "millionaire" on paper.

From a tax perspective, the main "problem" here is the lack of income averaging. Arguably, Moe should not be penalized for an extraordinary one-time gain. I'm sympathetic to Moe's plight, but I'm hesitant to endorse income averaging because I favor tax reform that will streamline -- not further complicate -- the tax code.

[3] Despite framing the correct issues, Noonan's hypothetical contains a couple of flaws. The first relates to his assumed savings balance upon retirement. Noonan stipulates that Moe earns $200,000 in salary and bonus after 40 years in the insurance business. Let's assume his salary increased no slower than the rate of inflation between year 1 and 40. He purchased a modest home for $95,000 decades ago, and had a $100,000 bank account the year before retirement.

Moe must have suffered from a drug or shopping addiction, because he should have had more than $100,000 in a bank account upon retirement. Noonan stipulates that Moe made "regular but modest" charitable contributions at church (deductible for tax purposes). Moe would have paid taxes at an effective tax rate around 20% (perhaps 25% including state income taxes). During the decade before retirement, with a six-figure income, 20% effective tax rate, "modest" charitable donations and negligible housing costs, Moe's savings account should have increased substantially.

Moe's net wealth is foundational to Noonan's analysis, so Noonan should have been more careful with his assumptions about Moe's spending and savings profile.

[4] Noonan also fumbles with respect to Moe's pension benefits. According to Noonan, the insurance company's defined benefit plan will provide Moe with $75,000 annually. Noonan characterizes $75,000 as "enough to live on but only just."

We know that Moe lives in a relatively affordable community, because his home value in the year of retirement is $450,000. Moe owns his home outright, so has relatively low costs associated with outright home ownership (maintenance and property taxes). He's retired, so he won't have commuting expenses and a number of other expenses associated with life as a working stiff. He's presumably eligible for Medicare and Social Security. All in all, $75,000 in annual pension benefits should provide a comfortable existence for our retired friend.

Morever, the pension benefits reflect a substantial "asset" that we should not disregard in computing Moe's net wealth. However, in fairness, the political left disregards the value of defined benefit pensions when focusing on "income as a proxy of wealth." So I can't be too critical in this instance.

[5] Enough tax for a Friday post. Noonan's portrait of an American success story was almost certainly moe-tivated by a success story from the 1990s. Let's kick it to Notorious B.I.G:

Dude, Who Moved My Deductions?

2011-10-05T16:46:00.000-07:00

They didn't cover this in Corporate Tax 101:

The federal government has found a new weapon in its war on marijuana — the tax man.
A San Francisco Bay area medical marijuana dispensary that promotes itself as the world's largest has been hit with a $2.4 million tax bill following an audit by the Internal Revenue Service, the dispensary founder said Tuesday.
The back taxes, penalties and interest levied against Harborside Health Center came after the IRS examined its returns for 2007 and 2008 and determined a 1982 tax code prohibiting cost deductions for businesses that traffic in illegal drugs applies to the dispensary.
Harborside is a spa-like fixture on Oakland's waterfront with 94,114 registered customers and 84 full-time employees that offers an average of 30 varieties of medical marijuana every day and has $22 million in annual sales.

One nice thing about life as a tax professional. You learn something new every day. I had no idea that someone had developed 30 varieties of medical marijuana. Does the development work qualify for R&D tax credits? Are they keeping the R&D work in the United States? Or outsourcing to a 16-year old with a second-grade education, earning pennies a day to get stoned in some foreign country?

Paul Caron at TaxProf Blog added some additional color on the pending IRS controversy.

I just keep imagining Jeff Spicoli's reaction to an aggressive IRS audit. (Parental warning: PG-13 content) Classic.

Are All Taxes Created Equal?

2011-10-03T09:51:00.001-07:00

On Friday, I discussed a Citizens for Tax Justice report advocating for the Buffett Rule. I'm officially done wasting time on the Buffett Rule itself. Today I'll discuss a collateral issue raised by the CTJ report.

[1] CTJ argues that any comparison of effective tax rates paid by individuals must include payroll taxes. Some critics of the Buffett Rule have solely focused on income taxes paid by individuals in various tax brackets. I haven't studied the issue in enough detail to draw a firm conclusion. However, the CTJ argument would be considerably weaker if payroll taxes were excluded from the math.

Are payroll taxes equivalent to other income taxes? Where do we draw the line between taxes that should be included in the computation of effective tax rates, and taxes that should not?

Payroll taxes primarily fund Social Security and Medicare payments. Social Security and Medicare are "social insurance" programs. An individual's payments into Social Security and Medicare resemble insurance premiums (albeit mandatory insurance). Most notably, an individual's Social Security benefits during retirement depend on the amount of "premiums" paid during his or her working career. The "premiums" are pooled into trust structures; the trusts "invest" net cash inflows into Treasuries; and the trusts will redeem the Treasuries to cover net cash outflows.

If payroll taxes are (effectively) insurance premiums, then they should be excluded from the effective tax rate computations. The fact that government "collects" the social insurance premiums does not transmute them into the equivalent of income taxes. Ultimately, social insurance results in a direct payment to an individual beneficiary. Social insurance premiums which support direct payments to individuals are not comparable to income tax revenue that fund other government operations. Sure, we all derive some indirect benefit from government expenditures on defense and transportation and agriculture. But there seems to be a qualitative difference between payroll and income taxes that justify excluding the former when computing the effective tax rates paid by different income groups.

Note that Social Security and Medicare may be "insolvent" under current projections, meaning that government receives an "F" for its stewardship of the social insurance programs. We might have solvent programs if we handed the keys over to actuaries and sent the politicians home. However, an insolvent social insurance program is still social insurance.

[2] All that said, the political right generally discusses payroll taxes as if they are income taxes borne by the employee or self-employed individual. They certainly "feel" like taxes to me. If the right presses that argument, then I agree with CTJ that payroll taxes should be included in the effective tax rate computation. Let's compare apples to apples, not apples to oranges.

[3] Some economists theorize that labor bears a portion of -- and perhaps all of -- the corporate income tax. Two interesting observations.

First, under CTJ's methodology, the effective tax rates paid by all taxpayers would increase if we assume that employees bear a portion of the corporate income tax. I'm not sure how the burden would be shared among low-, middle- and high-income employees. Food for academic thought.

Second, if the theory is correct, it dismantles the argument underlying the 15% tax rate for qualified dividends and capital gains. If labor, and not capital, bears the burden of corporate income taxes, then the owners of capital should not receive preferential tax treatment upon a corporation's distribution of previously-taxed earnings. I'll wait patiently for a counter from the Wall Street Journal editorial board.

[4] Back to CTJ's premise that payroll taxes should be included in effective tax rate computations, because they are economically borne by employees (not employers). As discussed above, payroll taxes are equivalent to social insurance premiums. If we include social insurance premiums in the effective tax rate computation, how about other amounts paid by an employer for the benefit of employees?

For example, many employers offer generous health insurance benefits for employees on a pre-tax basis. Absent the tax preference and historical legacy of U.S. health care, employers would increase wage income to employees, and employees would use the increased wages to purchase individual health insurance policies. Like social insurance premiums (payroll taxes), employees bear the economic burden of employer-sponsored health insurance premiums.

Obamacare mandates that all individuals must obtain health insurance or pay a penalty. Should the payment of health insurance premiums be viewed as a "tax" for the same reason that social insurance premiums are viewed as a "tax"? Does the fact that a federally-mandated insurance program is administered privately really matter? Wouldn't that be a triumph of form over substance? If we include health insurance premiums in the effective tax rate computation, middle-class effective tax rates would skyrocket, and effective tax rates for higher-income taxpayers would also increase dramatically. However, the political left might not be enthusiastic to highlight this fact in public debate.

CTJ for Mega-Billionaires!

2011-09-30T16:21:00.000-07:00

I was hoping to end my discussion of the Buffett Rule with this post last Friday. However, no rest for the weary. On Tuesday, an organization named "Citizens for Tax Justice" entered the fray. CTJ published a report advocating for the Buffett Rule.

I've been critical of CTJ in the past. On June 1, CTJ published a report "analyzing" the financial statements of 12 "illustrative" U.S. corporations. I believe that the purported "analysis" contained material inaccuracies and omissions. I sent a letter to Tax Notes suggesting that CTJ's report was borderline unethical (131 Tax Notes 1199 (June 13, 2011)). I was concerned that unsophisticated readers would take CTJ's misleading "analysis" at face value. As expected, the political left feigned outrage over CTJ's dubious conclusions.

The latest report from CTJ has its weaknesses, but raises some interesting questions. Unlike the June report, CTJ's advocacy of the Buffett Rule doesn't taint the organization's credibility. Five observations:

Distortions

[1] Mega-billionaire Warren Buffett hasn't released his tax returns, so this is speculative. CTJ states that Buffett has long criticized the "loopholes" in the tax code that allow him to pay a lower effective tax rate (at 17.4%) than his middle-class secretary (at 30%). A "loophole" is defined as "an ambiguity in a system, such as a law or security, which can be used to circumvent or otherwise avoid the intent, implied or explicitly stated, of the system."

The tax code is filled with loopholes (as defined), but it is unlikely that Buffett is exploiting one. More likely, he simply derives a large proportion of his annual income from qualified dividends and capital gains. Qualified dividends are taxed at a 15% rate, because the distributing corporation was previously taxed on its earnings at a 35% rate. The same principle applies to capital gains from the disposition of stock in a corporation with accumulated earnings. The tax preference reflects an explicit Congressional judgment to blunt the "double taxation dilemma" associated with the taxation of C corporations and their owners. It is no more a "loophole" than any number of tax preferences that are widely available to virtually all taxpayers.

CTJ may not be happy with the result, but they should tone down the misleading rhetoric.

[2] CTJ claims that Buffett's effective tax rate (17.4%) is "typical" of taxpayers with $10 million or more of income. CTJ's claim is inconsistent with the data on page 3 of its report. Based on those numbers, the "average" taxpayer with $10 million or more of income pays an effective tax rate of approximately 24.6%.

Again, words are important. Buffett is not "typical" of uber-wealthy individuals. The data suggests that the $10 million club is comprised of two groups. One group recognizes a large proportion of its income from qualified dividends and capital gains, taxable at the 15% rate described above. The other group recognizes a large proportion of its income as ordinary income (wage income or other income for services (athletes, celebrities) or short-term capital gains (hedge fund managers)).

CTJ wants the first group (the investors) to pay tax at rates comparable to the second group (the athlete/celebrity/hedge fund VIPs).

Consensus and Questions

[3] I agree with CTJ on a fundamental principle. I believe that all income should be taxed at the same tax rates.

I suspect we disagree on the next principle. I believe that we should lower income tax rates for corporations and individuals (with the decrease in revenue offset, in part, by an increase in tax rates applicable to capital gains). My two principles work in tandem. The decrease in the top marginal corporate income tax rate would undermine much of the rationale for the 15% tax rate (as described above).

[4] CTJ compares an individual taxpayer with $60,000 in wage income and an individual taxpayer with $60,000 in qualified dividends and capital gains. The former pays an effective tax rate of approximately 30% (including employer and employee payroll taxes; more on that in my next post). The latter pays an effective tax rate of 4%. I would lower the tax rate applicable to the wage earner, offset in part by higher taxes on the investor. Does this increase the overall "fairness" of the tax system in CTJ's view?

[5] On a similar note, CTJ states that "it’s downright unfair when millionaire investors pay effective tax rates far lower than those of most middle-income people." (To get there, note that CTJ is including payroll taxes in the computation of effective tax rates for middle-income taxpayers.) But isn't it unfair when middle-income investors (the individual with $60,000 in investment income above) pay effective tax rates far lower than those of middle-income wage earners? And isn't it unfair when gazillionaires pay effective tax rates far higher than other gazillionaires?

The "fairness" point highlights why the proposed Buffett Rule is a class warfare strategy, as discussed here and here. CTJ compares the tax rates paid by millionaires to the tax rates paid by the middle class. I'm concerned about the disparate treatment of wage earners and small business owners relative to the investor class. I'm concerned about efficiency and fairness, but I don't need class warfare rhetoric to articulate the concern. We don't need a "Buffett Rule" to accomplish fundamental tax reform. We simply need legislators who are willing to prioritize and compromise.

Prioritize and Compromise

2011-09-28T10:56:00.000-07:00

On Monday, Michael Durst elaborated on a previous tax reform proposal (see Durst, "An Employment, Equity, and Competitiveness Tax Act," Tax Notes, Sept. 26, 2011; discussing Durst, "Radical Centrism and the Corporate Income Tax," Tax Notes, Sept. 5, 2011).

Durst describes his proposal as "a two-pronged, radically centrist tax package" with two key elements:

1. A reduction in the corporate tax rate to 15 percent, along with elimination of opportunities to shift income to tax havens and other significant corporate base broadeners. The goal would be to increase U.S. job creation, both through the effects of the lower rate and by eliminating current tax haven techniques that encourage job creation outside instead of within the United States.

2. A reform of the individual income tax that would make the tax more progressive, primarily by increases in rates applying to the highest-income taxpayers. Maximum rates nevertheless would remain low by historical standards....

I don't agree with Durst's entire reform proposal, but I agree with Durst that legislators need to prioritize and compromise. Our tax system is a ramshackle structure decomposing from within, and I'd love to strip it down to the studs and begin renovation. However, if we have to renovate incrementally, I'd start with corporate tax reform.

Our corporate tax rate is uncompetitive by international standards. Capital is mobile and ruthlessly unpatriotic. As such, it migrates to the highest after-tax return opportunities. The uncompetitive U.S. tax rate discourages capital allocation to U.S. businesses by decreasing after-tax returns to investors. This has a pernicious ripple effect that hits the capital-intensive manufacturing industry particularly hard. Less capital means a higher cost of capital. A higher cost of capital means higher input costs. Higher input costs mean higher-cost products and services. Higher-cost products and services are less competitive in domestic and international markets (and more expensive for domestic consumers).

Compounding matters, the U.S. transfer pricing regime is porous, favoring multinational enterprises that can migrate intangibles offshore over U.S. businesses with tangible assets, operations and employees in the United States. The deck is effectively stacked against U.S. businesses relative to their multinational and international competitors.

A growing consensus of tax professionals, academics and economists has acknowledged the need to reform the corporate tax system by lowering rates. Hopefully, that message will begin to resonate with legislators, who are struggling to cope with our lapsed economic hegemony. Although I don't expect a "grass roots" movement for corporate tax reform, I hope that the most zealous advocates of high corporate tax rates achieve irrelevance.

Meanwhile, there is no free lunch. Although corporate tax reform is a priority, we can't escape the fact that government obligations will continue to swell as the Baby Boom generation enters retirement. Realistically, we'll need to offset a decrease in corporate tax revenues with another source of revenues. Legislators should consider a VAT, and they should consider progressive increases in average tax rates as a trade-off for corporate income tax reform.

In particular, a reduction in the corporate tax rate could be partially offset by eliminating the tax preference for certain investment income. Corporate earnings are taxed at a 35% top marginal rate, and the 15% rate applicable to qualified dividends and long-term capital gains reduces the overall tax burden on the underlying business income. By lowering the corporate tax rate, legislators would undermine the conceptual justification for the 15% rate.

The existing political climate is depressing to those of us who don't extract power or lobbying money from gridlock. Tax reform seems virtually impossible before 2012. However, we don't need a "Buffett Rule" to jump start the process. Corporate tax reform is possible if legislators would simply prioritize and compromise. A reduction in corporate tax rates, offset by taxing investment income at the same rates as ordinary income, could be an important step towards fundamental tax reform.

Stay tuned for more details on my own corporate tax reform proposal.

Surprising C Corps

2011-09-26T14:38:00.001-07:00

Today in Tax Notes, Martin Sullivan contributed an interesting article on "small business" C corporations (see "The Small Business Love-Hate Relationship With Corporate Tax").

Sullivan's article mines data in a new study prepared by a group of economists at the Treasury Department. The data indicate that nearly 900,000 small business employers filed tax returns as C corporations in 2007. The thresholds for a "small business employer": gross receipts or total income of less than $10 million; and wage or salary deductions of more than $10,000.

At first blush, the numbers sound pretty crazy. The income of a C corporation is subject to double taxation. Under the "double-taxation dilemma," a C corporation pays tax on its income (the first tax, up to a 35% marginal rate). Then its owners pay tax on dividend payments from the C corporation (the second tax, at a 15% rate for qualified dividends). Including state income taxes, a shareholder of a C corporation may suffer a 55-60% tax expense on income of the underlying business.

For small business owners, the "double-taxation dilemma" is essentially voluntary. And many individual owners of small businesses have elected out. Income earned by "pass-through" entities (e.g., S corporations and partnerships) is subject to a single level of tax. Unlike a C corporation, a pass-through entity does not itself pay tax. Instead, its owners report their share of income from the underlying business, and pay tax on that income (a single tax, up to a 35% marginal rate in 2011).

Sullivan's article explores why small business owners may elect into the "double-taxation dilemma" and operate their businesses through C corporations. Sullivan demonstrates that, "[u]nder the right conditions, a C corporation can be a nice little tax shelter for a small business. That helps explain why so many small businesses remain C corporations when they have the option of becoming LLCs or S corporations."

I follow Sullivan's conclusion. However, I'd guess that many of these C corporations owe their "existence" to bad tax advice or tax illiteracy (i.e., no tax advice). In the M&A context, I've seen numerous instances where a small business owner inadvertently grows a business under a C corporation "wrapper." They come to regret that planning (or lack of planning) when they decide to sell the business. (Due to the "double-taxation dilemma," in most instances, a purchaser will pay more for a "pass-through" entity than a C corporation.) Moreover, most "small" business owners are focused on their small businesses and are resource constrained with no "budget" for tax planning. To this point, Sullivan lists some of the pitfalls for a small business owner seeking to exploit a C corporation tax shelter.

Sullivan's article is worth a read for tax nerds. It encouraged me to jot down some corporate tax reform ideas that have been rattling around in my head. More to come in a subsequent post.

All Sizzle, No Steak

2011-09-23T13:42:00.000-07:00

Ask a Wall Street financial expert to name the most high-profile resident of Nebraska. They'll probably answer Warren Buffett, the legendary investor and "Oracle of Omaha." Now ask a Nebraska farmer. They'll probably answer Tom Osborne, the legendary football coach of the Nebraska Cornhuskers.

In Nebraska, Cornhusker football is a quasi-religious experience. When the 'Huskers play at home, their stadium becomes the third-largest city in the state (behind Lincoln and Omaha, Buffett's home city). While the 'Husker fans take their teams seriously, they don't converge on Lincoln solely for the football. With college football, comes serious tailgating. And with serious tailgating, comes grilled meat for the inner caveman.

During a 'Husker tailgating party, when the charcoal starts glowing, fans break out the brats and burgers and steaks. Nebraskans want their steaks fresh, juicy and big, with an anonymous American beer on the side. They're looking for the steak in steak, not the sizzle.

On Monday, September 19, President Obama ann ounced five principles of tax reform (part of his plan for economic growth and deficit reduction). As I discussed in my last post, the fifth principle is "observe the Buffett rule." The Buffett Rule says that people making more than $1 million a year should not pay a smaller share of their income in taxes than middle-class families pay.

The rule is all sizzle, no steak. That's ironic, given its namesake. Then again, mega-billionaire Buffett would probably be more comfortable at an Obama fundraising event than a 'Husker tailgating party.

Sizzle, Drizzle, Fizzle

The Buffett Rule attracted immediate criticism. For tax professionals and economists familiar with tax data, the premise of the Buffett Rule didn't pass a "smell test." It just didn't seem like a widespread problem that should become a central plank of tax reform. Gene Sperling conceded as much this week on a White House blog post "clarifying" the Buffett Rule.

The $100 Million Man

For several years, Buffett has claimed that he pays a lower effective (or average) tax rate than his secretary, who earned $60,000 in 2007. Buffett claimed that he paid tax at a 17.7% average rate (for example, $1.77 million in tax on $10 million in income). He claimed that his secretary paid tax at a 30% average rate ($18,000 of tax on $60,000 in income).

The numbers recited by Buffett never made sense to me. I understand why an uber-wealthy individual taxpayer might pay a low effective tax rate. More on that below. I don't understand how a secretary earning $60,000 could get stuck with tax at a 30% rate. As discussed in the next section, it seems unlikely (impossible?) that Buffett's secretary pays tax at a 30% average tax rate.

Why can an uber-wealthy individual taxpayer pay a low effective tax rate? Seems kind of unfair, right? Under current law, qualified dividends and long-term capital gains are subject to tax at a 15% rate. The 15% tax rate is intended to reduce the double-taxation dilemma that occurs when a corporation distributes its previously-taxed earnings to its shareholders. If a high proportion of an individual's taxable income is derived from dividends or capital gains, that individual's effective tax rate gets "averaged" down towards 15%.

In fact, under current tax rules, a mega-millionaire could earn millions from tax-exempt bond investments, and pay an effective tax rate of zero! Imagine a successful Internet entrepreneur cashed out at the top of the bubble in 1999, paid taxes on his fabulous gains, and rolled $100 million of cash into tax-exempt bonds yielding 5%. His tax-exempt bonds would generate annual cash income of $5 million. However, the income from the bonds is exempt from federal income tax. Zero tax on $5 million in income results in a 0% effective federal income tax rate. That's a lower rate than Buffett, his secretary, and the other 99.99% of us endure.

Of course, Congress didn't exempt state and municipal bond income from taxation as a favor to our $100 Million Man. The exemption for interest paid on tax-exempt bonds represents a subsidy to state and local governments. The federal tax subsidy reduces the cost of financing by permitting state and local governments to issue debt at lower yields. The subsidy reflects a policy choice, and arguably a "bad" policy choice that encourages undisciplined spending by state and local governments.

Note that Congress could increase the 0% effective tax rate applicable to our $100 Million Man by eliminating the tax subsidy for states and municipalities. Eliminating the tax subsidy would increase borrowing costs and decrease the funds available for other state and local objectives. Maybe that's better policy in the long run. But the political left assaults common sense when it demagogues "millionaires and billionaires" who benefit from structural policy decisions (like the tax subsidy for state and municipal bonds). Our $100 Million Man isn't "gaming" the system to achieve a 0% effective tax rate. He's simply playing by the rules of the game that Congress put on the table.

Numbers Don't Lie

Let's get back to Buffett and his secretary. Buffett has complained that he pays a higher effective tax rate (at 17.7%) than his secretary (at 30%). President Obama has seized Buffett's complaint and incorporated it into his "principles" that should guide "fundamental tax reform."

Because the President has made Buffett's complaint a prime-time issue, it raises three questions. Is the complaint accurate, i.e., does Buffett really pay a lower effective tax rate than his secretary? Is the problem widespread based on existing tax data? And is Buffett's concern fundamental to our long-term fiscal solvency and economic competitiveness?

No, no, and no.

[1] Buffett's claim does not seem accurate, much less possible, based on prevailing tax rates. Of course, we don't have complete facts on Buffett's secretary. Is he or she married? Does he or she have children? If married, what kind of earnings does his or her spouse bring to the table? The list could go on for 10 paragraphs.

Having been deprived of the actual facts by Buffett and Obama, I plugged some assumptions into a tax calculator. I assume that Secretary reports $60,000 in taxable income, claims the standard deduction ($5,700), a single exemption ($3,700), and takes advantage of the reduced Social Security tax rate in 2011 (4.2%). On my assumptions, Secretary is in the 25% tax bracket, but pays income tax at a 17.3% average rate. (For another cut at the exercise, see this hypothetical from Peter Pappas.)

We'll never know if Buffett was exaggerating the numbers, confused about the fact that marginal tax rates exceed average tax rates, or had special knowledge about his secretary's tax position (e.g., secretary is married to a spouse with a $200,000 income). However, it seems highly unlikely that Buffett's claim was accurate. So the fifth "principle" guiding Obama's tax reform platform is based on exaggeration, confusion, or some combination of the two.

[2] The "problem" identified by Buffett (based on exaggeration or confusion) is inconsistent with the existing tax data, as discussed her e and here.

The nearby table is copied and pasted from the Wall Street Journal article. Although the mega-billionaire Buffett (at 17.7%) may pay a lower effective tax rate than an average working professional married couple with taxable income of $250,000 (at 19.6%), that is not the case for the average "millionaire or billionaire." Both the average millionaire (at 23.3%) and the average working professional married couple (at 19.6%) pay significantly higher effective tax rates than the average middle-class secretary (at 8.9%, assuming taxable income in the $50,000 to $100,000 range).

[3] Finally, the "problem" identified by Buffett (based on exaggeration or confusion) is not fundamental to our long-term fiscal solvency or economic competitiveness, as I discussed in my last blog post.

White House Spin Fizzles

In light of the numbers, the Obama administration went into spin mode. Gene Sperling posted this defense of the "Buffett Rule" on the White House blog last week. Sperling clarified several of the questions that jumped to my mind when I heard about the proposal. Ironically, however, Sperling's attempt to rebut criticism of the proposal confirmed that the "principle" is a class-warfare tactic that will distract from actual tax reform.

So what did Sperling say?

[1] The Buffett Rule will only potentially apply to those with taxable income over $1 million -- approximately 0.3% of American taxpayers. We're off to a shaky start. I thought this was supposed to be a "fundamental" principle of tax reform. And it only potentially applies to 0.3% of taxpayers?

[2] Even among that 0.3% of American taxpayers, it affects only those within that group that pay low tax rates:

In fact, many — if not most — of the few true small business owners making over $1 million already pay ordinary income tax rates (and not the preferential rates) and thus would not be impacted at all by the Buffett Rule.

Okay, so the Administration believes that "many" but not "most" taxpayers reporting more than $1 million in taxable income pay tax at ordinary income rates (35% in 2011). That seems consistent with the data (see table above; the average tax rate paid by taxpayers in this group was 23.3%). However, now we're talking perhaps 0.1% or 0.2% of American taxpayers under the microscope.

[3] The Buffett Rule is not about "all taxpayers." It is about those taxpayers who are able to pay at lower tax rates than middle-class families:

Take IRS data on the taxes paid by the 400 highest-income households in 2008, all making over $110 million per year and making an average of $271 million per year. Some of those 400 taxpayers do pay their fair share, but according to that data, one-third of this group pays less than 15 percent of their income in taxes and 85 percent pays less than 30 percent.

Now, we're getting somewhere. It appears that the Administration is obsessed with roughly 133 taxpayers (one-third of 400). Because 133 taxpayers recognize a disproportionate amount of income from qualified dividends and capital gains (see above), the Buffett Rule has become a central plank of tax reform? Excuse me while I read the White House blog again, because I must be missing the joke.

[4] Sperling then launches into a series of hypotheticals where he, perhaps channeling Buffett, confuses marginal tax rates for average tax rates.

Conclusion

I'm pretty much sick of Warren Buffett and his bumbling foray into tax policy. Team Obama has taken an alleged "problem" involving 100-200 uber-wealthy taxpayers, and begun marketing the "solution" as fundamental tax reform. The emphasis on average tax rates might be a good class warfare tactic, but it misses the critical question. The critical question is: how much of the total income tax burden should we impose on the top 0.1% of taxpayers (or top 0.3%, or 1%, and so on). Perhaps we'll look at the numbers and conclude that they're paying their "fair share." Perhaps we'll conclude that they're not. A focus on "average tax rates" simply distracts from the question.

Meanwhile, the Nebraska Cornhuskers are 3-0 going into a game against Wyoming. Break out the steak, and leave the sizzle to Team Obama.

White House Clarifies "Buffett Rule"

2011-09-21T11:01:00.000-07:00

Late on Wednesday afternoon, Gene Sperling posted on the White House blog (see Buffett Rule Fact and Fictions).

Sperling commences the blog as follows:

On Monday, the President proposed the Buffett Rule as one of five principles for comprehensive tax reform. This is a rule of simple fairness—no household making over $1 million annually should pay less in federal taxes* than middle-class families pay. Contrary to some misconceptions, the Buffett Rule is not designed as the sole or main source of raising new revenues, but one of five principles that should be achieved by tax reform:

1. Cut rates
2. Cut inefficient and unfair tax breaks
3. Cut the deficit by $1.5 trillion over 10 years
4. Increase investment and growth in the United States
5. Observe the “Buffett rule.”

Of these principles — all of which we believe are key to reform — the Buffett rule has received the most attention. It has been attacked with claims of “class warfare” that are completely without merit. How can it be class warfare to ensure that there is greater parity between the taxes paid by the most well-off and those paid by tens of millions of hardworking families? Still, since not all of the reports about the Buffett Rule have been accurate, I want to clarify what we mean – and why the President believes this is an important principle.

[*Note: Sperling probably meant to say that "no household making over $1 million annually should pay federal taxes at lower effective rates than the rates that middle-class families pay." The remainder of Sperling's post focuses on average tax rates paid by individuals with varying degrees of income. Alternatively, perhaps Sperling was referring to millionaire/billionaire investors who derive 100% of their disposable income from tax-exempt bond investments, and thus literally pay zero income tax to any jurisdiction.]

In my last post, I criticized the Buffett Rule (a/k/a Vanderbilt Rule) as motivated by class warfare politics. My critique was partly motivated by the lack of detail underlying the "principle." If the principle were not motivated by class warfare politics, why announce the principle without detail as to its application?

Sperling's post added some meat to Obama's bare-bones "principle." Meanwhile, Sperling tried to rebut the critics who viewed the Vanderbilt Rule as class-warfare politics. I appreciate the effort to clarify some of the obvious question marks. But I'm still convinced that Obama's proposal was motivated by class-warfare politics. I'll touch on that point in this blog post. I'll have some more observations about Sperling's rebuttal argument in my next blog post.

Class-Warfare Politics

Take another look at Obama's five principles for tax reform. The first two principles would require amendments to (or perhaps replacement of) the Income Tax Code, impacting tens of millions of individual taxpayers and many thousands of businesses. The third principle would require a contentious bipartisan effort to begin restoring the nation's long-term fiscal health. The fourth principle acknowledges that our broken tax system and uncompetitive business tax rates increase the cost of doing business in the United States, crippling economic growth and job creation.

We can all agree on those four "principles." We can all agree that they are serious goals, and, in today's political and economic climate, will require heavy lifting by our political leaders. We may disagree on the tax and spending changes necessary to achieve those goals. But the goals are fundamental to our long-term economic competitiveness and prosperity.

How about the fifth principle? As Sperling's post confirms, the fifth principle reflects an unhealthy obsession with the 400 wealthiest American individuals. It is not about fixing the tax system, making life simpler and fairer for tens of millions of individual taxpayers, eliminating "tax expenditures" that distort fundamental economic decisions (contributing to the real estate bubble and the crisis in health care inflation), decreasing the costs of business tax compliance, addressing our long-term fiscal challenges, or improving our global competitiveness.

Compare the fifth principle to the other four principles. If a subset of the 400 wealthiest Americans pay tax at lower effective rates than the middle class, does that impact our long-term economic competitiveness and prosperity? Does that make business tax compliance more costly? Does that distort or complicate economic decisions of tens of millions of taxpayers? Of course not. A few billionaires who benefit from structural tax breaks, fairly or unfairly, are a microscopic tail on an 800-pound dogzilla.

Admittedly, the fact that those lucky billionaires pay lower effective tax rates than some middle-class and upper-middle-class taxpayers rubs me the wrong way. I would personally raise the capital gains tax rate to "pay down" ordinary income tax rates. But those changes are already contemplated by the first and second principles (cut rates; and cut inefficient and unfair tax breaks). We don't need to taint a serious tax reform effort with 2012 campaign slogans ("Hope, Change ... and Observe the Buffett Rule!").

From this independent's view, the Buffett Rule (a/k/a Vanderbilt Rule) does not belong on the list of fundamental tax reform principles. Obama included the "principle" in the list as a class warfare tactic to distract voters from his dismal economic record. I'll discuss the details of Sperling's rebuttal argument in my next blog post.

The Vanderbilt Rule

2011-09-19T19:17:00.000-07:00

President Obama has "branded" his proposal to increase taxes on "millionaires and billionaires." The new proposal will now be known as the "Buffett Rule."

The basic principle underlying the Buffett Rule is that uber-wealthy taxpayers should pay higher effective tax rates than middle-class taxpayers.

I'm not sure how the Buffett Rule is supposed to work in practice. Perhaps it is supposed to be a "Super AMT." Perhaps it is supposed to increase tax rates on capital gains for uber-wealthy taxpayers. Or limit the deductibility of charitable donations. Or cap the amount of qualifying tax-exempt income in a given year. Perhaps the President will limit the proposal to taxpayers that report more than $1 million in taxable income during a given year. Or perhaps he will extend it to working professional married couples with $250,000 taxable incomes.

Regardless of the mechanics, the spirit of the President's proposal is simple class warfare. It doesn't take a political messiah to persuade 90% of the voting public to favor increased taxes on the other 10%. You can play with the numbers (95/5, 99/1, etc.)

The irony of the "branding effort" didn't escape financial analyst Jeff Macke at Yahoo Finance Breakout:

Warren Buffett made billions off the financial crisis by getting Goldman Sachs (GS) and General Electric (GE) to pay him usurious rates in exchange for what amounted to endorsement deals. Buffett is giving his entire estate to the Bill and Melinda Gates Foundation because he is of the opinion that the government is a poor allocator of capital. Buffett would like me to pay higher taxes to the very government he's opting to stiff.

Mr. Buffett has never met a preferential deal he didn't like and has 56,000 times as much money as someone with $1 million. The only reason the White House is using Buffett to promote this tax hike is because the administration thinks voters are ignorant regarding who Buffett really is. Buffett has no more place in a Jobs Act conversation than does the ghost of Cornelius Vanderbilt.

Buffett is a legendary investor and has created fantastic wealth for thousands of his shareholders. However, Macke hits the nail on the head. Buffett's proclamation that millionaires and billionaires should pay higher taxes reeks of hypocrisy. And somehow, the hypocritical mega-billionaire has taken center stage in the debate over the President's second stimulus proposal (ahem, "jobs plan").

Next time, why not link class warfare tax policy to someone with more historical gravitas? Personally, I think the "Vanderbilt Rule" has a much nicer ring than the "Buffett Rule." And after all, Vanderbilt was one of the richest Americans in history.

Meanwhile, Halloween is just around the corner. Would it be difficult to pull off the Ghost of Cornelius Vanderbilt?

One Job Saved?

2011-09-15T12:27:00.000-07:00

Obama's much-hyped speech outlining the "American Jobs Act" did not seem to resonate with anyone except this guy and this guy on YouTube. His cheerleaders on the political left questioned why Obama would rely so heavily on tax cuts, given the "obstructionist" bent of Congressional Republicans. His critics on the political right questioned why another round of temporary stimulus proposals would translate into net, long-term employment gains.

Various observers suggested that Obama's speech was primarily intended to launch his 2012 election campaign. He framed the stimulus proposal as a "silver bullet" that would create millions of jobs and reduce unemployment. A cynic would argue that he is mainly trying to save one job: his own.

The total cost of the new stimulus proposals is estimated to be $447 billion. How would that get "spread around"?

[1] The proposal would pump $175 billion into the private economy by cutting employee payroll taxes in half in 2012. This measure should be politically popular, because most working Americans will benefit, temporarily, from the payroll tax holiday. But we've been down this path before. Like a night of hard drinking, a temporary stimulus might be fun while it lasts. But the next day, or the next year, we'll wake up with a hangover. One "temporary" stimulus leads to the next (the "hair of the dog") and the next, and the next. President Obama (the politician) is perfectly happy to kick the can down the road. The rest of us see a looming budget crisis and desire a permanent improvement in the conditions to economic growth.

[2] The proposal has $62 billion in targeted spending intended to help the long-term unemployed. Most of that ($54 billion) involves a series of fuzzy changes to the unemployment insurance system, including a $5 billion "pathways back to work fund." Although not broken out, I'm guessing that a big chunk of the other $49 billion simply represents an extension of unemployment assistance.

The $62 billion also includes a tax credit of up to $4,000 for hiring workers who have been looking for a job over six months (projected cost of $8 billion). Although the price tag is low, this type of credit is frustrating tax policy at its worst. Very few (if any) managers or business owners would hire new employees for a $4,000 (or smaller) credit. The credit would primarily be a windfall to businesses that were otherwise intending to hire employees (so no stimulative impact). It would create an additional audit burden for the IRS, which is already overwhelmed by new responsibilities enforcing social programs. As such, it virtually invites fraud and abuse (which plagues all these ill-conceived stimulus efforts). Perversely, it does not reward employers that have struggled to retain employees during the Great Recession.

[3] The proposal includes $140 billion in "stimulus" measures, including $35 billion for "teacher rehiring" ($30 billion) and "first responders" ($5 billion), $30 billion for "modernizing schools," $50 billion for "immediate surface transportation," a $10 billion "national infrastructure bank" and $15 billion for "neighborhood stabilization."

The $50 billion in transportation spending is infrastructure spending that should be part of the regular Congressional budgeting process. We need first-class infrastructure if we are to remain a first-class global economic competitor. The funding mechanism should be part of the regular Congressional budgeting process.

The state grants for "rehiring" and "modernizing schools" represents a bail out for undisciplined state governments. State governments do not need federal funding to address local education and security objectives. They need to prioritize state and local spending on education and security over other spending measures. For example, if a state legislature cannot adequately fund teaching salaries, the state could impose cuts on other state employees (or other spending programs) and allocate the "savings" to the teachers.

[4] Finally, the proposal involves $65 billion in payroll tax cuts for employers (and $5 billion to extend 100% bonus depreciation into 2012). The main thrust of the proposal involves: a cut in the "employer portion" of the payroll tax from 6.2% to 3.1% in 2012; and a full payroll tax holiday for any expansion of payroll up to $50 million above the prior year. These proposals suffer from the same defects as the employee payroll tax cut and the $4,000 hiring tax credit. They are short-term in nature, are unlikely to "stimulate" hiring, and would primarily result in windfalls for businesses in growth mode.

President Obama's stimulus plan (ahem, "jobs bill") may save one job and get him re-elected. But its mix of short-term incentives and bad tax policy measures has failed before. Our political leaders should be focused on regulatory and tax reforms that will encourage private business investment and result in long-term employment opportunities. Short-term stimuli may appeal to a sitting President, but the rest of us will have to live with the hangover.

Robin Hood: Man in Speedo

2011-09-14T13:53:00.000-07:00

President Obama has tried to position himself as a post-partisan Robin Hood, protecting the interests of the working class against rapaciously greedy working professional married couples with $250,000 incomes (bling-bling). He better stock up on Speedos, because his tax policies will leave us treading water for the next decade.

As I discussed yesterday, a dart-throwing monkey could put together a list of Obama's talking points for any given speech on tax policy. But, all fun aside, the posture of the U.S. political left on tax policy contains the seeds of its own undoing.

So what's the major flaw with the direction of Obama's tax policy?

The Obama administration and its cheerleaders generally believe that the solution to any budgetary issue is to "raise taxes on the wealthy" and to "close tax loopholes for greedy corporations." They make exceptions for favored industries and favored campaign donors, but they stay pretty consistent on message.

On the surface, this seems like good politics. If you convince 98% of the voting public that 2% of the voting public is not paying its "fair share," you can generate healthy majorities in favor of higher taxes on the 2%. At a minimum, you can use the Robin Hood card to get yourself elected or re-elected!

However, the political left harbors a desire to expand government and socialize the funding mechanism for various services (health care, green energy, affordable housing, etc.). The left's appetite for new programs requires new tax revenues. Mind you, we're not talking 'new tax revenues to reduce the trillion dollar budget deficit.' We're talking 'new tax revenues to pay for the President's new stimulus plan,' or 'new tax revenues to pay for Obamacare.'

Let me pause and note that politicians on the right have been complicit in the federal spending orgy that created our long-term budget crisis. However, the emergence of the Tea Party has created significant pressure on the right to end its complicity.

So the left needs new revenues, and it boldly declares class warfare on working professionals and their distant cousins in Martha's Vineyard and Sun Valley, the "millionaires and billionaires." In its thirst for revenues, it amends the Internal Revenue Code to create a series of "pay fors."

What do I mean by "pay for"? A "pay for" is a change to the Code that is projected to raise enough revenue to "pay for" a liberal spending objective. In recent years, Congress has enacted numerous "pay fors" without carefully weighing the consequences. One such folly was expanded 1099 reporting for small business (subsequently repealed). Another was the codification of the economic substance doctrine (which has left everyone, from the IRS to the tax practitioner community, scratching their heads).

Here's the thing about "pay fors." Tax policy driven by "pay fors" is no tax policy at all. "Pay fors" are a series of effectively random changes to the Code that are driven by political momentum to pay for a desired spending program. It is impossible to verify that the projected revenues from a given legislative change ever materialize.

And here's the other thing about "pay fors." When the political left closes a "loophole" to fund a new spending program, the revenues from that "loophole" are not available for deficit reduction. For example, President Obama would "pay for" the cost of his proposed stimulus act (ahem, "jobs plan") by raising taxes on the various bad apples described above (working professional married couples, millionaires and billionaires, oil and gas companies, private equity fund managers). However, if that proposal is enacted, we are still facing trillion dollar deficits as far as the eye can see. If the revenues of a new spending program are financed with a "pay for" that changes the existing tax rules, we're effectively trading water.

In this sense, the tax policy agenda of the political left contains the seeds of its own undoing. Sure, we can "pay for" new spending programs (the new stimulus act, Obamacare, whatever) by increasing taxes on the "wealthy" and "big corporations." But we're left treading water from a long-term budget perspective. Meanwhile, the Code gets more complex, and many businesses and individuals spend more time and money on non-productive tax planning and tax compliance activities.

The only way to finance the spending objectives of the political left and to tackle our long-term fiscal challenges is to increase taxes on everybody: rich, upper-middle class, middle class, lower-middle class, and poor. Maybe the left will convince voters and taxpayers that we should move in that direction. I wouldn't put money on that bet.

The Monkey, Millionaires and Billionaires

2011-09-13T17:02:00.001-07:00

President Obama recently announced his latest stimulus proposal (ahem, "jobs plan"). To pay for the stimulus proposal, Obama went to the populist grab bag of tax "reforms," proposing tax increases oil and gas companies and on "millionaires and billionaires."

Oh, by the way, Obama defines "millionaires and billionaires" as "married couples earning $250,000" and "unmarried individuals earning $200,000." I still haven't thought of an easy way to describe this category of taxpayers, other than "working professionals." Apparently, in Obama's world, a working professional married couple that earns $250,000 is more similar to a billionaire than a working professional married couple that earns $249,999 or, for that matter, $149,999.

That's not my world, and probably not your world, but too much time in the Beltway scrambles all common sense. In any event, that topic is fodder for another post.

Obama tax policy would be infuriating if it were not so obvious that there is no policy behind the policy. Obama's solution to the nation's dysfunctional health care sector? Raise taxes on the "wealthy." Obama's solution to 9% unemployment? Raise taxes on the "wealthy." Obama's solution to the federal budget crisis? Raise taxes on the "wealthy."

Keep in mind, I'm a political independent and I support the notion that we should tax capital gains at the same rates as ordinary income. My problem is two-fold.

Number one, President Obama talks a big game about increased taxes on "millionaires and billionaires." But there aren't enough "millionaires and billionaires" to make a significant dent in any of his spending proposals. He is hiding behind class warfare rhetoric to make tax increases on working professionals seem like tax increases on the uber-rich. It's slimy behavior, regardless of the politics.

Number two, I want some policy debate around the idea that the "wealthy," including working professionals, are not paying enough tax. Let's slice and dice the distribution of income taxes at various income levels. Do we really want a society where half the population pays zero income taxes? (Yes, many are subject to payroll, and most are subject to sales taxes, but we're discussing income taxes.) Should the top 5% of taxpayers pay more taxes? The top 20%? The uber-wealthy in the top 0.1%? Let's have a national discussion about the numbers and whether different groups of taxpayers are paying their "fair share."

Instead, we get the same, tired proposals from the Obama administration. I suspect that President Obama has two large spinning wheels in a super-secret room in the White House (think 'Price is Right'). On one spinning wheel are a series of "stimulus" ideas: tax credits for this or that; infrastructure spending; cash grants to state governments. On the other spinning wheel are Obama's "tax policy" ideas: raise taxes on the "wealthy"; close "corporate loopholes" for multinational taxpayers that "send jobs overseas"; increase taxes on the "big oil and gas companies."

Before Obama decides to hit the road for the day, he assembles with his advisors in the super-secret room. His advisors trot out a monkey. Monkey seems to enjoy throwing darts at the spinning Price is Right wheels. Advisors spin the wheel. Monkey throws a few darts. Advisors track the landings and furiously scribble some notes. The darts plot out Obama's speaking agenda for the day. Obama slips into zen-like meditative trance as the Price is Right wheels turn and turn. Advisors break the trance with some fresh organic coffee ground by a Berkeley PhD. Monkey gets some fruit and tries to bite Berkeley PhD as a secret service handler leads him back to his monkey room for the day.

This is tax policy in the Obama administration.

Energy Tax Subsidies for "Fat Cats" (Part Four)

2011-08-30T19:26:00.001-07:00

My fourth and final post on the U.S. energy sector. I'm finally getting around to the topic that motivated this series of posts: U.S. tax subsidies to encourage the development of renewable energy.

In my last post, I described a hypothetical wind farm development in Iowa. Wind and solar are currently "non-economic" without some type of government subsidization. In other words, the returns to an investor in a renewable energy project do not justify the risk associated with the investment.

In typical fashion, Congress decided to "solve" the economic obstacles to renewable energy development through the tax code. Investors in qualified renewable energy projects are entitled to two types of tax subsidies. The first type of tax subsidy involves tax credits linked to electricity generation by qualified facilities (wind farms, solar projects, etc.). The second type of tax subsidy involves accelerated tax depreciation for equipment deployed in qualified facilities.

As I described in my last post, the tax subsidies may convert an otherwise non-economic project into a project that will attract private financing.

In a logical world, we would assume that Congress would want to maximize the amount of private capital that would flow into renewable energy projects. After all, new renewable energy facilities require construction activities before COD (jobs), and operations/maintenance activities after COD (jobs) (jobs, jobs, jobs). In fact, there would be a sort-of multiplier effect; we would need to upgrade the nation's outdated transmission "grid" to accommodate more wind and solar power. Moreover, renewable energy provides obvious benefits by reducing pollution, improving air quality, etc.

Unfortunately, Congress isn't subject to the constraints of a logical world. Instead of providing broad eligibility to use credits (and depreciation) against taxable income, Congress effectively limited participation to corporate taxpayers. By limiting participation to corporate taxpayers, Congress kept individual investors (taxpayers) out of the market. This decision may have been predicated on a political judgment that uber-wealthy individuals would create "blowback" by using energy tax subsidies to shelter income. However, it starved the renewable energy developers of one source of capital following the 2007 financial meltdown (as discussed below).

Let's get back to my Iowa wind-farm development. Our developer friend needs $100 million, for a project that is not economic unless the developer can "monetize" the tax subsidies available to the project. The developer cannot reach out to individuals; only corporations can use the tax subsidies in practice. Which corporations are providing "tax equity" to these projects?

There are currently 15 tax equity investors active in renewable energy development. The list is a "who's who" of TARP recipients. Bank of America, JP Morgan, GE Capital, Citi, Wells Fargo, Northern Trust. In addition, at least one insurance company is participating in the sector (MetLife). The only non-financial institution on the list is Google, which has recently entered the sector with a couple high-profile investments.

As you can see, most "tax equity" for renewable energy is provided by financial institutions (banks and, to a lesser extent, insurance companies). Financial institutions are logical participants in the sector. They generate steady taxable income from U.S. sources, and thus can offset U.S. tax liabilities with tax subsidies from renewable energy projects. They are also in the business of underwriting loans to borrowers, i.e., evaluating the quality of a borrower's income stream in determining whether to advance cash to the borrower.

Unfortunately, Congress built the tax subsidies for renewable energy with Wall Street in mind. During the "boom boom" years of the real estate bubble, financial institutions were flush with profits and taxable income, and they surged into the renewable development space. The surge of capital pushed down the cost of "tax equity" into a range of 6-7%, promoting development. As we all know, the real estate bubble burst with devastating consequences on the economy at large, and concentrated pain within the banking sector. Financial institutions updated their business models to reflect lower profits and lower taxable income (or tax losses). The surge of capital into the renewable energy sector became a trickle and then a drought. Under current market conditions, the cost of "tax equity" has climbed into a range of 10-15% (depending on type of project, among other things).

I keep expecting other corporate taxpayers to join the party. In fact, the reluctance of non-financial institutions to commit "tax equity" to renewable energy projects leaves me scratching my head. (Again, the mad geniuses at Google are a notable exception.) I understand that industrial and technology and service-oriented businesses do not have the same underwriting experience as the large banks. However, many of these companies have large cash stockpiles, and "tax equity" investors are seeing pre-tax returns of 20-25%. Industry sources tell me that, notwithstanding the economics, CFOs get hung up on the fact that "tax equity" investments are non-core activities.

Why has Google decided to be a trailblazer, where others dare not tread? I don't have a good theory. I'm surprised that other large corporate taxpayers are not taking advantage of the rich "tax equity" yields to invest in the space. I'm guessing that the marketing advantages for "going green and socially responsible" would tend to outweigh the benefit of the tax subsidies.

So where does that leave our wind farm developer? Maybe Google will be interested; more likely, the developer will join the line of developers seeking capital from the TARP recipients.

Where does that leave us as electricity consumers (ratepayers)? No surprise here. The cost of renewable energy development has increased, and utilities pass through costs to consumers. We'll be paying higher electricity costs as utilities source more electricity from (higher cost) renewable facilities. Unless other corporate taxpayers start participating in the "tax equity" market, electricity consumers (ratepayers) and taxpayers will pitch in to repair the balance sheets of the financial institutions participating in the market. But you probably won't see this story in the New York Times.

Energy Subsidies for "Fat Cats" (Part Three)

2011-08-26T17:18:00.000-07:00

My third post on the U.S. renewable energy sector. I'm finally getting to the tax policy angle, where the "fat cats" on Wall Street are enjoying the good times, again. [I originally intended to finish this off in three posts. I realized that it will take four.]

As I described in my last post, "traditional" power plants burn coal and natural gas to satisfy most of our electricity demand. In the past decade, policymakers have begun pushing the development of "renewable" energy resources (primarily wind and solar) through a carrot and stick approach. The "carrot" involves tax subsidies for the development of wind and solar generation facilities. The "stick" involves a government mandate, often labelled a renewable portfolio standard ("RPS"), that requires utilities to source a fraction of their electricity from renewables. In the U.S., various states have enacted RPSs with various degrees of "teeth," but there is no national standard.

I'm focusing on the "carrot," but a quick observation on the "stick." Regulated utilities pass along costs to their customers. If a utility pays higher costs to source higher-cost "renewable" energy, then utility ratepayers (me, you, your kids, your grandma, your landlord, your employer, your local mall) will see the increased costs on their electric bills. Ultimately, higher utility costs are borne by individuals, directly or indirectly. Public Utility Commissions ("PUCs") exist to "protect" ratepayers from higher costs. Because renewable energy is still higher cost than energy from fossil fuels, PUCs will serve as a natural "check" on demand for renewables.

Back to the "carrot." Congress has enacted a set of tax subsidies to encourage renewable energy development. If you've done any interstate driving lately, you've probably seen "wind farms" (clusters of wind turbines on towers) popping up like dandelions. Those wind farms, and solar generation facilities currently under development, could not get off the ground without tax subsidies.

So why can't renewable energy developers get their projects into commercial operation without tax subsidies? Because an investment in renewables is non-economic under current market conditions. By non-economic, I mean that an unsubsidized renewable energy project would have negative risk-adjusted returns to its investors. For example, assume a wind farm or solar generation facility costs $10 million to develop. Based on current technology costs, financing costs and electricity rates, the investment might only yield a 2% average return over its operating life. But an investor can get a risk-free 3% return by investing in 30-year Treasuries. No rational investor would invest $10 million in a highly risky start-up venture (a wind farm or solar generation facility) with lower expected returns (2%) than a risk-free return (3%). [Note that 2% is a hypothetical number for easy discussion purposes.]

As I discussed in my last post, policymakers could tackle this issue using one of two approaches. The first approach would involve an across-the-board increase in electricity rates. For example, Congress could impose a carbon tax, which would increase utility costs for coal and natural gas. This would increase rates for electricity from traditional power plants (because the cost of coal and natural gas are passed through to electricity consumers). In turn, utilities could pay higher rates for renewable energy without causing "green rate shock" to electricity consumers.

Congress has rejected this approach for political reasons (higher electricity rates are politically unpopular; and higher costs for coal will decrease investment and union jobs in the coal mining industry). Instead, Congress has enacted tax subsidies for renewable energy development. The tax subsidies, when added to prevailing electricity rates, are sufficient to motivate investors to allocate capital to renewable energy projects.

The tax subsidies historically included tax credits and accelerated depreciation. This is where things get tricky and interesting. I've been talking about "tax subsidies" very loosely. Let's get into the anatomy of a deal.

So how do developers make these deals work?

Let's say you are a wind developer. You have identified a strip of windy farmland in Iowa, and you want to lease the land and install a series of towers and wind turbines. Of course, the farmer in question probably doesn't need much electricity; you'll need some infrastructure (converters and transmission cables) to connect your generation facility to the regional "grid" and transmit the electrons to Des Moines or Omaha. On the cost side of the ledger, you have (i) cost of land, (ii) cost of equipment (wind turbines, converters, hardware and integrated software), (iii) cost of infrastructure (towers, transmission), (iv) cost of financing, and (v) "soft costs" (attorneys, engineers, consultants and accountants necessary to get permits, conduct environmental studies, project wind patterns, draft leases, arrange financing, and pay the bills). Let's assume the total cost, from the planning phase to commercial operation, is $100 million.

How about revenues?

You've identified a Midwestern utility that is willing to sign a long-term power purchase agreement ("PPA") and pay slightly above-market prices for the electricity from your windfarm. They'll take all the electricity you can generate, but the amount of electricity generated depends on the technology (the efficiency of the wind turbine) and the wind itself. If the wind blows more than expected, the project will generate more electricity, more revenue and more earnings for its owners. If the wind blows less than expected, the project will generate less electricity, less revenue and less earnings for its owners. Ultimately, you know that you'll have a revenue stream from the project, but you can't predict the operating cash flows with precision (because they depend on wind flows).

To recap: you need $100 million to get your project past its commercial operation date ("COD"). You have a long-term PPA, which is expected to generate sufficient revenues over time to generate an average 5% cash yield on the project. (For example, the owner will receive $5 million in net cash from the project annually, measured in today's dollars.) That yield may be higher, or it may be lower, depending on how much the wind blows after COD.

Where do you get the $100 million?

You probably don't have that cash lying under your mattress. You can't borrow from a bank, because a bank is not comfortable with your credit profile (a developer with no assets). You need equity from somewhere. But as noted, the cash yield on your risky new wind farm (5%) is not attractive relative to a risk-free yield (3%).

Our developer friend needs a dose of "tax equity." Remember, Congress has chosen to subsidize renewable energy development through tax credits and accelerated depreciation. As a developer, you don't have sufficient taxable income to absorb the tax credits and depreciation from the project. However, plenty of large corporate taxpayers have U.S. taxable income, i.e., "tax appetite" that would permit them to reduce their own tax liabilities by tax credits and depreciation from the project. Some of these large corporate taxpayers are even willing to participate in the renewable energy space, despite the risks. Never fear, "tax equity" may be here!

Why is "tax equity" willing to participate in a deal that a "normal" investor would not touch?

A normal investor may not be interested in a risky start-up business that yields 2% more than a risk-free return. However, a "tax equity" investor can use the credits and depreciation from the project to offset taxes that it would otherwise pay to federal and state tax authorities. The decrease in cash-tax liability is economically equivalent to an increase in operating cash flow. For example, if the project generates $5 million in tax credits and $20 million in depreciation expense in Year 1, the effective yield for that year would be 18% ($5 million operating cash flow, plus $5 million in tax credits that save $5 million in taxes, plus $8 million in tax savings from depreciation expense ($20 million times 40% assumed tax rate)).

Who is actually participating as "tax equity" in renewable energy deals?

Stay tuned for my next post.

Energy Subsidies for "Fat Cats" (Part Two)

2011-08-25T16:13:00.000-07:00

This is the second of four posts discussing the tax subsidies for renewable energy development that have been captured by large financial institutions (and Google!).

A quick overview of the energy sector, from “traditional” electricity generation to renewables:

We are a nation of gadget junkies, and our appliances, computers, TVs, cell phones, pads, pods and more essential infrastructure needs (subways, hospitals, refrigerators) are powered by electricity. We satisfy most of that electricity demand with supply from “traditional” electrical generation facilities. Traditional power plants mainly run on fossil fuels -- coal and natural gas -- which are abundant and cheap. Unfortunately, burning coal results in a parade of horribles (smog, soot, acid rain, air toxins, and greenhouse gas emissions). Natural gas is cleaner, but still a greenhouse gas. Finally, nuclear energy, although a “clean” alternative to fossil fuels, has always been controversial (and even more so following the tsunami in Japan).

Unlike fossil fuels, which are abundant in the United States but ultimately finite, “alternative” sources of energy are renewable. Our primary sources of “renewable” energy include hydro, solar, wind and biomass. Hydroelectric power is relatively cheap, but derived from rivers and dams, which limits generation capacity. Sunlight and wind are free and abundant in some places, but the technology required to convert sunlight and wind into electricity is expensive. Biomass generation technology is cheaper than solar/wind, but utility-scale development is limited to areas where the underlying fuel supply is abundant.

The policy dilemma is to formulate a coherent energy policy that balances the costs and benefits of “traditional” energy (coal, natural gas and nuclear), with the costs and benefits of “renewable” energy (primarily solar and wind). Throw politics into the mix, and it’s easier said than done. However, most everyone can agree that the cost of energy has a huge impact on our individual and collective standard of living. It has an equally dramatic impact on the competitiveness of U.S. manufacturers and exporters.

Thus, low-cost energy is better than high-cost energy. Although a simple concept, execution is tricky, because it is not always clear how to define the “cost” of electricity generation.

Using current technology, coal and natural gas are the cheapest sources of energy for electrical generation. They are both abundant natural resources with high energy content relative to cost of extraction, and they can both be used to provide “baseload” power without the “intermittency” problems of wind and solar power. A recent EIA report estimated the average cost of new conventional coal generation at 9.5 cents/kWh; conventional (combined cycle) natural gas at 6.6 cents/kWh; advanced nuclear at 11.4 cents/kWh; wind at 9.7 cents/kWh; solar photovoltaic at 21.1 cents/kWh; biomass at 11.3 cents/kWh; and hydro at 8.6 cents/kWh.

Unfortunately, burning coal and natural gas has negative side-effects (air pollution, smog, acid rain, greenhouse gas emissions, etc). These negative side-effects are not reflected in the price of the underlying commodities. Economists refer to these hidden costs (negative side-effects) as “externalities.” Basically, an externality is a negative consequence of economic activity that is not included in the price for that activity. If the “externality” were included in the price of the economic activity (“internalized”), the cost of the activity would increase, decreasing the amount of the activity.

Back to the energy sector. Although coal and natural gas are the cheapest sources of energy for electrical generation, they are “artificially” cheap. The cost of producing energy from coal and natural gas does not reflect the negative side-effects (the “externalities”). If those costs were “internalized” into the cost of the commodities, renewable energy generation would become more competitive relative to traditional fossil fuels. (Based on our existing “electrical grid” infrastructure, renewable energy also presents an “intermittency” problem. For example, the wind tends to blow more at night, when electricity demand is lower than “peak” business hours. This “intermittency” problem is an externality associated with renewable energy.)

Policymakers could “internalize” the costs of fossil fuels by imposing a tax on coal and natural gas (a “carbon” tax). However, a carbon tax would increase energy costs for residential and industrial consumers (the cost of fuel used to generate electricity would increase). Moreover, it would be impossible to ensure that the proceeds of a carbon tax would be used to defray the societal costs of traditional energy generation. Liberal politicians that advocate for such a tax would be tempted to direct the tax revenues to the liberal policy objective du jour.

In any case, it appears unlikely that Congress will enact a carbon tax while I am still alive to consume electricity. Instead, Congress has tackled the energy-cost differential from the opposite direction. Rather than increasing the cost of fossil fuels, Congress has attempted to decrease the cost of renewable energy through government subsidies. Among other subsidies, Congress has attempted to stimulate renewable energy development through tax subsidies.

In my third post on this topic, I’ll discuss the anatomy of a renewable energy deal. In my fourth post, I'll move to the tax policy angle. As foreshadowed in my first post, the tax subsidies for renewable energy development have primarily flowed to large financial institutions. Perversely, the consequence has been less renewable energy development, at a higher cost, imposing a secondary level of costs on energy consumers. So taxpayers are stuck with higher taxes, energy consumers (for the most part taxpayers) are paying higher costs for energy, while large financial institutions (and Google!) are extracting tax subsidies as intermediaries. The entire fiasco could only have been devised by our political "leaders" in Washington D.C.

Energy Subsidies for "Fat Cats" (Part One)

2011-08-24T16:05:00.000-07:00

Among the many failures of the political class, our disjointed, haphazard and inefficient “energy policy” goes high on the list. I hesitate to use the phrase “energy policy,” because there seems to be no concerted effort to steer the U.S. energy sector in a coherent direction (“policy” is non-existent). Decisions about energy policy are dominated by short-term calculations of politicians who are primarily motivated by the next re-election campaign.

The policy mess reflects the influence of bizarre alliances. On the one hand, liberal politicians grandstand publicly about the perils of “climate change” (pandering to environmentalists), while protecting the coal industry against cleaner forms of energy (pandering to unions). On the other hand, conservative politicians trumpet the virtues of smaller government and free markets, while protecting irrational energy subsidies for local constituents (pandering to corporate welfare recipients).

A good example is the one-two punch of import duties on foreign-produced ethanol, and tax credits for U.S.-produced ethanol (see here). Do we want lower-cost ethanol and more ethanol consumption (arguably good for the environment but bad for U.S. farmers)? Or do we want higher-cost ethanol and less ethanol consumption (arguably bad for the environment but good for U.S. farmers)?

Meanwhile, President Obama has fostered a perception that he can ride around on unicorn shooting “green jobs” out of his orifices. (You pick the orifice; credit to Paul Begala for the imagery.) In truth, renewable energy development has slowed dramatically in the past two years. President Obama’s “green jobs” economy is a pipe dream. And, ironically, the “fat cats” on Wall Street are the primary beneficiaries of tax policy intended to subsidize the development of renewable energy production.

This will be a four-part blog post. In part two, I’ll provide a layman’s overview of the energy sector, from “traditional” fossil fuels to alternative energy sources. In part three, I’ll explain the anatomy of a deal. In part four, I'll describe why the “fat cats” on Wall Street are receiving a tax windfall to finance renewable energy development.

What do you get when incoherent energy policy meets bad tax policy? Energy (tax) subsidies for "fat cats." More to come.

Solar Fizzles; Green Jobs "Pipe Dream"

2011-08-22T15:34:00.000-07:00

This week, I'm going to focus on the U.S. energy sector. I'll be discussing the landscape broadly, and then specifically discussing the tax policies intended to subsidize the development of renewable energy.

Before I get into the tax policy angle, a couple recent developments:

[1] Governments Lose Bets on Solar Manufacturing

Two U.S. solar manufacturers have recently filed for bankruptcy (Evergreen Solar and Intel spin-off SpectraWatt). The price of solar panels has fallen dramatically as China ramps low-cost manufacturing. That's good news for U.S. energy consumers and the environment, because the cost differential between solar power and power generation from fossil fuels is narrowing. If the trend continues, solar power will become a competitive alternative energy source without government subsidies.

However, the good news for consumers and the environment is bad news for U.S. solar manufacturers and their stakeholders (investors, employees, government benefactors). Despite federal and state subsidies directed at the solar industry, the cost of manufacturing in the United States far exceeds the cost of manufacturing in China and other emerging markets. Evergreen Solar made a losing bet on the wrong technology. SpectraWatt crumbled under market pricing conditions. Industry analysts predict more consolidation in the industry (i.e., more bankruptcies for U.S. and foreign manufacturers).

Along with investors and employees, taxpayers joined in the pain from the bankruptcy filings. Massachusetts directed $21 million in cash grants to Evergreen (along with tax incentives that are now moot). SpectraWatt's bankruptcy filing reported $6 million in "state economic inducements" as assets.

Talk about skewed incentives. Our politicians get to "bet" on business deals with other people's money. If the "bet" is successful, the politician takes the credit. If the "bet" is a bust, the politician blames China and suffers no consequences (because he or she has no skin in the game). Unlike a private enterprise, the "investment" process is so opaque that it's difficult to identify anyone to hold accountable.

[2] Green Jobs "Pipe Dream"

The collapse of the U.S. solar manufacturing industry is the latest bad news for advocates of a transformative "green" economy. On August 18, the New York Times published an interesting article discussing the dismal growth in the "green jobs" sector. (The article focused on the San Francisco Bay Area and California with some general observations about the sector nationally.)

In a development that will take few of us by surprise:

[T]he green economy is not proving to be the job-creation engine that many politicians envisioned. President Obama once pledged to create five million green jobs over 10 years. Gov. Jerry Brown promised 500,000 clean-technology jobs statewide by the end of the decade. But the results so far suggest such numbers are a pipe dream.... A study released in July by the non-partisan Brookings Institution found clean-technology jobs accounted for just 2 percent of employment nationwide [2.7 million jobs].

I suppose that we get the politicians that we deserve. If voters took these types of "pledges" at face value, they were bound to be disappointed. I have no problem with either politician's attempt to set "lofty" aspirations. However, at some point, a "lofty" aspiration starts to resemble the empty promise of a snake oil salesman. Let's see if anyone in the next election cycle tries to hold President Obama accountable for overpromising and underdelivering on his green jobs "pipe dream."

[3] Your Bus Driver Has A "Green Job"

One note on methodology. I skimmed the Brookings Institution report; the allocation of "green jobs" among industries is surprising. The largest two categories of "green jobs" are Waste Management/Treatment (386,000 jobs) and Public Mass Transit (351,000 jobs), followed by Energy-Saving Building Materials (162,000 jobs), Regulation and Compliance (142,000 jobs), Professional Environmental Services (141,000 jobs), Organic Food/Farming (130,000 jobs), and Recyling/Refuse (129,000 jobs).

I'm sure that many of the individuals working in these industries would be surprised that their position qualifies as a "green job." I understand the methodology, but most of these job "categories" have existed for decades -- long before politicians became obsessed with "sustainability." When you start looking at the numbers, it makes you wonder how President Obama kept a straight face when he pledged to create five million new green jobs over the next decade.

Tax Reform: Bill Parks

2011-08-19T14:40:00.000-07:00

I'd like to use Friday to discuss an interesting article that was published in Tax Notes during the week.

On August 15, Bill Parks offered a set of principles to guide corporate tax reform (For Corporate Taxes: Lower Rates, Raise Revenues, 132 Tax Notes 745).

Our tax system is broken, and the best way forward would be a Big Reform which substantially changes existing tax rules and regulations. In the United States, the taxation of business income has become increasingly skewed between multinational "princes" and domestic "paupers." What do I mean by "princes" and "paupers"? Let's examine two hypothetical businesses.

Assume that ToolCo manufactures specialized parts and equipment for U.S. industrial clients. The business is medium-sized (less than 500 employees), located in the Midwest, and generates solid but unspectacular profits for its owners. ToolCo uses state-of-art engineering software, including some applications (intellectual property) designed by its resourceful technology group, in the manufacturing process. Because ToolCo is a domestic business with domestic IP development, manufacturing and sales, ToolCo's effective tax rate for a multi-year period is consistently in the range of 40%.

Compare ToolCo to BigTool Inc. Like its smaller competitor, BigTool manufactures specialized parts and equipment. However, BigTool is a U.S. based multinational, with thousands of employees located in the U.S. and foreign countries. Through transfer pricing and cost sharing arrangements, BigTool shifts much of the intellectual property for its operations to low-tax foreign jurisdictions. Consequently, BigTool pays the U.S. tax rate (40%) on a relatively small proportion of its worldwide profit. Its global effective tax rate for a multi-year period is consistently in the range of 20%.

In my simple examples, BigTool is the multinational "prince," and ToolCo is the domestic "pauper." The U.S. tax system imposes higher costs on purely domestic businesses, compared to multinational business that can develop intangibles offshore and use transfer pricing to shift income to low-tax jurisdictions.

I am not alleging that U.S.-based multinationals are "avoiding" tax or engaging in otherwise unscrupulous behavior. In fact, large public multinationals are subject to extremely rigorous accounting and financial reporting requirements. They are simply capitalizing on a structural advantage permitted by the existing tax system. The bottom line result, however, is perverse. Capital will flow away from domestic businesses (where after-tax returns are lower) towards multinational businesses (where after-tax returns are higher).

As noted, Bill Parks's recent article offers a set of principles to guide corporate tax reform. I've been noodling on Big Reform ideas lately, and Bill nails one of them on the head:

I propose that we assess corporate taxes on the same percentage of worldwide profits as domestic sales contribute to worldwide sales... Any anomalies will be a small price to pay for fairness and consistency. It eliminates the tendency to manipulate many factors to show most or all profits outside the United States. Calculating this percentage would require firms to report revenues and expenses to the IRS using [International Financial Reporting Standards or "IFRS"].

In other words, scrap existing book-tax differences and key taxable income off book income (in Bill's article, book income reported under IFRS principles). Then, allocate book income between the U.S. and foreign jurisdictions based on a percentage of sales in the respective jurisdictions (again, as reported under IFRS principles). Bill's theory is that the allocation proposal would generate more tax revenue than the existing international tax rules. He would use the additional revenue to lower corporate income tax rates.

The proposal has an intuitive appeal based on its simplicity. It would eliminate our reliance on transfer pricing rules to define and protect the U.S. tax base. Less is more when it comes to transfer pricing: the existing rules are porous, ineffective and impose daunting costs on taxpayers and the IRS.

Let's revisit my example in light of Bill's proposal. ToolCo (the mid-size, purely U.S. business) would be a winner. By broadening the base and lowering rates, domestic manufacturers and service providers (like ToolCo) will have increasingly competitive cost structures. BigTool (the large, multinational business) could be a winner or a loser, depending on its mix of U.S. and foreign sales. If, say, 80% of its sales were made in the United States, it would pay more U.S. tax. On balance, it seems likely that Bill's idea would result in a fairer tax distribution between domestic and foreign businesses. In other words, multinationals would pay more tax under Bill's proposal, because income would no longer flush down the cracks of a leaky transfer pricing system.

Bill's article provides a reminder about tax reform. Reform should be guided by fairness and simplicity. Policymakers should weigh both virtues when designing an improved tax system. Incremental reforms that add complexity are probably worse than no reform at all.

The Buffett Bandwagon (Part Two)

2011-08-18T08:50:00.000-07:00

Warren Buffett recently published a lecture on tax policy in the New York Times. I discussed Buffett's article here, and a response from the Wall Street Journal here. Today is my last day beating this dead horse.

The Double Taxation Dilemma

In sum, Buffett's main concern is the preferential tax treatment of capital gains for "millionaires and billionaires." Unlike the WSJ, I agree that we should tax capital gains at the same rates as ordinary income. That remains a topic for another day. For now, a relatively quick observation, beginning with Corporate Tax 101.

Most public companies are C corporations, and most of those C corporations pay some U.S. tax on their earnings. The earnings are taxed a second time when the C corporations pay taxable dividends to their shareholders. We refer to this tax law mechanic as "double taxation."

(Likewise, if a shareholder disposes of her shares at a gain which reflects the increased value resulting from the corporate earnings, the gain is subject to tax, resulting in an effective "double tax" on the shareholder. This entire double-tax "problem" could be solved if we treated all corporations as flow-through entities, taxed shareholders on their interest in corporate earnings, and gave shareholders a basis increase for the underlying earnings. Yet another topic for a later post.)

Under current tax rules, qualified dividends and long-term capital gains are subject to preferential tax rates. As the WSJ correctly observes, the lower tax rates reflect a crude attempt to blunt the impact of the "double taxation" dilemma. If a C corporation pays tax at a 40% blended federal-state tax rate, it seems like an overreach to tax dividends at ordinary income rates (35% under current rules). So far, so good.

At this point, the WSJ oversimplifies the commercial and tax landscape. It is true that some amount of capital gains reflects sale of stock in public C corporations (resulting in double taxation). However, I suspect that a large amount of capital gains are derived from the sale of other assets.

For example, if I purchase a bond, and the value of the bond increase because Treasury rates decline, capital gain from the sale of the bond would qualify for a preferential tax rate. However, unlike the shares in a C corporation, which derive their value from the after-tax earnings of the corporation, bonds reflect the valuation of pre-tax cash flows. The WSJ argument falls over when you introduce capital assets other than shares in a C corporation. We don't have a "double taxation" dilemma to solve!

As I'll discuss later, I would tax capital gains at the same rates as ordinary income. In connection with that change, I would reform the tax code to treat all business entities (including public C corporations) as flow-throughs. This one-two punch would eliminate the "double taxation" dilemma. More to come on all of the above.

The Buffett Bandwagon (Part One)

2011-08-17T15:41:00.000-07:00

Yesterday, I discussed Warren Buffett's most recent lecture on tax policy. Today, the Wall Street Journal jumped on the bandwagon. Meanwhile, David Logan and Peter Pappas beat us both to the punch.

The Bait and Switch

I touched on this yesterday, but the WSJ gives us some numbers to drive home the point. Buffett repudiated the central pillar of President Obama's tax policy agenda by advising that Congress should "leave rates for 99.7 percent of taxpayers unchanged." In other words, Buffett was making a "surgical" argument about the tax policy applicable to actual millionaires and billionaires.

Unlike Buffett, President Obama wants to raises taxes on families with $250,000 in taxable income ($200,000 for individuals). This is roughly the top 2% of U.S. taxpayers, and includes millions of hard-working taxpayers who are light years away from the "millionaire club." So why is President Obama obsessed with tax increases for the working affluent? Because there simply aren't enough "millionaires and billionaires" to quench the President's thirst for additional revenue. From the WSJ:

In 2009, 237,000 taxpayers reported income above $1 million and they paid $178 billion in taxes. A mere 8,274 filers reported income above $10 million, and they paid only $54 billion in taxes.

But 3.92 million reported income above $200,000 in 2009, and they paid $434 billion in taxes. To put it another way, roughly 90% of the tax filers who would pay more under Mr. Obama's plan aren't millionaires, and 99.99% aren't billionaires.

Mr. Buffett says it's only "fair" to raise his taxes, but he's lending his credibility to raising taxes on millions of middle-class earners for whom a few extra thousand dollars in after-tax income is a big deal. Unlike Mr. Buffett, those middle-class earners aren't rich and may earn $250,000 for only a few years of their working lives. How is that fair?

President Obama has attempted to "energize the base" by lumping together the working affluent with "millionaires and billionaires." But here's the problem with this plank in Obama's platform. As government expands, the definition of "wealthy" taxpayer will go down. Today, it's $250,000. Tomorrow, it will be $200,000, or perhaps $150,000. After all, wealth is relative. Pretty soon, everybody at 400% of the federal poverty line will be considered "wealthy," and everybody else will be looking to attract "government investments" by way of transfer payments. If the ultimate goal is "equality," then increasing taxes on the working affluent, and then the middle class, is a good way to start. (If you can't raise the lowest common denominator, then simply lower it...voila, equality!)

Meanwhile, the actual "millionaires and billionaires" will likely keep squabbling about tax policy while sipping margaritas at the beach.

Buffett on Taxes ... Again

2011-08-16T13:38:00.000-07:00

For the umpteenth time, Warren Buffett has petitioned Congress to raise tax rates on "millionaires and billionaires."

In a New York Times editorial published August 14, Buffett makes the following recommendation to Congress:

I would leave rates for 99.7 percent of taxpayers unchanged and continue the current 2-percentage-point reduction in the employee contribution to the payroll tax. This cut helps the poor and the middle class, who need every break they can get.

But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

I'm weary of Buffett's lectures on tax policy. One week, he lectures Congress to raise taxes on "millionaires and billionaires." The next week, he lectures President Obama for scapegoating the private jet industry. (Note that Buffett's company, Berkshire Hathaway, owns NetJets, a business-jet operator.) He occasionally makes a valid point, but advocates of Big Government ignore the nuances and use Buffett as the poster boy for Big Taxes on everyone.

A few observations on Buffett's tired refrain:

[1] Buffett's main concern is the preferential tax treatment of capital gains. I'm sympathetic to the argument, but that's a topic for another day. My problem with Buffett is that his focus on capital gains obscures a more pressing issue: our tax system is fundamentally broken.

Imagine a patient in critical condition in a hospital emergency room. Buffett is like an orthopedic surgeon, anxiously fluttering around the ER doctors while fretting over a manageable knee injury. Sure, the knee injury will require treatment. But we need to stabilize the patient before we treat the knee. We need comprehensive tax reform, and the taxation of capital gains should be part of that reform process. Buffett's focus on capital gains recognized by "millionaires and billionaires" puts the cart before the horse.

[2] Buffett thinks that dividend and capital gains tax rates should be higher for "millionaires and billionaires." How about a compromise position? In connection with fundamental tax reform, why not "phase out" the tax preference for dividends and capital gains in excess of $1 million? That seems to me a kind of rough justice. Although Buffett might be open to such a compromise, President Obama is focused on class warfare for political purposes.

[3] Buffett would "leave rates for 99.7 percent of taxpayers unchanged." This is a repudiation, not an endorsement, of President Obama and other left-wing policymakers who sweep households with $250,000 in adjusted gross income into the same category as "millionaires and billionaires."

[4] Although Buffett repudiates the central strategy in President Obama's class warfare playbook, expect the media and left-wing policymakers to focus on a more general narrative: billionaire Warren Buffett as the poster-boy for Big Taxes on everyone.

[5] I keep waiting for Buffett to put his money where his mouth is. Nothing prevents Buffett, Bill Gates, or any other "millionaire or billionaire" from making a large "donation" to the federal government, or state government(s), or local municipalities. However, Buffett has pledged most of his personal fortune to charitable foundations. Kudos to Buffett for the philanthropic gestures, but the call for Bigger Taxes is starkly hypocritical. If Buffett believes that politicians are good economic stewards, why did he allocate most of his personal fortune to charitable foundations rather than writing a big check to the IRS?

Message to Buffett: more action ... less talk.

Downgrade

2011-08-15T09:21:00.000-07:00

I’m ending my hiatus and getting back in the blogging saddle. I was traveling for a few weeks, and catching up for a few weeks. During my travels, I was fortunate to avoid the political drama (and media frenzy) surrounding the debt-ceiling debate. While catching up, I couldn’t avoid the media frenzy (or political drama).

We all know the ultimate outcome of the debate: an agreement to lift the debt ceiling by approximately $2 trillion in three steps, conditioned on "deficit savings" of a similar amount. A good summary of legislation (the "Budget Control Act of 2011") is available here.

The first two steps will increase the debt ceiling by approximately $900 billion. The third step will increase the debt ceiling by another $1.2-$1.5 trillion, depending on the outcome of budget negotiations within a Congressional fiscal-reform “SuperCommittee.” Democrats and Republicans will each appoint six members to the SuperCommittee, and the twelve members of Congress will negotiate a mix of spending cuts and revenue increases that are intended to exceed the amount of the debt-ceiling increase. If the SuperCommittee is unable to agree on a mix of cuts and revenue increases, automatic spending cuts will take effect.

The ratings agency S&P is not sanguine that the SuperCommittee will take credible steps towards “fiscal consolidation” in the existing political climate. On Friday, August 5, S&P downgraded the credit rating of U.S. Treasuries from AAA to AA+ (with a negative outlook). The Downgrade and other economic factors traumatized the financial markets last week. Ironically, investors dumped stocks in favor of U.S. Treasuries as a “safe haven” investment. Go figure.

Reactions to the Downgrade were mixed. The Obama administration challenged the credibility of the Downgrade, arguing that S&P’s assumptions were flawed. (An important factor motivating the Downgrade is the spectacularly polarized relationship between Democrats and Republicans, and the resulting dysfunction on Capitol Hill.) Conspiracy theorists speculated that S&P was attempting to establish its objectivity, and thus salvage its reputation in Europe, where it has begun losing market share after downgrades of European sovereigns.

The majority view ranged from indifference to resignation to mild optimism. For most political and market observers, the Downgrade was neither a surprise (S&P telegraphed it in mid-July), nor a harbinger of doom (as noted, investors fled to U.S. Treasuries after the downgrade). Most observers viewed the Downgrade as an official wake-up call.

In my view, the Downgrade was several years late. We’ve always known that entitlement spending was unsustainable in the long run; and the gap between projected revenues and expenditures has been exacerbated by the Great Recession. We collectively borrowed too much to fuel a decades-long binge on consumption and government transfer payments. The resulting economic bubble has burst with devastating consequences; the aging Baby Boom population will become an immense strain on federal and state budgets in the next decade; and our flabby industrial sector faces ruthless competition from emerging-market economies. We are facing the abyss, and our political leaders have been slow to acknowledge the severity of our fiscal imbalance. Everyone deserves a share of the blame: Democrats; Republicans; and a voting public that rewards incompetence with re-election.

Can the new SuperCommittee take baby steps towards fiscal sustainability? During the last year, two bipartisan committees produced serious recommendations to address our nation’s long-term fiscal imbalance (see here and here). I’m hopeful, although not optimistic, that the SuperCommittee will build upon some of those recommendations.

If I had to wager, I’d put my money on “politics as usual,” with Democrats (and many Republicans) opposing sensible entitlement reforms, and Republicans (and many Democrats) opposing sensible reforms to tax expenditures. The Obama administration ignored the recommendations of its own budget-reform committee, which speaks volumes about its commitment to tackle the fiscal crisis. More disturbingly, President Obama takes every opportunity to poison the well, by obsessing publicly over tax breaks to “millionaires and billionaires,” defining “millionaires and billionaires” as “households earning more than $250,000.” But that’s a post for another day.

Cisco Trims Workforce by 9%

2011-07-20T16:24:00.000-07:00

On Monday, tech-giant Cisco announced that it would reduce its workforce by approximately 9% to reduce costs and improve profitability.

Why do I highlight this on a tax blog? (No, I'm not trying to channel Jim Cramer.)

John Chambers, Cisco's CEO, is one of the most vocal advocates of a repatriation tax holiday. Chambers (and other advocates of a repatriation tax holiday) argues that U.S. based multinationals would use repatriated cash to expand U.S. business activities, stimulating jobs, aggregate demand and economic growth.

I've discussed the proposed repatriation tax holiday here, here and here. Although a repatriation tax holiday has some intuitive appeal (Andy Stern's 'it can't hurt' principle), it would be a step in the wrong direction from a policy perspective.

Cisco's recent announcement underscores my concerns about the proposal. Cisco is a tech giant with insignificant long-term debt and abundant cash. If Cisco management were targeting robust growth opportunities, Cisco would be hiring employees and using its cash to expand its business (within and outside the United States). Instead, Cisco management is in cost-cutting mode, which involves reduction in employee headcount.

I completely support Cisco's attempt to increase shareholder value by optimizing its cost structure. I also support Cisco's right to lobby for a repatriation tax holiday. However, I believe that Cisco and other advocates of such a holiday are distorting facts, insofar as they suggest that offshore cash will be used to increase U.S. hiring. Cisco's recent workforce reduction impeaches Chambers's credibility on that point.

I've said it before, and I'll probably say it again: a repatriation tax holiday is no Holy Grail for lawmakers seeking to address our jobless recovery. Long term, we need comprehensive and fundamental business tax reform, including reform of the international tax rules.

Bad (Hair) Day

2011-06-27T17:19:00.000-07:00

Bad (hair) day for Rod Blagojevich; good day for the rest of us.

It is incredibly difficult to hold politicians accountable for unethical or illegal behavior. Politicians are slippery and calculating by nature, and, after all, they make up the rules of the game.

More important, incumbent politicians have an enormous advantage in a two-party political system plagued by earmarks and legislative gerrymandering. It is very difficult to roust sleepy voters to "throw the bums out." (What else explains Charlie Rangel, who might be in jail if he were not in Congress for the past 40 years?)

In rare cases, the justice system provides the ultimate "check" on political misconduct. Today was one of those days.

Early this afternoon, a Chicago jury found Blago guilty of enough crimes to keep him in stripes for the next 350 years. Although a "bittersweet moment" for U.S. Attorney Patrick Fitzgerald, the rest of us can savor good-old-fashioned accountability for Blago's enormous abuse of the public trust.

Congrats to prosecuting attorneys Reid Schar, Chris Niewoehner and Carrie Hamilton on the decision. They've invested several years of late nights and bad take-out food to make Blago the poster boy for sleazy politicians across the country.

Get a Real Job

2011-06-24T09:24:00.000-07:00

The chair of the American Bar Association Section of Taxation wants tax advisors to get a real job. (Thanks to Paul Caron for archiving the PDF copy of the Tax Notes article.)

On June 9, 2011, Egerton mused that:

The goal that Congress ought to have is to put as many of us out of business as possible. Now I say that with full confidence that it's not going to happen," said Charles H. Egerton. Although Congress may stop short of completely restructuring the code, he said, "we'll have to reinvent ourselves. That's a price we need to be willing to pay."

Egerton's comments in an obscure industry publication for tax nerds won't receive much attention. That's a shame. I believe that Egerton is onto something. As he says, our "[Income Tax Code] is just an inscrutable mess. It is complex. It is largely inadministrable." And he's not even considering state tax rules and regulations!

Take a few moments to consider the bigger picture. In America, our quality of life is driven by our political freedom and economic prosperity. Our economic prosperity is driven by the creativity and innovation of our entrepreneurs, technologists and business leaders over the past two centuries. Sure, we had a good "business climate" to promote economic growth (stable rule of law, property rights, market-based capitalism, etc.). But within that temperate climate, Americans have built a remarkable economic engine. We have been really good at developing, financing, producing and marketing goods and services into domestic and international markets. Or more simply: making and selling things.

Where do tax professionals fit into that picture? What value do tax professionals add to the "commercial matrix" of development, finance, production and marketing? The answer may bruise the egos of practitioners and academics from both sides of the political spectrum. The answer is: absolutely none. With respect for your virtues, brothers and sisters, we are simply leeching off a "complex, inscrutable and inadministrable" regulatory regime.

So we have developed an army of tax professionals -- intelligent, earnest, focused men and women -- who contribute virtually nothing to the long-run evolution of the "real economy." As a nation, we allocate nearly half a trillion dollars to tax planning and tax compliance each year -- half a trillion dollars that could be used in more productive activities. Sure, some of us will argue that 'tax professionals help clients comply with the tax rules as they are, and that keeps more cash in the private economy where it will be invested more efficiently than cash in the government coffers.' However, that argument rings hollow. We aren't making things better by leeching off the commercial matrix. We shouldn't (and we don't) need an army of tax professionals to tend to the clients. We need a better, simpler tax regime. And we need more intelligent, earnest, focused men and women involved in the "real economy."

I believe that the tax community should take Egerton's challenge to heart, and begin working on serious proposals to "downsize" our ranks by drastically simplifying the U.S. tax regime. Many tax professionals will resist the challenge, because they earn a comfortable living. And let's face it: displacement from a specialty niche in tax would be socially jarring and economically painful for many. But no pain, no gain. We are currently part of the problem. One of our cultural legacies is our ability to troubleshoot problems. Perhaps the U.S. tax community can rise to the challenge.

Worst of the Week (Everson)

2011-06-23T11:14:00.000-07:00

Two editorials this week are competing for my inaugural "worst of the week" award. Yesterday, I discussed an opinion letter to the Wall Street Journal which expressed Thomas Geoghegan's controversial view on domestic business migration. Today, I'm discussing an editorial by former IRS Commissioner Mark Everson. (Thanks to Peter Pappas and Paul Caron for the lead.)

Second Nominee: Mark Everson

Everson seems to want to say something profound. Unfortunately, his editorial ends up reading as a series of non sequitors. It reminded me of a sci-fi movie with decent special effects but no plot. You walk away thinking: 'that editorial could have made sense, if there were any theme or continuity or relevant message.' After five years as IRS Commissioner, this is all we get?

In a nutshell, Everson suggests that greedy lawyers and accountants contributed to the 2008 financial crisis by abandoning their ethical moorings in pursuit of outrageous professional fees. But that's not quite right... The vast majority of lawyers and accountants represent clients who had nothing to do with the 2008 financial crisis. So let me try again. In a nutshell, Everson calls out greedy lawyers and accountants whose client base includes Wall Street firms and U.S. based multinationals. But, wait, that's not quite right either... Perhaps he suggests that greedy tax lawyers and complicit accounting firms destroyed the moral integrity of the law and accounting professions. Or that the GE tax department is undermining Obamacare. Or that the attorney-client privilege is an anachronism that should be cast aside by the Supreme Court 2.0. Again, 'that editorial could have made sense, if there were any theme or continuity or relevant message.'

I'll stop trying to condense the editorial into a single theme. He basically strings together eight different ideas:

(1) Attorney and auditors are no longer driven by ethics, professionalism and independence that long fostered the "integrity of capitalism." Instead, law firms and accounting firms are driven chiefly by the earnings of their partners. That means regulators cannot rely on these professionals to "check" corporate risk taking.

Two points here. The vast majority of attorneys and auditors work with an incredibly diverse group of clients. The vast majority of these attorneys and auditors display ethical behavior, professionalism and independence from their clients. Everson seems to be focused mainly on "BigLaw" attorneys and "BigFour" auditors whose client base includes Wall Street firms and multinational corporations. Talk about painting with too broad a brush.

Everson's insinuation that the BigLaw/BigFour do not check client risk assumption is absurd. Has he ever been subject to a BigFour audit? Has he tried obtaining an opinion from a BigLaw partner whose home is at risk for malpractice liabilities? Perhaps not, if he truly believes that the BigLaw/BigFour provide no "check" on client risk assumption.

(2) New lawyers at prestigious Wall Street law firms are overpaid.

I'm confused. What does this have to do with the professional decay that Everson previously alleged? Is there some evidence that cutting the pay of new associates will make them more ethical, professional and independent? And what does this have to do with the auditors? Are new BigFour auditors overpaid? Or is the point that BigLaw cannot support its highly-paid young associates without unethical practices?

Everson notes that, in 1948, his father graduated Harvard Law and took a job at a prestigious New York law firm earning $3,600 per year. A new associate at the firm today would make 40 times more than his father (call it $145,000).

Okay, but what happened to Ivy League tuition in the last 60 years? I quickly found data for Penn Law. Today's cost of tuition and fees: approximately $51,000. The 1948 cost of tuition and fees: $615. That means a law school education today costs 80 times more than a law school education in 1948, while new associates today earn 40 times more than new associates in 1948. Perhaps the law firms are exploiting young associates, or the law schools are exploiting law students, but none of this has anything to do with ethics, professionalism or independence from clients.

(3) In the good old days, lawyers and auditors "moving up the ladder, didn't expect to get rich." Wealth was reserved for business owners, corporate execs, talented investors and investment bankers.

This is just melodramatic. I don't know the historical relationship between BigLaw profits per partner and the income of their high-net-worth individual clients (or senior execs at their corporate clients). However, I'd be surprised if it has changed materially over the years. BigLaw attorneys and BigFour auditors make good money for long, high-stress days and nights, but they don't capture the economic premiums of Fortune 500 execs or technology founders (among other high-net worth clients).

(4) Lawyers' and accountants' "core mission" has changed. They used to help clients adhere to professional standards and follow the law. Now they focus on "growing billings" to support lavish profits per partner.

Another stretch. Accountants are focused on numbers, not "helping clients follow the law." For example, if a client is fined for violation of environmental regulations, an auditor must review how the client booked resulting liabilities/penalties. The auditor's role is to confirm that the client's financial reporting of the incident is materially correct. The auditor's role is not to help prevent the underlying environmental violation.

Lawyers provide legal services to clients across a range of matters. I'm not aware of any BigLaw firms which systematically conspired with clients to break the law. If it happened, our 24/7 media cycle will inevitably uncover the conspiracy.

(5) Corporate clients are unwilling to pay exorbitant legal fees (in excess of $1,000 per hour for certain BigLaw partners) for "conservative" legal advice. As evidenced by a recent article about GE's tax department, lawyers and accounting groups are now viewed as profit centers rather than compliance officers.

Sure, legal fees charged by seasoned partners at elite BigLaw firms are pretty shocking. During law school in the early '90s, one of my professors charged $1,500 per hour ($2,200 in today's dollars) to serve as an expert witness in various legal proceedings. That shocks me to this day! The point is: legal fee inflation has nothing to do with an attorney's ethics, professionalism or independence from his or her clients.

The point about GE and "tax departments as profit centers" is wildly exaggerated. The vast majority of U.S. businesses cannot and do not use their tax departments as "profit centers." Their tax departments are primarily focused on accounting for income taxes and tax compliance. As a former IRS Commissioner, Everson should know better.

(6) KPMG is a poster child for the "new norm" of unethical behavior.

No, the unethical decisions of a few senior execs at KPMG does not taint the character or values of thousands of hard-working attorneys and auditors not engaged in marketing of tax shelters. Give me a break.

(7) Congress should re-assess the attorney-client privilege as applicable to corporations.

Seriously? Now he's probably focused on taxes again. The ACP is effectively obsolete in light of new IRS Schedule UTP for corporate taxpayers. (And I note that tax planning did not cause the 2008 financial crisis!)

(8) Businesses should change their compensation structure for finance and legal execs, eliminating reliance on equity compensation.

Now, Everson simply lost me. There is a point here that might be worth exploring in a different blog post. But it's not worth further time for now.

* * *

So which editorial is the Worst of the Week? Geoghegan or Everson? Let me know what you think.

Worst of the Week (Geoghegan)

2011-06-22T11:59:00.000-07:00

Two editorials this week are competing for my inaugural "worst of the week" award. I'll discuss one today and the second tomorrow.

First Nominee: Thomas Geoghegan

Boeing is in a spat with the National Labor Relations Board (NLRB) over a decision to open a $1 billion facility in South Carolina to manufacture its new 787 Dreamliner aircraft.

On Monday, the Wall Street Journal published an opinion piece by Thomas Geoghegan. Geoghegan, a lawyer in Chicago, believes that Boeing's case is a "teachable moment." Specifically, Goeghegan remonstrates against business migration from higher-cost urban areas (like Chicago and Seattle), to lower-cost U.S. states (like South Carolina or Louisiana).

Geoghegan relies on an anecdotal experience with Outboard Marine Corporation to conclude that "when major firms move South, it is usually a harbinger of quality decline." He suggests that Southern union-busting has resulted in inferior schools and, in turn, "poorly educated and low-skilled workers that are simply unable to compete."

After highlighting the mental deficiencies of Southern rednecks, Geoghegan loops back to Boeing. In a revelation that will surprise Boeing shareholders, Geoghegan asserts that:

Boeing is not a product of the free market—it's an extension of the U.S. government. Over the years, our taxpayers have paid to create a Boeing work force with exceptionally high skills. That work force is not just an asset for Boeing—it's an asset for the country. Why should the country let Boeing take it apart?

So let me sum up the argument. Business executives should no longer have the economic freedom to deploy investment capital based on an analysis of commercial risks and opportunities. Domestic business migration from higher-cost locations to lower-cost locations is economic suicide and will accelerate the collapse of our economy and standard of living. Super-smart labor lawyers (like Geoghegan) and regulators (like the NLRB) will prevent businesses and their shareholders from committing aforementioned economic suicide. Meanwhile, Southern rednecks can keep themselves busy wrangling alligators and trading food stamps for NASCAR tickets.

In all seriousness, Geoghegan's editorial is disturbing on several fronts. It is blatantly condescending towards men and women in the South. (I'm not sure how Geoghegan defines "South," but I'm guessing "South of the Mason-Dixon line.") It reflects an economic authoritarian philosophy that the rules of the game should be stacked in favor of "enlightened Northerners" (who, by the way, are more friendly towards unions) and against their "unevolved Southern cousins" (who, by the way, favor "right to work" policies). Moreover, it is painfully detached from economic reality.

Geoghegan apparently believes that the cost of an employee solely reflects the productivity and quality of that employee. Hence, an employee based in Chicago that earns $28 per hour, is more productive and performs higher-quality services than an employee based in Louisiana that earns $14 per hour. But most of us understand that labor costs are related to the underlying cost of living in a given area. To pay the bills, those of us living in higher-cost urban areas need to earn relatively higher incomes than those of us living in lower-cost rural areas. Hourly wage differentials tell us nothing about the educational background, motivation or performance of individual employees.

As Geoghegan is probably aware, a Harvard law grad working as a corporate attorney in New York City would charge higher rates than a Harvard law grad working as a corporate attorney in Miami. (Let's assume that both law grads are twin sisters, and that they had identical educational backgrounds before Harvard.) Is the Miami lawyer paid sub-par wages because she spends her day hunting raccoons and eating fried Twinkies? No, the pricing differential simply derives from market economics (including a lower cost to do business in Miami relative to New York City).

To use a more concrete example, compare the fates of domestic auto manufacturers and their foreign counterparts with U.S. manufacturing facilities. Under the weight of union contracts, Detroit automakers GM and Chrysler were forced into bankruptcy and bailed out by taxpayers. Their foreign counterparts, with non-unionized workforces in various Southern states, survived the Great Recession without taxpayer support (thanks to leaner cost-structures and more operational flexibility).

Although the Journal can be commended for publishing a diversity of views, I wonder if this was a bait and switch. Locate a labor lawyer who believes in a centrally-planned economy (run by super-smart labor lawyers and the NLRB), and give him a platform to embarrass himself and discredit the NLRB by association.

Up tomorrow: Everson ... Seriously?

Adult Supervision

2011-06-21T16:42:00.000-07:00

California taxpayers are enjoying a day of schadenfreude (which goes nicely with a fresh Hefeweizen, as I'll explain below).

If you have access to the Internet, you've heard that California is a fiscal basket case lurching towards Greek-style insolvency. The latest chapter in California budgetary chaos pits a Democratic Governor (Jerry Brown) and Democratic Controller (John Chiang) against Democratic legislators.

Since his election in 2010, Brown has been negotiating a budget with Democrats and Republicans. The state continues to project large fiscal deficits and an unsustainable "wall of debt" in the next decade. Compounding the impact of the Great Recession, businesses are fleeing the state's oppressive regulatory and tax regime in droves.

To his credit, Brown has rolled up his sleeves and attempted to exercise some adult supervision of the legislators in the sandbox. He has proposed a mix of temporary tax extensions and spending cuts to balance the state budget and improve the overall trajectory of state finances. Brown hoped to bring the temporary tax extensions to a statewide vote through the ballot initiative process. However, he was unable to persuade Republicans to support a ballot initiative. (Republicans claim that Brown was unwilling to consider necessary reforms to the state's unsustainable pension system. We don't know what transpired behind closed doors.)

Unable to sway Republicans to support Brown's proposal, Democratic legislators enacted "Plan B" on Wednesday, June 15. Plan B was basically a variation of "kick the can down the road." After approving the plan, Democrats broke out a case of Hefeweizen to celebrate another year of accounting gimmicks.

The next day, Brown added insult to (hangover) injury by vetoing the Democratic budget. After taking an obligatory swipe at state Republicans, Brown described the Democratic budget as containing "legally questionable maneuvers, costly borrowing and unrealistic savings."

And now for the taxpayer schadenfreude. California voters approved a law last fall that permitted legislators to pass a budget with a simple majority vote but stripped them of pay for every day the budget is late. Today, Controller Chiang announced that the Democratic budget was defective, and, consequently, legislators would be working for free until they passed a balanced budget. Despite his party affiliation, Chiang did not give the Democratic legislators a free pass: "My office's careful review of the recently passed budget found components that were miscalculated, miscounted or unfinished."

Ballot initiatives are a big part of California's political and budgetary quagmire. However, in this case, the voters deserve a celebratory case of Hefeweizen for trying to impose some accountability on their state "political leaders."

Repatriation Holiday Part II (update #2)

2011-06-20T14:24:00.000-07:00

Last week, I blogged here and here about a proposed tax break that would encourage U.S. multinationals to repatriate cash to the United States.

Today, the New York Times jumped on the bandwagon, publishing an article by David Kocieniewski ("Companies Push for Tax Break on Foreign Cash"). (Note: the Kocieniewski article refers to calendar year 2005; although the underlying legislation was enacted in October 2004, most taxpayers brought cash home from their foreign subsidiaries during 2005.)

Although the Kocieniewski article echoes several of my observations, it contains additional color on the 2004 repatriation holiday:

- 800 corporations took advantage of the repatriation holiday

- According to this study by the NBER, they repatriated $312 billion

- An astonishing 92 percent of that money was returned to shareholders in the form of dividends and stock buybacks

- 60 percent of the benefits went to just 15 of the largest U.S. multinationals

- According to Kristin J. Forbes, a professor of economics at MIT’s Sloan School of Management (and a member of President Bush’s council of economic advisers), “[f]or every dollar that was brought back, there were zero cents used for additional capital expenditures, research and development, or hiring and employees wages”

As I mentioned in my original post, Big Pharma was a major beneficiary of the 2004 legislation. The Kocieniewski article explores certain actions by Merck, which used dividends from its foreign subsidiaries to support dividends and stock buybacks while cutting jobs in the United States. Members of Congress, please repeat after me: "cash is fungible ... cash is fungible ... cash is fungible."

I don't fault the large tech or pharmaceutical companies that lobbied for the 2004 legislation. Nor do I fault the U.S. multinationals that brought offshore cash back to the United States at a 5.25% rate. (Compliance with existing tax laws is not "corporate tax avoidance," a topic that I will discuss more extensively in future posts.)

I do assign fault to the Bush administration and the members of Congress (Republican and Democrat) that enacted the 2004 legislation. The 2004 repatriation holiday was bad tax policy. Perhaps it was motivated by "positive" wishful thinking, but it seems to have been motivated by "stick your head in the sand" wishful thinking. Or, more likely, well-timed political donations to grease the Congressional wheels. We don't need a sequel.

I'll conclude this post with by repeating the conclusion from my last post. Any repatriation incentives should be linked to comprehensive income tax reform, not enacted out of desperation to "do something."

An Encouraging Vote to Kill Ethanol Subsidies

2011-06-17T18:00:00.000-07:00

In a surprise development, the Senate yesterday approved an amendment that would kill the ethanol tax credit and repeal the import tariff on foreign ethanol. I'll refer to the tax credit and import tariff collectively as "ethanol subsidies."

Cheers to Tom Coburn (R-Okla.), who drove the effort to repeal the ethanol subsidies, and Dianne Feinstein (D-Calif.), who co-sponsored the amendment. Jeers to the Obama administration, and Charles Grassley (R-Iowa) (the most vocal advocate of ethanol subsidies), who refused to support the measure.

The vote represents an encouraging display of bipartisan cooperation (or "ethanol miracle," if you're feeling melodramatic). 37 Republicans joined 38 Democrats and two Independents to support the measure. Despite the urgency of the challenges facing our nation, we have rarely witnessed bipartisan cooperation on any meaningful policy issue in recent years. Although this was largely a symbolic victory, it demonstrates that sound policy can trump special-interest politics in a time of fiscal emergency.

The ethanol subsidies are an example of a bad policy that refuses to die. The federal government has subsidized the ethanol industry since the 1970s. Successive administrations have pandered to the farm states and environmentalists, shifting the rationale for subsidies as the political climate changed. Team Gore argued that corn-based ethanol results in higher energy output and lower carbon output than petroleum-based gasoline. (He has subsequently reversed course and indicated that his support for ethanol was politically motivated.) Teams Bush and Obama have both argued that ethanol can move us towards the elusive dream of "energy independence." Team Obama is also concerned about the "jobs argument," i.e., that reduction in ethanol subsidies will reduce the number of "good American jobs" in the ethanol industry.

Although economists have grumbled about ethanol subsidies for a decade (see Ed Dolan's blog here and here for a good discussion), the U.S. Government Accountability Office directed a spotlight on the subsidies in a report earlier this year. The GAO projected that the cost of the ethanol tax credit would increase from $5.4 billion in 2010 to $6.75 billion in 2015. The GAO characterized this expenditure as "duplicative," in light of renewable fuel standards that will phase in over the next decade.

The ethanol subsidies demonstrate the power of special interests (in this case, a coalition of farmers, landowners, fuel producers and naive environmentalists) to capture windfall profits from unwitting taxpayers. The "ethanol coalition" has fended off repeal for years, despite analysis indicating that (i) corn-based ethanol has lower energy output and higher carbon output than petroleum-based gasoline and (ii) ethanol subsidies were materially increasing food costs to consumers. The import tariff on foreign ethanol is particularly maddening; why increase the cost of foreign ethanol to consumers if ethanol is "greener" than petroleum-based gasoline? And why increase the cost of foreign ethanol if domestic ethanol production is increasing food costs to consumers?

The Senate vote yesterday demonstrates that members of Congress can look across the aisle, lock arms with their colleagues, and move forward to eliminate special-interest boondoggles that we can no longer afford. Let's hope that Congress will build on this momentum in the days ahead, and that the Obama administration will catch up.

Repatriation Holiday Part II (update #1)

2011-06-16T12:12:00.000-07:00

Yesterday, I discussed H.R. 1834, the Freedom to Invest Act of 2011. See here for the text of the proposed legislation.

The proposal would "refresh" Section 965 of the Internal Revenue Code, enacted in 2004 to impose a 5.25% tax rate on earnings distributed by a controlled foreign corporation to its U.S. parent.

In today's edition, Tax Notes provides additional color on the wrangling behind the legislative scenes. Representatives Jared Polis (D-Colo.) (bill co-sponsor), Loretta Sanchez (D-Calif.) and Kay Hagan (D-N.C.) argued for the repatriation incentive. Sanchez and Hagan seemed to buy into the Stern theory, discussed yesterday ('we're desperate for government revenue and repatriation can't hurt').

Fortunately, it is not a done deal:

[L]egislators remain mixed on the tax break, with some worrying that the money will not be used to spur job growth. After Congress approved a repatriation holiday as part of the American Job Creation Act of 2004, several corporations brought back billions of dollars but later laid off thousands of workers. Pfizer Inc. repatriated around $37 billion and laid off about 3,500 employees. Ford Motor Co., which repatriated $850 million, let 10,000 people go.

Polis said to make repatriation politically palatable, lawmakers "want to be able to point to a direct, ironclad nexus of job creation." Polis said he supports that so long as it does not interfere with the overall goal of encouraging repatriation.

Is Congress capable of creating "an ironclad nexus of job creation"? Let's not hold our breath on that one.

Tax Notes reports that Dave Camp (R-Mich.), Ways and Means Committee Chair, does not support the proposal. I hope that Chairman Camp stays firm in his resistance to this bad idea for a sequel.

Earlier this year, Senators Ron Wyden (D-Ore.) and Dan Coates (R-Ind.) sponsored broader tax reform legislation (the Bipartisan Tax Fairness and Simplification Act of 2011, see here) which would include a repatriation incentive as a transition to a new tax system. Any repatriation incentives should be linked to comprehensive income tax reform, not enacted out of desperation to "do something."

Repatriation Holiday Part II: The Horror Continues

2011-06-15T17:40:00.001-07:00

As the U.S. economy recovers from the Great Recession, U.S.-based multinationals continue to build large cash balances offshore. Some U.S. pundits and politicians view the offshore cash as a "holy grail" of economic stimulus. They propose a sequel to the "repatriation holiday" that Congress enacted in 2004. From a policy perspective, the original act was a bust. Let's hope that reason prevails, and Congress doesn't release the sequel.

(This will be a relatively short blog on a complicated topic that requires further elaboration.)

Tonight on CNBC, Larry Kudlow discussed a proposed repatriation holiday with Andy Stern, Former SEIU President, and Bob Lutz, Former Vice Chairman of General Motors. Interestingly, Stern -- a national Democratic figure -- argued in favor of a repatriation holiday, while Lutz -- a career industrialist -- argued against a repatriation holiday.

Stern's basic argument for a repatriation tax holiday is that 'it can't hurt to flow a trillion dollars back into the United States from offshore balance sheets.' He favors a holiday now because (i) it will probably create some U.S. jobs directly, (ii) it will help some multinationals shore up underfunded U.S. pension plans, and (iii) although much of the cash may be used for dividends and share buybacks, some of the dividends/buybacks will be taxable, increasing tax revenue to desperate federal, state and local governments.

Lutz argued that the 2004 holiday failed to stimulate the economy or create jobs. Moreover, Lutz noted that the 'trillion dollar' figure is an exaggeration. On that point, Lutz emphasized that the "strings attached" to a tax holiday would deter many corporate executives from repatriating cash. (A current proposal, H.R. 1834, would effectively penalize corporations that repatriate cash without maintaining existing U.S. employee headcounts.)

I'm on Lutz's side of this policy debate. The 2004 holiday was a total bust. Two points escaped policymakers in 2004:

First, cash is fungible. Although multinationals repatriated cash to the United States, they did not use the "offshore cash" to expand their U.S. business activities. They shored up pensions, and they increased dividends/buybacks, but those uses of cash did not have a stimulative impact on the overall economy. (Technically, a multinational that repatriated cash was required to implement a "domestic reinvestment plan" or "DRIP" to document use of the cash within the United States. Economic analysis suggests that the DRIPs were droops.)

Second, a huge amount of offshore cash was (and is) controlled by multinational tech and pharma companies (think Cisco, Microsoft, Pfizer). Although the tech and pharma industries are robust engines of growth, they have low external leverage ratios and are not cash constrained in the United States. If they want to build factories or hire employees, they have existing sources of financing to achieve those objectives.

Unlike the tech and pharma industries, America's small- and mid-size business managers are not sitting on buckets of offshore cash. Another repatriation holiday may have some indirect benefits for these businesses, but no direct benefits. It's simply not the "holy grail" that its advocates would suggest.

We need fundamental corporate income tax reform, including lower tax rates on all business income. A tax holiday would make reform more difficult, because repatriation is a significant lever in the overall policy debate. Let's hope Congress leaves the sequel to 2004 on the cutting room floor.

Taking the Plunge

2011-06-15T13:02:00.000-07:00

After months of procrastination, it's time to enter the tax blogosphere.

Does the web need another blog discussing taxes, politics and economics?

Maybe not. Most of us are suffering from information overload. Many of us have to make a conscious effort to unplug, relax, and avoid the Three Ps (pundits, politicians, and partisan rhetoric). All of us have better things to do, when push comes to shove.

For me, however, now is the time to take the plunge and launch Tax Didactic. If you have stumbled across my blog, I hope you learn something new or take a look at something old from a new perspective.

What gave Tax Didactic a jump start?

I've long been frustrated by bloggers, regurgitators and pundits ("BLURPs") who manipulate facts to drive an underlying political agenda. Each of us brings a subjective viewpoint to a given set of facts. No analysis is completely unbiased.

However, many of the BLURPs cross the line. I encounter far too much "analysis" that contains a "splash" of facts and a heavy "pour" of political opinion. The brazenly political BLURPs seem to become intoxicated by their own published detritus. On the right and the left, political BLURPs consult the same playbook. They mistake correlation for causation. They mutate facts to suit their political agendas. They pull quotes out of context. They have been enlightened with an economic Theory of Everything.

(On the left, the TOE begins in the 1980s. A lefty BLURP can trace all problems in America back to Reagan. Check out an interview with Richard Trumka, or an article by David Cay Johnston. On the right, the TOE dates back to the New Deal. That's vague and unsatisfying, but Obama needs a few years to ripen.)

Enough is enough. I'm jumping into the fray as a politically independent tax professional. I don't have all the answers, but I can discuss evolving issues without the bias of a political BLURP.

(Plus, my wife can only handle so many of my vents about tax policy.)