California Governor Jerry Brown is dealing with a "taxing" headache these days. Within the last week, Brown has taken a jarring one-two punch.
[1] The state is projected to run budget deficits for years to come. Despite rosy economic assumptions, Brown's 2012-13 budget was expected to result in a $9.2 billion deficit. A report issued today by the nonpartisan Legislative Analyst's Office concludes that Brown's forecast is overstated by approximately $6.5 billion.
Brown was looking at roughly a $9 billion budget gap. Now he's looking at $15 billion. To quote another governor wunderkind: "Oops"!
Silicon Valley is experiencing a "mini-bubble," and Facebook's pending IPO is expected to create hundreds of new millionaires. Brown's revenue estimate assumes that "social networking" entrepreneurs and investors will pay billions in state taxes on capital gain income. The LAO report emphasizes that capital gain income is highly variable and notoriously difficult to project. California has been down this road before. Those who cannot remember the past are doomed to repeat it.
California is lurching down a path towards Greek-style insolvency. Here's the basic formula. Politicians create an expansive state bureaucracy. The state employees organize into dues-paying members of public employee unions. The unions funnel dues into political elections to support candidates who promise to keep the gravy train running. The politicians become pawns of union bosses. They borrow money to cover budget deficits as state employees become increasingly detached from the public sector.
In the long run, the cycle is unsustainable and doomed to implode. California cannot afford to pay its recurring bills and satisfy its health and pension commitments to retired state employees. However, that's a problem for the next generation. Brown is a political careerist, and he has no interest in disrupting the cozy relationship between Democratic politicians and public employee unions in California.
[2] Brown wants to solve the $9.2 billion budget gap with a two-pronged tax increase. He wants state voters to approve an initiative to raise tax revenue. The "Brown Tax Initiative" would raise the sales tax by half a cent and raise tax rates on families who earn more than $250,000. In a savvy -- but disgusting -- political move, Brown would link a failure of his initiative to automatic cuts in the K-12 education budget.
Does the income threshold sound familiar? Yes, another Democratic politician defines a working family with $250,000 in income as nouveau riche. To give Brown some credit, his initiative would at least "spread the pain around." Everybody pays sales taxes; a vote to increase the sales tax is a vote to tax me and the "man behind the tree." I'm more disgusted by Brown's decision to hold K-12 teachers and students ransom for his tax increase proposal. (Full disclosure: my wife is an elementary-school teacher.)
The LAO report complicates Brown's overall strategy. The Brown Tax Initiative will not cover the LAO's projected revenue shortfall. Brown will have to go back to the drawing board. Or play games with the numbers, which is usually the "solution" to problems in Sacramento.
[3] Meanwhile, recent poll data suggests that the Brown Tax Initiative may be caught in the crossfire among competing initiatives. Someone pass the Tylenol!
Brown is not the only advocate for higher taxes on the "wealthy." Public employee unions are pushing a "Millionaire Tax Initiative." They want to increase tax rates by 3% for incomes over $1 million, and by 5% for incomes over $2 million.
A wealthy lawyer (Molly Munger) and the state PTA is pushing the "Munger Tax Initiative." The Munger Tax Initiative would progressively raise taxes on all taxpayers, and would funnel the revenue into education.
According to the recent poll, likely voters express support for the Millionaire Tax Initiative (63%) and the Brown Tax Initiative (58%). More likely voters oppose (48%) than support (45%) the Munger Tax Initiative. No big surprise. The first initiative provides a "free lunch" courtesy of the highest-income taxpayers. The second initiative echoes Team Obama's drumbeat to raise taxes on the top 3%. The third initiative would require increased taxes for everybody, which triggers some soul-searching among voters.
If you need to guard the entrance to Hades, I'd recommend a three-headed monster named Cerberus. However, a three-headed tax initiative may confuse and fatigue California voters. Team Brown conducted an unofficial poll suggesting that voters will play "knock out" and select one plan while rejecting the others. If so, voters may fragment their support for the initiatives and tank the entire process. (Team Munger disputes Brown's logic.)
A final remark on the California initiative process. Why exactly do we elect state politicians, when they put any tough decision on the ballot?
Monday, February 27, 2012
Friday, February 24, 2012
Obama Woos the Corporate 1%
[1] You really can't make this stuff up. On February 11th, the Wall Street Journal reported that (sub. required):
The existing tax subsidy regime for renewable energy development is dysfunctional. Team Obama needs cash from big U.S. businesses with big U.S. tax bills. Without cash from the Corporate 1%, renewable energy development will continue to limp along. Hopefully, the "most transparent administration" in history will release a transcript of the March 13 meeting. But we can be assured that the real "action" will occur behind the scenes. Crony capitalism at its best.
[2] Back in August 2011, I wrote a series of posts describing the relationship between tax subsidies and renewable energy development. See Part 1, Part 2, Part 3, Part 4. The political left wants to subsidize renewable energy through federal spending. The political right favors the magic of "tax expenditures" over direct outlays. Together, they devised a laughably flawed regime that provides tax credits for certain types of renewable energy.
Why is the regime laughably flawed? A quick summary of my August posts. I'm focused on wind and solar development, although the same principles apply in other contexts.
Congress wants more development of wind and solar projects. But generating electricity from wind and solar resources costs more than generating electricity from coal and natural gas ("bad" fossil fuels). Because wind and solar are "uneconomic," no rational actor would develop wind or solar projects without some kind of subsidy regime. Put another way, a rational consumer would not choose to purchase expensive, unsubsidized electricity from wind and solar projects.
There are various ways to subsidize energy development. For example, Congress could have passed a direct subsidy for electricity produced by wind and solar projects. The direct subsidy would have been, say, 1.0 cent per kilowatt hours of electricity produced by a "qualified" energy facility for a given number of years. The entire program could have been administered by the Energy Department ... which is, after all, responsible for our national energy policy. Under a direct subsidy regime, a wind or solar project would merit development if (a) sales of electricity to utilities or other unrelated customers, plus (b) the 1.0 cent/KwH subsidy from the Energy Department, exceeded the cost of debt and equity required to finance development. Nice and easy.
Instead of a direct subsidy, Congress enacted a complicated tax subsidy. Actually, a series of slightly different, complicated tax subsidies. For wind, Congress enacted a "production tax credit" or "PTC." For solar, Congress enacted an "investment tax credit" or "ITC." In addition, wind and solar property qualifies for accelerated tax depreciation. Suffice to say, a taxpayer must have positive income tax liability to use PTCs, ITCs and accelerated depreciation. (Unless extended, the PTC regime will expire on December 31, 2012, adding more complexity and uncertainty into the mix.)
Importantly, a taxpayer with positive tax liability cannot simply "purchase" tax credits. On the flip side, a developer without tax liability cannot "sell" tax credits or excess depreciation. Instead, taxpayers with cash and tax liability must invest cash (so-called "tax equity") into qualifying wind and solar projects.
In exchange for its financing commitment, a tax equity investor receives tax credits, accelerated depreciation and some cash until the project satisfies an agreed IRR "hurdle." After the IRR hurdle is satisfied, somewhere down the road, the tax equity or common equity/sponsor exercises a put or call to close the transaction. Under the put/call arrangement, the common equity/sponsor purchases the tax equity investor's position based on its residual value.
[3] And that's why the regime is laughably flawed. It is complex and impenetrable for most taxpayers and most tax advisors. Plus, the commitment of cash to a renewable energy development project is absolutely "non-core" to most corporate treasurers and CFOs. Meanwhile, administering the subsidy regime falls into the lap of the IRS. Why not administer energy subsidies through the Energy Department?
In practice, there are only 15-20 active participants in the tax equity market. The market is dominated by large national banks, some regional banks, and a few other taxpayers in the financial services business (GE; insurance companies).
Before the financial meltdown in 2008, tax equity yields ranged from 6-8% on an after-tax basis (10-12% on a pre-tax basis). Then the financial system flirted with Armageddon. All of a sudden, market facilitators (the banks and insurance companies and GE) began running tax losses. Without taxable income, facilitators didn't need tax credits, so the market effectively froze up. This didn't bode well for Team Obama's "green jobs agenda." So the administration's Congressional allies quietly created a program to bail out the developers. During 2010 and 2011, qualifying projects could elect to receive Treasury grants (so-called "1603 grants") in lieu of tax credits. The 1603 grant program permitted the industry to survive the turbulence of the Great Recession.
Time flies, and we're in 2012. The Treasury grant program has expired, and Congress recently declined to renew it. Renewable energy development again hinges on 15-20 banks and insurance companies. Because there is a massive supply/demand imbalance (more renewable energy developers than tax equity), tax equity yields have skyrocketed. Yields for reputable developers have jumped from the 6% range to the 12% range. Yields for marginal developers are in the 15-20% range.
[4] Now we come full circle. The tax equity market is dysfunctional, and would make an interesting study for an economics PhD dissertation. Plenty of corporate taxpayers outside the financial services business (think retail, domestic services) have (a) large U.S. tax bills, and (b) stockpiles of cash earning 1% or less in ultra-secure investments. But tax equity yields are running 12-20% after-tax.
As evidenced by Team Obama's pending meet-and-greet, many of those large corporate taxpayers are probably put off by the complexity of the tax subsidy regime. But many of them routinely invest in other tax credit schemes, including low-income housing tax credits. Team Obama loves to demonize big business and large corporate taxpayers. Can it persuade those "big bad corporations" to commit cash in support of Obama's "green jobs agenda"?
In the world of crony capitalism, anything can happen. It's always a good time when you're rolling in the Corporate 1%.
The Obama administration is attempting to persuade U.S. corporations about the benefits of investing in renewable energy, in an effort to help the industry after a government grant program expired.Yes, crony capitalism at its best. Team Obama sings a populist tune for its cheerleaders on the political left. Most of the time, someone needs to stand up for the "99%" against the big, bad "1%". But, ahem, there are some exceptions. A big exception involves the much touted "green jobs agenda." Guess what? The "green jobs agenda" can really use some help from the Corporate 1%.
The Energy Department-led effort includes a planned March 13 meeting at which senior financial-firm executives and Energy Secretary Steven Chu would speak, documents viewed by The Wall Street Journal show. The 79 invitees include some of the largest companies in the U.S., from Exxon Mobil Corp. to Walt Disney Co., according to the documents.
The existing tax subsidy regime for renewable energy development is dysfunctional. Team Obama needs cash from big U.S. businesses with big U.S. tax bills. Without cash from the Corporate 1%, renewable energy development will continue to limp along. Hopefully, the "most transparent administration" in history will release a transcript of the March 13 meeting. But we can be assured that the real "action" will occur behind the scenes. Crony capitalism at its best.
[2] Back in August 2011, I wrote a series of posts describing the relationship between tax subsidies and renewable energy development. See Part 1, Part 2, Part 3, Part 4. The political left wants to subsidize renewable energy through federal spending. The political right favors the magic of "tax expenditures" over direct outlays. Together, they devised a laughably flawed regime that provides tax credits for certain types of renewable energy.
Why is the regime laughably flawed? A quick summary of my August posts. I'm focused on wind and solar development, although the same principles apply in other contexts.
Congress wants more development of wind and solar projects. But generating electricity from wind and solar resources costs more than generating electricity from coal and natural gas ("bad" fossil fuels). Because wind and solar are "uneconomic," no rational actor would develop wind or solar projects without some kind of subsidy regime. Put another way, a rational consumer would not choose to purchase expensive, unsubsidized electricity from wind and solar projects.
There are various ways to subsidize energy development. For example, Congress could have passed a direct subsidy for electricity produced by wind and solar projects. The direct subsidy would have been, say, 1.0 cent per kilowatt hours of electricity produced by a "qualified" energy facility for a given number of years. The entire program could have been administered by the Energy Department ... which is, after all, responsible for our national energy policy. Under a direct subsidy regime, a wind or solar project would merit development if (a) sales of electricity to utilities or other unrelated customers, plus (b) the 1.0 cent/KwH subsidy from the Energy Department, exceeded the cost of debt and equity required to finance development. Nice and easy.
Instead of a direct subsidy, Congress enacted a complicated tax subsidy. Actually, a series of slightly different, complicated tax subsidies. For wind, Congress enacted a "production tax credit" or "PTC." For solar, Congress enacted an "investment tax credit" or "ITC." In addition, wind and solar property qualifies for accelerated tax depreciation. Suffice to say, a taxpayer must have positive income tax liability to use PTCs, ITCs and accelerated depreciation. (Unless extended, the PTC regime will expire on December 31, 2012, adding more complexity and uncertainty into the mix.)
Importantly, a taxpayer with positive tax liability cannot simply "purchase" tax credits. On the flip side, a developer without tax liability cannot "sell" tax credits or excess depreciation. Instead, taxpayers with cash and tax liability must invest cash (so-called "tax equity") into qualifying wind and solar projects.
In exchange for its financing commitment, a tax equity investor receives tax credits, accelerated depreciation and some cash until the project satisfies an agreed IRR "hurdle." After the IRR hurdle is satisfied, somewhere down the road, the tax equity or common equity/sponsor exercises a put or call to close the transaction. Under the put/call arrangement, the common equity/sponsor purchases the tax equity investor's position based on its residual value.
[3] And that's why the regime is laughably flawed. It is complex and impenetrable for most taxpayers and most tax advisors. Plus, the commitment of cash to a renewable energy development project is absolutely "non-core" to most corporate treasurers and CFOs. Meanwhile, administering the subsidy regime falls into the lap of the IRS. Why not administer energy subsidies through the Energy Department?
In practice, there are only 15-20 active participants in the tax equity market. The market is dominated by large national banks, some regional banks, and a few other taxpayers in the financial services business (GE; insurance companies).
Before the financial meltdown in 2008, tax equity yields ranged from 6-8% on an after-tax basis (10-12% on a pre-tax basis). Then the financial system flirted with Armageddon. All of a sudden, market facilitators (the banks and insurance companies and GE) began running tax losses. Without taxable income, facilitators didn't need tax credits, so the market effectively froze up. This didn't bode well for Team Obama's "green jobs agenda." So the administration's Congressional allies quietly created a program to bail out the developers. During 2010 and 2011, qualifying projects could elect to receive Treasury grants (so-called "1603 grants") in lieu of tax credits. The 1603 grant program permitted the industry to survive the turbulence of the Great Recession.
Time flies, and we're in 2012. The Treasury grant program has expired, and Congress recently declined to renew it. Renewable energy development again hinges on 15-20 banks and insurance companies. Because there is a massive supply/demand imbalance (more renewable energy developers than tax equity), tax equity yields have skyrocketed. Yields for reputable developers have jumped from the 6% range to the 12% range. Yields for marginal developers are in the 15-20% range.
[4] Now we come full circle. The tax equity market is dysfunctional, and would make an interesting study for an economics PhD dissertation. Plenty of corporate taxpayers outside the financial services business (think retail, domestic services) have (a) large U.S. tax bills, and (b) stockpiles of cash earning 1% or less in ultra-secure investments. But tax equity yields are running 12-20% after-tax.
As evidenced by Team Obama's pending meet-and-greet, many of those large corporate taxpayers are probably put off by the complexity of the tax subsidy regime. But many of them routinely invest in other tax credit schemes, including low-income housing tax credits. Team Obama loves to demonize big business and large corporate taxpayers. Can it persuade those "big bad corporations" to commit cash in support of Obama's "green jobs agenda"?
In the world of crony capitalism, anything can happen. It's always a good time when you're rolling in the Corporate 1%.
Wednesday, February 22, 2012
Obama's Dividend Assault: Silver Lining for Private Equity?
[1] Among the proposals in the 2013 budget, Team Obama wants to increase the tax rates on dividends received by the "rich." Obama defines "rich" to include families that earn $250,000 annually (and single individuals that earn $200,000).
(Any higher thresholds would substantially reduce the amount of taxes raised from increased taxes on the "rich." As government's thirst for revenue intensifies, expect the threshold to drop. It's all relative. A family that earns $150,000 is living large compared to a family that earns $50,000. And an individual that earns $75,000 is sampling the good life compared to an individual that earns $25,000.)
[2] In today's Wall Street Journal, the editors took aim at President Obama's "assault" on dividends. (Sub. required; thanks to Paul Caron for the link.)
[3] I'm actually more interested in the "knock on" effects of the dividend tax increase. The WSJ editors argue that increased dividend tax rates will "make stocks less valuable." Maybe so, but probably not.
The WSJ article includes a graph that tracks reported dividend payments from 1990 through 2009. The graph suggests that corporations increased dividend pay outs in response to a dividend rate cut in 2003. Let's assume that the relationship is causal, i.e., the decrease in tax rate on dividends caused corporations to increase dividend pay outs.
What happens if tax policy changes, and dividend tax rates are increased (for those "rich" families that earn $250,000 annually and their distant cousins, the mega-millionaires and uber-billionaires)?
If there is a causal relationship between dividend tax rates and corporate distributions, we'd expect corporations to reduce distributions. However, corporations have two ways to return cash to shareholders. They can pay dividends, which is arguably good for retail investors on fixed incomes (traditionally, "widows and orphans"). And they can engage in stock repurchase transactions, which is arguably good for other investors who want capital appreciation without dividend income (and current tax leakage).
A dividend tax increase does not impact the cash from operations available for distribution to a corporation's shareholders. It simply impacts the form of distribution. Ironically, this flexibility at the corporate level makes static budget forecasts unreliable. A dividend tax rate increase may raise immaterial revenues if corporations shift gears and increase stock repurchase activity. So what's the point? Political distraction. And, if nothing else, President Obama gets to wear his Robin Hood tights and cape for his political admirers.
[4] Finally, let's assume that higher taxes on dividend income do, in fact, take some air out of the market for public equities. In other words, assume that Obama's assault on dividends "make stocks less valuable." Would this be bad for the "tens of millions" of Americans that own stock "through pension funds"?
In fact, lower equity valuations would probably benefit pension funds and their individual beneficiaries. Ironically, lower equity valuations may provide a silver lining for their private equity advisors.
I won't get into a full-blown discussion of the relationship between pension funds and private equity. Suffice to say, despite all the hype about private equity, a substantial majority of the capital for private equity managers is invested by pension funds.
Unlike high-income individuals, pension funds generally pay no income tax on dividend income (or interest income, or other forms of passive income). If increased dividend tax rates decrease equity valuations, private equity managers will have "cheaper" opportunities to deploy their investment capital. They can improve the performance of portfolio companies, strip out operating cash flows through tax-exempt interest and dividend payments, and flip investments at slightly lower earnings multiples.
Big pension funds win. Private equity fund managers win. Only small individual retail investors lose. But what else is new when government interferes with capital markets?
(Any higher thresholds would substantially reduce the amount of taxes raised from increased taxes on the "rich." As government's thirst for revenue intensifies, expect the threshold to drop. It's all relative. A family that earns $150,000 is living large compared to a family that earns $50,000. And an individual that earns $75,000 is sampling the good life compared to an individual that earns $25,000.)
[2] In today's Wall Street Journal, the editors took aim at President Obama's "assault" on dividends. (Sub. required; thanks to Paul Caron for the link.)
Mr. Obama is proposing to raise the dividend tax rate to the higher personal income tax rate of 39.6% that will kick in next year. Add in the planned phase-out of deductions and exemptions, and the rate hits 41%. Then add the 3.8% investment tax surcharge in ObamaCare, and the new dividend tax rate in 2013 would be 44.8%—nearly three times today's 15% rate.The numbers are pretty shocking, but consistent with Obama's core philosophy. Obama is campaigning in 2012 as a populist Robin Hood. As many have noted, the 2013 budget is a political document at its core.
Keep in mind that dividends are paid to shareholders only after the corporation pays taxes on its profits. So assuming a maximum 35% corporate tax rate and a 44.8% dividend tax, the total tax on corporate earnings passed through as dividends would be 64.1%.
[3] I'm actually more interested in the "knock on" effects of the dividend tax increase. The WSJ editors argue that increased dividend tax rates will "make stocks less valuable." Maybe so, but probably not.
The WSJ article includes a graph that tracks reported dividend payments from 1990 through 2009. The graph suggests that corporations increased dividend pay outs in response to a dividend rate cut in 2003. Let's assume that the relationship is causal, i.e., the decrease in tax rate on dividends caused corporations to increase dividend pay outs.
What happens if tax policy changes, and dividend tax rates are increased (for those "rich" families that earn $250,000 annually and their distant cousins, the mega-millionaires and uber-billionaires)?
If there is a causal relationship between dividend tax rates and corporate distributions, we'd expect corporations to reduce distributions. However, corporations have two ways to return cash to shareholders. They can pay dividends, which is arguably good for retail investors on fixed incomes (traditionally, "widows and orphans"). And they can engage in stock repurchase transactions, which is arguably good for other investors who want capital appreciation without dividend income (and current tax leakage).
A dividend tax increase does not impact the cash from operations available for distribution to a corporation's shareholders. It simply impacts the form of distribution. Ironically, this flexibility at the corporate level makes static budget forecasts unreliable. A dividend tax rate increase may raise immaterial revenues if corporations shift gears and increase stock repurchase activity. So what's the point? Political distraction. And, if nothing else, President Obama gets to wear his Robin Hood tights and cape for his political admirers.
[4] Finally, let's assume that higher taxes on dividend income do, in fact, take some air out of the market for public equities. In other words, assume that Obama's assault on dividends "make stocks less valuable." Would this be bad for the "tens of millions" of Americans that own stock "through pension funds"?
In fact, lower equity valuations would probably benefit pension funds and their individual beneficiaries. Ironically, lower equity valuations may provide a silver lining for their private equity advisors.
I won't get into a full-blown discussion of the relationship between pension funds and private equity. Suffice to say, despite all the hype about private equity, a substantial majority of the capital for private equity managers is invested by pension funds.
Unlike high-income individuals, pension funds generally pay no income tax on dividend income (or interest income, or other forms of passive income). If increased dividend tax rates decrease equity valuations, private equity managers will have "cheaper" opportunities to deploy their investment capital. They can improve the performance of portfolio companies, strip out operating cash flows through tax-exempt interest and dividend payments, and flip investments at slightly lower earnings multiples.
Big pension funds win. Private equity fund managers win. Only small individual retail investors lose. But what else is new when government interferes with capital markets?
Back in Action
For readers that paid attention to this blog in the second half of 2011, I apologize. I intended to take a one-month hiatus in December. The one-month hiatus turned into two months and then three months.
Meanwhile, there has been no shortage of "tax news." Most of it is politically motivated rubbish. Team Obama continues to hype its class warfare fantasy that increased taxes on the "rich" will solve virtually every social, economic and environmental problem that has surfaced in the past decade. The political right has countered with its own policy lies and distortions. It's going to be a long year for us political independents.
I can't possibly "catch up" on the barrage of tax news clippings over the past 10 or 11 weeks. So I'll jump back into the fray as developments catch my eye.
* * * * *
As I've previously observed, Team Obama is completely incoherent when it comes to tax policy. Sometimes, Obama talks the talk of common sense tax reform. Mostly, Obama walks the walk of a populist Robin Hood. Sure, he wants tax simplification ... but he also wants to expand tax incentives for "favored" industries and activities. Sure, he wants to improve the competitiveness of U.S. businesses ... so long as the government can use tax policy to shape the winners and losers in the domestic business landscape.
The President's fiscal 2013 budget proposal reflects his irreconcilable tax priorities: simplification; competitiveness; corporate welfare; income redistribution. The former two goals would be good for all of us. The latter two goals are good for politicians seeking annuities -- in the form of political donations -- from corporate lobbyists, unions, and other special interest groups. Martin Sullivan puts it this way:
Team Obama is not interested in, nor committed to, fundamental tax reform. The existing system creates winners and losers, and the Obama administration believes that the government exists to create winners and losers. Team Obama is very comfortable with the status quo, so long as it can influence the choice of winners and losers.
The media and the blogosphere will spill much ink on the topic of "fundamental tax reform" this year. The Obama administration will give a wink to simplification and a nod to increased competitiveness. But it's all about distraction in 2012. Any debate about "tax reform" takes some of the focus off trillion dollar budget deficits as far as the eye can see. It's savvy "politics as usual" from a master of smoke and mirrors.
Meanwhile, there has been no shortage of "tax news." Most of it is politically motivated rubbish. Team Obama continues to hype its class warfare fantasy that increased taxes on the "rich" will solve virtually every social, economic and environmental problem that has surfaced in the past decade. The political right has countered with its own policy lies and distortions. It's going to be a long year for us political independents.
I can't possibly "catch up" on the barrage of tax news clippings over the past 10 or 11 weeks. So I'll jump back into the fray as developments catch my eye.
* * * * *
As I've previously observed, Team Obama is completely incoherent when it comes to tax policy. Sometimes, Obama talks the talk of common sense tax reform. Mostly, Obama walks the walk of a populist Robin Hood. Sure, he wants tax simplification ... but he also wants to expand tax incentives for "favored" industries and activities. Sure, he wants to improve the competitiveness of U.S. businesses ... so long as the government can use tax policy to shape the winners and losers in the domestic business landscape.
The President's fiscal 2013 budget proposal reflects his irreconcilable tax priorities: simplification; competitiveness; corporate welfare; income redistribution. The former two goals would be good for all of us. The latter two goals are good for politicians seeking annuities -- in the form of political donations -- from corporate lobbyists, unions, and other special interest groups. Martin Sullivan puts it this way:
As it is trying to promote tax reform [in its fiscal 2013 budget proposal], the Obama administration is defying the logic of real tax reform -- the economic logic that tax neutrality is best for growth and job creation except in extraordinary circumstances.In his 2008 election campaign, President Obama vowed that he would renounce "politics as usual." That empty promise, like so many others, was simply "politics as usual." No surprise that, come 2012, we're getting more "politics as usual."
What administration incentives hinder true tax reform efforts? A conversion of the already complicated section 199 manufacturing deduction into a two-tiered incentive. A temporary incremental wage credit for small business. A tax credit for investment in communities that have experienced a job loss event. A tax credit for moving expenses when companies move jobs to the United States. New tax credits for alternative energy to replace the existing ineffective and outdated ones.
This is big government through tax policy. The complexity of these new tax breaks is extraordinary even by the standards of our tax code... And as for the coming corporate tax reform, there is no more place for them there than there is for a fox in the henhouse. (134 Tax Notes 922 (Feb. 20, 2012))
Team Obama is not interested in, nor committed to, fundamental tax reform. The existing system creates winners and losers, and the Obama administration believes that the government exists to create winners and losers. Team Obama is very comfortable with the status quo, so long as it can influence the choice of winners and losers.
The media and the blogosphere will spill much ink on the topic of "fundamental tax reform" this year. The Obama administration will give a wink to simplification and a nod to increased competitiveness. But it's all about distraction in 2012. Any debate about "tax reform" takes some of the focus off trillion dollar budget deficits as far as the eye can see. It's savvy "politics as usual" from a master of smoke and mirrors.
Friday, December 2, 2011
December Programming Note
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)
Happy Holidays! See you in January (maybe late December)
Monday, November 28, 2011
Sheppard on Earnings Stripping
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.
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.
Friday, November 25, 2011
Hypocrisy and McMansions
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:
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.
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.
Wednesday, November 23, 2011
Reilly and Solomon on 28% Cap
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:
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:
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.
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:
Sophistry, Complexity and InequityAn 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.
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.
Monday, November 21, 2011
Sacrifice Without Balance
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.
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.
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.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.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.
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.
Friday, November 18, 2011
Subsidizing Millionaires
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:
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 | |||
Wednesday, November 16, 2011
Break Out the Dentures
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.
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.
Monday, November 14, 2011
Kenny Rogers vs ObamaCare
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.
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.
Friday, November 11, 2011
If You Talk the Talk...
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.
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:
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.
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.
Wednesday, November 9, 2011
Whitesnake Maule's Again
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:
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:
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.Why am I calling out Maule for factual manipulation?
* Okay, I should have said "facts, statistics and economic common sense."
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
Monday, November 7, 2011
Inequality and U.S. Economic Hegemony
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.
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.
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