When Tax Simplification Can be a Bad Thing

According to a Bloomberg report, President Obama asked Paul Volcker and the Economic Recovery Advisory Board for a proposal by December 4 to overhaul the tax code.

I almost jumped for joy, but tempered my excitement when I read the details. An overhaul of the tax code is clearly needed, but we don't want one that makes matters worse. Spokesman Tom Gavin said the board has a mandate "to simplify the tax code, protect progressivity in the revenue base, close tax loopholes and find ways to reduce tax evasion and ... corporate welfare."

The tax code is unnecessarily complicated. I am all in favor of simplifying it. It takes the average taxpayer much too long to file a return. In fact, the code has become so complicated that more and more taxpayers have to turn to professionals for help. But simplification must be done in a fair way. Economists used to joke that Bill Clinton wanted to simplify the tax code when he was president. Under the fictitious Clinton plan a tax return would have only two lines: 1. How much money did you make? 2. Send it in. This is the kind of simplification we definitely do not need.

However, we do need to make paying taxes easy and painless. There is no reason why Americans should spend a full weekend or more filing a return. One quick fix is to eliminate all deductions in exchange for significantly lower tax rates. Take the mortgage interest deduction for instance. This deduction exists only because the home building industry has convinced Congress that using the tax code to promote home ownership is a good thing. Unfortunately, this tax subsidy contributed to the housing bubble. Consumers make choices. Whether they choose to buy a house, a car, or more clothing, the rest of us should not be subsidizing that decision.

Of course, I am also in favor of reducing tax evasion. Everyone should pay their "fair" share. However, it is not the stereotypical rich who are evading taxes. Tax evasion is most pervasive among those who work on a cash basis. It is not difficult for them to under report their income. And let us not forget about people engaged in the illegal drug trade. One study estimated that 10 years ago Americans spent $65 billion on illegal drugs. All of it went untaxed.

As for protecting progressivity of the tax code, this is a worrisome sign. While I agree that taxes are a necessity and that those who make more should pay more, a progressive tax code is specifically designed to punish people for doing well. It may be too much to hope that a Democratic administration would understand this, but a tax code that is too progressive reduces the incentive to work hard. At a time when we need to encourage the most productive members of our society to start businesses and employ more people, the last thing we should do is threaten to tax them at higher rates if they succeed.

Geithner's Stock Rises on PPIP

A government program has to have a catchy name. So it was that Treasury Secretary Timothy Geithner introduced the Public-Private Investment Program. This is the latest plan to save the banks and free up credit. According to this plan, the government will work in partnership with the private sector to buy up so-called toxic assets from the banks. The hope is that by removing these assets from the banks' balance sheets, banks will be more willing to lend.

The first thing you should notice is who gets top billing in the name of the plan. It is not called the Private-Public Investment Program for a reason. The government wants to make sure taxpayers come first.

The next thing you should ask is will the program work as planned? This program assumes that banks are not lending because of these toxic assets. It fails to consider the possibility that maybe businesses don't want to borrow. In general, businesses borrow money when they want to expand. When demand is strong and they are growing, they have to finance that growth. But when there is a recession and demand is weak, there is no point in expanding so there is no need for financing. Of course, this is a bit of a Catch-22. The recession won't end until businesses borrow and invest. But businesses won't invest until they are convinced the recession is coming to an end.

You should also ask if the banks even want to sell all those toxic assets in the first place. After all, they have already marked them down. They may prefer to wait until the markets improve so they can benefit by marking them back up. Of course, there is a price for everything and banks will sell at the right price. But the public-private partners will want to buy at as low a price as possible. A little arm-twisting by the government may be necessary to convince the banks to sell.

Nonetheless, Secretary Geithner's new plan is the best plan we have seen to date. The market certainly liked it and rallied strongly in response. Geithner has been criticized for talking in generalities and providing no specifics about how he will respond to the financial crisis. This time, he gave us specifics. Those who were shorting Geithner and calling for his resignation got a little burned. Today his stock went up at least a few points.

Is the U.S. a Developed or an Emerging Country?

Ian Bremmer and Sean West have an op-ed in today's Wall Street Journal called AIG and 'Political Risk.' I urge you to read it. While some people are upset that AIG employees got any bonuses at all, others are equally upset that the government has stepped in and threatened to take them away. The authors argue that the outrage by Congress and the Obama administration over the bonuses is a result of nothing more than political expendiency. It scores populist points. However, it also raises the risk for investors and does nothing to resolve the financial crisis.

Bremmer has been warning for several months now that Congressional actions represent the most important political risk investors face this year. I know Bremmer well so I sent him an email congratulating him on the article and expressing remorse that the U.S. suddenly seems hellbent on turning toward socialism. He replied by saying that what is going on is right up his alley because he has been studying emerging markets for twenty years. So there we have it. The world's most developed nation is behaving more like an emerging country.

Fed's Actions Induce Rally

Stocks surged immediately following the Fed's press release today. In perhaps its boldest action to date, the Fed said it would significantly increase the size of its balance sheet by buying up to $750 billion of mortgage-backed securities, up to $100 billion more of agency debt, and up to $300 billion of longer-term Treasury securities. In other words, it will flood the market with money.

The Fed has come under criticism is recent weeks for tightening the money supply. Steve Forbes, for example, recently pointed out that despite lowering short term interest rates, the Fed's balance sheet has actually shrunk by almost $400 billion since December. Today's decision reverses this trend.

Despite today's actions, investors know that the economy will not improve until housing prices stop falling. What the Fed announced today should support housing prices by reducing mortgage rates, but that may not be enough to generate sufficient demand. After all, housing inventories are still too high, and mortgage rates are just one component of the cost of buying. As I've discussed on this blog many times before, property taxes represent a major cost of owning a home and there is nothing being done to address this problem.

I continue to believe this is an excellent time for long-term investors to be buying equities. Those who are willing to wait five to ten years should not hesitate to get in now. Nonetheless, I also think there is a reasonable chance we will see another significant selloff in stocks in the near term. If we are lucky, the recession will be over by yearend. However, there is more bad news to come. With corporate profits falling and unemployment rising, we are still a long way from being out of the woods.

Leon Charney Report

I come across a lot of smart people. Leon Charney is one of them. Charney is a New York attorney who played a significant role in the Camp David Accords, which were signed during the Carter administration. Charney is also an astute investor who appears on the Forbes Billionaires list.

Unlike most other investors, Charney actually managed to hold on to his wealth this past year. He also has a popular PBS television show that airs in the New York City area. I have been a guest on his program a number of times. We filmed an episode on March 5, which aired on March 8. I am honored that an investor of his calibre even cares about my opinion. Click here to watch this episode of the Leon Charney Report.

Explaining Mark-to-Market Accounting

A good friend forwarded this humorous explanation of mark-to-market accounting. It was produced by John Carney and can be found at businessinsider.com:

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98. You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.

That is very entertaining, but here is a more realistic view of mark-to-market accounting:

Suppose it is not your cows that catch on fire and die, but your neighbor's cows. Your neighbor tries to sell his dead cows, but no one wants to buy them.

Since you own the same kind of cows, mark-to-market accounting forces you to value your cows at zero because no one is willing to buy your neighbor's cows.

Even though your cows are still alive, still producing milk, and still helping you generate positive cash flows, you have to pretend they are worthless.

This is why mark-to-market accounting needs to be fixed.

Cash is Trash

It is nice to see a violent rally in the stock market for a change. It is also nice to hear that Citigroup may not be as sick as everyone thought. At last look, the stock was up about 35% for the day. Of course, for a penny stock, that does not mean much in absolute terms. Nonetheless, it is encouraging to think that one of the most important financial institutions in the country is actually going to survive the recession.

FAS 157 (mark-to-market accounting) has made many of our financial institutions look sicker than they actually are. Even those that are cash-flow positive look like they are losing money on paper. This has scared investors and helped drive stock prices down. In fact, Warren Buffett recently said, "The investment world has gone from underpricing risk to overpricing it." In the end, those companies that manage to survive will come out stronger; and those investors brave enough to take advantage of the turmoil will come out richer.

Despite today's good news, the recession is real and will continue for many more months. Credit spreads are still too high, consumers are still not spending, and corporations are still laying people off. Undoubtedly, stocks will remain volatile and we could see another selloff. Yet, I believe the risk of holding cash outweighs the risk of being long for anyone who has an investment horizon of five years or more.

Those who are interested can view these videos I taped for the MoneyShow on February 6:

Economy--No Progress Yet

Any Energy Plays?

Buffett Makes Mistakes, Too

President's Unemployment Forecast Much Too Rosy

In looking over President Obama's proposed budget for fiscal year 2010, I found Table S-8 Comparison of Economic Assumptions particularly interesting. As the name implies, this table compares economic assumptions under the proposed budget to the Congressional Budget Office's assumptions and to the Blue Chip forecasts. What really stuck out to me were the forecasts for the unemployment rate.

The Blue Chip consensus forecast is for the unemployment rate to peak at 8.7% in 2010. The Congressional Budget Office predicts it will peak at 9.0% in 2010. However, the president's budget predicts the unemployment rate will peak at 8.1% this year and then fall to 7.9% in 2010.

Admittedly, the Congressional Budget Office ignores the possibly beneficial impact of the American Recovery and Reinvestment Act. Even so, the president's forecast seems much too optimistic, especially since he is also proposing to raise taxes on the people who do most of the investing in this country.

The government cannot create jobs nearly as efficiently as businesses can. However, by raising taxes on the investment class, the president is virtually guaranteeing that more people will find themselves out of work.

The unemployment rate was 7.6% in January. Tomorrow morning, the Bureau of Labor Statistics will report the unemployment rate for February. The consensus estimate is 7.9%. I have been warning since last September that the unemployment rate would reach 8-9% by June. I think the average for 2009 could exceed 8.5%. This is considerably higher than the president's forecast. Unfortunately, I think it is also much more realistic.

Why Financial Education is Important

One of our equity analysts forwarded this multiple choice question he found on CNBC's website. It asks, "After breaking 7,000, where's the Dow headed next?" The three choices are 5,000, 6,000, and 8,000. Amazingly, about one-third of the respondents answered 5,000. Which brings up an interesting question. How can the Dow go to 5,000 next without going to 6,000 first? Perhaps this group of respondents are the same people who created mortgage-backed derivative securities.