Prioritize and Compromise

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

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

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 announced 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 here 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"

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

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?

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

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

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)

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)

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)

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)

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"

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

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)

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)

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

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

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.