Month: December 2010

Where to Put Your Money: The Basics

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“Asset allocation” may sound like the kind of term used by rich money managers and Ivy League university endowments. In fact,  anyone with a savings account,  a 401(k),  a pension plan or real estate should be thinking about asset allocation. “Asset allocation” is just a fancy way of saying “don’t put all your eggs in one basket." By putting your money in several different baskets, you can reduce risk and potentially increase returns by diversifying your investments.

The remainder of this article can be found at the website Man Of The House.

Are You Your Biggest Investment?

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When it comes to your investments, you might consider your 401k or your house as the most valuable. Little do you know that your biggest investment is your career. Your career is an investment like any other and once you determine the financial value of your career, understanding how to invest the rest if your portfolio becomes much easier.

The remainder of this article can be found at the website Man Of The House.

How to reform the corporate tax code

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There has been alot of talk recently in Washington about reforming and simplifying the tax code, trading lower rates for fewer deductions. Frankly, I'm all for that, particularly with regard to the corporate tax code. My general view is that governments (federal, state and local) should concentrate more on creating conditions that are business-friendly in general, rather than friendly to specific businesses. Our current corporate tax system embodies the worst in special-interest politics. It has the second-highest statutory rate in the world, but the effective corporate tax rate is much lower. My studies have shown that we collect about the same percent of GDP in corporate taxes as other countries. That said, just about everything you find on the internet covering this topic is written by someone with an agenda, so it's hard to get it all straight.

Cutting through all the gobbelygook, there are two clear reasons why our current corporate tax system is bad for America.

  • By having a higher statutory rate we discourage non-favored business from establishing productive capacity in the Unites States. There are many areas in which the United States could be a big exporter of durable manufactured goods (where the cost of labor is small relative to the cost of capital), but the tax code basically discourages it.
  • We have a worldwide tax system. Most countries have a territorial tax system. In a worldwide system we tax American multinational profits no matter where they are earned, but allow companies to defer paying taxes earned on income abroad until those earnings are repatriated to the United States. Because we have a higher tax rate, multinational companies are basically encouraged to reinvest that cash abroad.

Thankfully, Obama seems to be moving in the direction of lowering the statutory rate, eliminating loopholes and moving to a territorial tax system. This is far better than the campaign position he took, which was to end corporate tax deferral and encourage companies to reincorporate and move their headquarters to places like Bermuda, Ireland and Switzerland so they could be taxed in a territorial system at a lower rate.

While moving to a territorial tax system would discourage the cash hoarding by companies abroad that has occurred since the end of the recession, there are two other changes that I recommend to encourage domestic investment (and the job creation that coincides with domestic investment):

  • Immediate expensing of R&D and investment. Companies are the most rational actors in the economy, so you can't really encourage investment that companies wouldn't make otherwise. You can, however, encourage them to pull investment forward by increasing investments' net present value by postponing tax expense, particularly for growing companies that are investing heavily. Such a change would also encourage foreign companies to invest in the United States. Obama has included a temporary proposal for investment expensing as part of a stimulus plan, and I would recommend making it permanent.
  • Expensing of dividend payments. The tax code encourages executives to receive option compensation as opposed to cash compensation. Options increase in value when the stock price per share goes up. Thus, when option-rich executives have extra cash, they favor conducting share buybacks over paying dividends. (The reason for this is that share buybacks reduce the number of shares outstanding while increasing demand for the stock. Dividends do neither of these things, but are more directly remunerative to shareholders.) In addition, companies tend to have extra cash when times are good and the stock price is high. If the company overpays for the stock, they are destroying shareholder value. Encouraging dividends would also reduce the tendency for companies to build up cash that they then burn on value-destroying, empire-building acquisitions. Companies should have to convince the capital markets to fund their acquisitions, as a matter of discipline. If we moved to allowing the deduction of dividend payments, the individual tax rate on dividends should be moved back to the income tax rate.

Making these two changes would encourage companies to either use profits for investment or dividends, and would discourage share buybacks, self-funded acquisitions and the needless hoarding of cash that is conducted particularly by so many US technology companies.



Top Tax Rate Fallacies

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It looks like we have a deal on taxes for the next two years. While the long term deficit will need to be dealt with sometime in the intermediate term, the deal provides some policy stability on income tax rates, produces a reasonable compromise on the estate tax and creates some legitimate short term stimulus in the form of a payroll tax cut and extension of unemployment benefits. Overall, I view this to be a good deal that will stimulate the economy short-term and set up a debate on long term spending and taxes for the 2012 election.

I am someone who believes that in general the private sector is better at allocating capital (with some spectaular exceptions, like the housing boom) and that government spending and incentives can often create vast distortions in the allocation of capital (like the government policies that encouraged the housing boom). I also believe in the wisdom in the electorate as a whole. The people want a real debate over tax and spending priorities.  It is the politicians at the Federal level aren't yet mature enough to have that discussion.  In the meantime, I'd rather keep taxes low.  Evnentually we need to figure out the right level of spending, and then figure out how to generate the proper revenue to support that level of spending, preferably with some sort of overhaul that improves our competitive position internationally.

That overarching political/strategic argument aside, many of the arguments I hear from conservatives on TV supporting an extension of the top tax rate are pretty weak economically.  Below I discuss a few of these:

  • Tax hikes will hurt small businesses – It is true that most small businesses file taxes effectively as individuals. While it's hard to pinpoint the exact figure, somewhere between 50 and 97 percent of all small businesses would be unaffected by the tax rate change. Even if a small business is affected by the tax rate hike, that won't affect how they hire since employee salaries and benefits are tax-deductable. If anything, it would encourage the business owner to work less hard and hire employees instead.  (I'm not saying that's a good thing, just economic logic.)  Higher taxes would reduce the cash available to make business investments, but that too gets deducted from taxes over time, as would the interest used to finance the investment.
  • Tax hikes will hurt savings and investment – On the margin, reductions in the top rates do result in additional private capital to be available for private investment.  The problem is that tinkering with marginal tax rates only indirectly encourages savings and investment. Such tax cuts directly increase only the reward on investing.  More efficient would be to directly encourage savings and investment themselves. Make savings itself tax deductible and/or allow for the immediate expensing of business investment. Or replace the payroll tax with a consumption tax to reward work while discouraging consumption.
  • Tax hikes will hurt savings and investment (part II) – In addition, if tax rates are cut but not offset with spending cuts, any increased investment must flow into Treasury securities to finance the deficit. Thus no new net private investment is actually created. If the increased number of treasuries are purchased by investors abroad, by accounting identity the amount adds to the trade deficit.  The increased trade deficit directly reduces GDP, offsetting any increase in domestic investment.

It's time for this country to move past empty slogans and work together for the long term vitality of the country. I'm not encouraging tax hikes…just a mature, realistic conversation about taxes and spending.