Tag Archives: tax

Crisis of Confidence

I, through my firm, was a customer of PFG, the latest registered broker dealer to steal from its clients’ accounts – first reports indicate $200 million may have been taken.  This pattern is becoming too frequent. Innocent victims have lost money yet again.  How did it come to this?

Broken Markets

Self-regulation by an oligopoly… I don’t think there is any economist or politician who wanted this outcome, but special interests and lobbying have led to this.  This is how the futures industry works today.

Capitalism is broken without fair rule of law and regulation, and today top firms organize and self-regulate with practices that add cost but lack teeth. This discourages competition from smaller companies, but it also gives the largest companies free reign to raid their clients’ accounts and hide their crimes for years. So far it seems there is little or no accountability when they are discovered.

If market participants cannot expect basic protections, then they will leave, prices will fall, volume will shrink, and markets will whither.  Companies will have less access to capital and be exposed to more risk, and the economy and workers will suffer.  We’re already a long way down this path.

The economic ideal and the allure of free markets is only possible when regulation protects innocent market participants, minimizes fraud and cheating, and does not deter innovation. That means expanded domain of the SIPC, the SEC should have unlimited authority to monitor accounts and communication (opt-in would be fine), and companies should only minimally participate in their own oversight. With this structure, investors would be protected, transparency would reduce fraud, and free markets could flourish with competition and innovation.

Sounds obvious, but don’t hold your breath.

Corporate Corruption

There are a lot of types of corporate corruption, but they all start from an imbalance in power and oversight.  There is one tiny change could have a huge impact on this problem: allow shareholders to nominate people for elections of the Board of Directors of public companies.  It’s a small, seemingly obvious shareholder right, but it would have a big impact.

Management should not have the exclusive right to nominate their bosses. In fact, because the Board of Directors is supposed to represent the owners’ interest, it seems crazy that owners can not nominate. When the owners of a company are empowered to nominate Board members, management comes back under control, compensation comes back to reality, performance is scrutinized better, and the interests of investors are better served.

In private equity and smaller firms of every kind, this is always how it has worked.  Major shareholders often join Boards of private companies and nominate other Board members.  How public companies ever achieved the ability to control the Board nominations without rights for shareholders, I’ll never understand.

Too much

There are so many other ways that markets are broken and corruption is bringing us down.  Is it too much to fix?  Are we destined to watch for the rest of our lives as the emerging markets grow right past us and Americans fight amongst ourselves? Is our political and influence machinery too dogmatic or corrupt to embrace new good ideas together?

I’m not confident.

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The Independent Globalist: an instruction manual

I drink your milkshake

You drank my milkshake!

Independent globalists optimize after-tax returns, labor, and supply chains into the tax and regulatory regimes that are most favorable.

It’s an optimization exercise and a chess game.  This seems to be the dominant strategy:

1) After-Tax Returns

The equation: taxes + regulation.   Taxes are simple; they reduce your profits by their rate.  Regulation is more complicated because it costs money to comply, but there are also opportunity costs from business activities that are no longer available.

The game: reduce and eliminate taxes and regulation.  Express the stresses of international competition to pressure national politics using one issue at a time in the countries where you do business.

2) Labor

The equation: salary + benefits, including long term commitments.  Retirement, health care, and other benefits have costs, but also may reduce employee turnover.

The game: reduce and eliminate costs within each role.  Divide operational units and move them to locations with optimal rules and costs.  Use the placement of these units to pressure politics to reduce labor’s collective bargaining rights.

3) Supply Chains

The equation: price.  Commodities and other non-labor costs are priced on global markets, and are mostly fungible.

The game: reduce and eliminate regulations that internalize costs of production for your suppliers.

The Credit Crunch and the Market

[Download the complete article in PDF format, with charts and better formatting]

The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.

Contagion

The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

Tax Retirement Savings Fairly

Problem: The 401(k) system means that my employer determines my tax rate on retirement savings. This means that any workers who do not have access to 401(k) plans through their employers have a higher tax rate on their retiment savings. This usually means that low-wage, hourly, and part-time employees pay higher tax rates on their retirement savings; obviously unfair.

Solution: Combine 401(k) into existing IRA program and eliminate old 401(k) program. In effect, increase the IRA contribution amount to $18k and eliminate 401(k)s.

Benefit: Everyone will have access to tax-advantaged retirement savings plans, not just those fortunate enough to work for companies that offer 401(k)s. Eliminates administrative cost for businesses. Simplifies tax code. Also, this plan helps small businesses by letting them compete more fairly with large companies that can offer 401(k)s.

View and comment on SinceSlicedBread.

Tax rates on dividends

Dividend income should be treated just like income from bonds. And dividend payments should be deductible for corporations just like interest payments on debt. That would clean up the code and solve the corporate double-taxation problem.

Social Security Reform

I am familiar with the Senators’ stated positions, and with President Bush’s proposed framework in this early stage. I think that they may be able to kill two birds with one stone if they think outside the box. What I mean is that they could achieve tax simplification, private accounts, and permanent sustainability while lowering the payroll tax rate. Let me explain:

  1. Every citizen has a private retirement account “PRA”.
  2. Contributions to PRAs are income tax deductible, investments incur no dividend or capital gains taxes, and can receive rollovers from 401(k)s and existing IRAs. Contributions default to money markets unless directed otherwise.
  3. Automatically, 10% is deducted from all pre-tax income, with no cap: 5% goes into the PRA, and 5% goes into the general Social Security fund. More can be contributed to the PRA at the discretion of each person: up to $3k + 15% of income, again, with no cap.
  4. Early withdrawal penalties from PRAs mirror IRA regulations, except that any citizen 60 or older may withdrawl from their PRA, and only those with a worthless PRA will receive Social Security benefits from the general Social Security fund (equal or better than existing Social Security Benefits).
  5. Upon death, any remaining assets in a PRA may be transferred to beneficiaries. If the beneficiary is anyone other than a spouse, transfers are treated as income to the beneficiaries.

This plan achieves tax simplification, private accounts, and permanent sustainability while lowering the payroll tax rate. It also promotes an ownership society and increases the savings incentives for rich and poor alike.

    Let me sum up:

  • This system achieves both private accounts and a stronger social safety net.
  • It requires that the wealthy contribute to social security at the same rate as everyone else, but allows for tax advantaged retirment contributions even for the wealthy.
  • It reduces the role of government because the government assists only those who have need (those who have no value left in their retirement account).
  • It strengthens the social safety net of government because it increases funding and concentrates assistance on the needy.
  • Retirement savings tax rates are no longer determined by the employer, as the 401(k) system provides.
  • A single account for tax advantaged retirement savings will make administration much easier.
  • Everyone is encouraged to get rich, and those who outlive their savings are protected.
  • If funding surpluses are too high, the tax rate can be lowered.

Please promote Social Security modernization through your representatives.

Taxes and Concentration of Wealth

The concentration of wealth plays a role in economic growth and employment, crime rates, and just about every aspect of American society. The primary tools government uses to manipulate the concentration of wealth are tax and healthcare policies. In this article, we focus on how recent tax policy is reshaping the concentration of wealth.

Policies that distribute wealth and power more broadly are sometimes called “socialist” by those who argue against them. Similarly, policies that concentrate wealth and power too much are sometimes called “oppressive” or “fascist”. Both of these names are misleading. In a capitalist democracy, a wide range of policy decisions can set the stage for incentives and fair business; we’re still working to find the best balance.

Capital gains income tax:

Under President Bush’s tax cuts, investors are now paying 15% tax on income from capital gains. Meanwhile, income from work is taxed about twice as much, depending on your marginal rate. The tax code is effectively encouraging income from capital gains by giving back half the tax on that type of income. It’s not clear to me that the government should be in the business of encouraging one type of income over another, but if we do then we should be encouraging income from work. Investors may argue that they have already earned this money and paid taxes on it so it should not be taxed again. This is true; remember that you only pay tax on the new income. The original amount you invested is not considered income and is not taxed again.

Estate taxes:

Estate taxes were created along with child labor laws, voting rights for women, and the establishment of an income tax during the Progressive Era (1900-1918). President Bush is eliminating the estate tax, and has proposed to make this tax cut permanent in the coming term. The question of whether we should we maintain estate taxes or eliminate them is a subjective question. Rather than make this point myself, let me defer to the words of President Franklin Roosevelt: “Great accumulations of wealth cannot be justified on the basis of personal and family security. In the last analysis such accumulations amount to the perpetuation of great and undesirable concentration of control in a relatively few individuals over the employment and welfare of many, many others. Such inherited economic power is as inconsistent with the ideals of this generation as inherited political power was inconsistent with the ideals of the generation which established our Government.” President Bush’s agenda for estate taxes is to reduce the estate tax over time to nothing, and in the next 4 years, his agenda is to make this permanent. If this happens, families of vast wealth will effectively be an elite class, removed from the rest of Americans by the virtue of birthright.

Dividend income tax:

Bush’s economic agenda for the next 4 years also includes eliminating the tax on dividend income (http://www.gop.com/GOPAgenda/AgendaPage.aspx?id=2). If this is passed, those who receive dividend payments will not pay any taxes on that income, giving them an after-tax raise of more than 50% (35% tax leaves 65%. Going from 65 to 100 is a 53.8% gain). That personal income will no-longer be contributing to the government revenues, and the shortfall will accumulate against us all in the form of budget deficit. If stopping the double-taxation of dividends is the goal, the correct way to deal with it would be to make dividend payments a deductible expense just like any other cost of doing business.

These recent tax cuts have been very effective in getting money back into the hands of Americans, but have put us into growing debt. The budget deficit is important because the national debt must someday be paid down, with interest. This is one of the most important factors that determines the value of the US dollar and international confidence in American investments. With extensive history and other nations as examples, we clearly see that as the debt gets bigger, we will experience inflation, not be able to buy as many foreign goods, and see less international interest in our stock markets. The U.S. budget deficit in 2004 will hit a record $445 billion, according to the White House. Not only would this be a record deficit, but also an unprecedented fall from record surplus.

Federal Budget Surplus or Deficit

Data source: http://www.cbo.gov/showdoc.cfm?index=1821&sequence=0

Instead, if income from all sources is simply taxed as income, then tax policy will be much more fair and government revenues will be higher. On this point, the Democratic agenda to roll back such specific portions of the recent tax cuts seems right. The timing, however, is sensitive: increasing taxes during economic recession can make problems worse.

In any event, the Federal Reserve (not tax policy) is the primary mechanism for managing economic recession. If the federal government uses changes in the tax code to manipulate the economic cycles, then it is acting as a backseat driver to the Federal Reserve. In addition to the complication this adds for the FED in determining the funds rate, it also makes it much harder for citizens and businesses to plan and prepare taxes.

The concentration of wealth threatens our nation. The poverty rate was 12.5% of all Americans in 2003. The numbers are even worse for children: 17.6% of Americans under the age of 18 are living in poverty (http://www.census.gov/hhes/income/income03/prs04asc.html). I hope you will agree that these numbers are too big. These Americans often disappear in our society and are not very well represented in politics: they may not apply for jobs or vote, they often do not have health insurance, they often do not pay taxes on the money they do earn; they hide from the system because the system demands taxes that they can’t afford to pay. Tax policy is exacerbating this problem and should be made fair in the ways I described above. Once the downward spiral of joblessness and poverty can be broken, the upward spiral of employment and fulfillment can begin. Increasing the workforce and reducing structural poverty is clearly in the interest of America.