Tag Archives: economy

Why Warren Buffet is Crazy (and Dead Wrong) Regarding Tax Policy

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The Oracle of Omaha Falls Short on Economics Warren Buffet - The Oracle of Omaha, but not of taxes

There are lots of reasons to listen to Warren Buffet.  His track record of building a team that can effectively evaluate companies and individual stocks to find those with value yet to be appreciated by the markets is unparalleled.  The candor reflected in his annual investment letters—admitting errors and mis-steps on a plain equal to that with which his states his successes—is refreshing and to be admired.   But not everything he says should be taken as financial gospel.

I live in Omaha now—the land of Buffet and the center of the Berkshire Hathaway universe—so I risk the appearance of pitchforks and angry villagers at my door in calling out this local luminary.  But under the vain pretension that Warren Buffet might hear about this article and give it a read, let’s try to correct his thinking on tax policy.

The Heart of the Matter

Much has been made in the media regarding “The Buffet Plan” or “The Buffet Rule.”  It is easy to get lost in the details.  Basically, he believes that the tax rates on capital gains and dividends should be raised for high income earners—he arbitrarily picks the $1 million dollar per year mark.  Sure, that sounds good.  It’s a number that has no basis in demographics or actual math to measure its impact other than it is a nice round number and sounds like a lot.  In other words, it is a “marketing” number as opposed to an analytical one (always check the math on “nice round numbers” … twice).

The Buffet Rule suggests that everyone who earns less than $1 million dollars can keep the current rates of 15% taxation on both capital gains (the amount of increase in value that you get when you sell an asset like a stock) and dividends (the income that a stock might have paid you along the way from the company’s profits).  However the rule asserts that those making $1 million or more should pay an even greater amount, effectively doubling the tax rate on capital gains and dividends to 30% (hmmm …. doubled to 30% … another nice round number).

It is worth stating that low income investors today already pay less on any dividends and capital gains that they receive (the rates start at 5%).  15% is the “top rate” on dividends and capital gains paid by the highest earners.  But it is also true that lower income individuals are less likely to have assets subject to these taxes outside of their 401k or other retirement accounts.

Sounds Good on Paper

Sure.  Get the rich to pay even more in taxes.  Who would argue with that, right?Buffet meets with President Obama

There are some very important concepts to cover here, so for the sake of clarity let’s set aside that this plan, if implemented, is forecast to only add $35 billion to the tax collected each year (less than 5 days’ worth of government spending / 9 days of debt)—a literal drop in the metaphorical budget bucket—reflecting more “feel good” policy than actual progress.  That plan and forecast completely miss or ignore important things that we all need to understand before we should make any changes at all.  These are:

  • The difference between income types
  • Men are not mountains
  • The Laffer Curve Lives

Income Types

Some people are trying to make the case that where people get their income doesn’t matter.  In truth—it matters a lot.  Most of us think about income in the context of our paychecks.  We work so that on payday we are paid via direct deposit or—for old school types like me—a physical paycheck.  Sometimes we have investments or additional deductions for our 401k.  But most of us do not “see” the impact of investments or investment income in our day-to-day lives.

But an individual can get to the point where he is managing investments himself, or even paying a professional to do it for him.  It is these people that would be affected by changes in tax policy now.  These folks might earn a high salary and, after several years, have built up enough extra funds that they start investing on their own.  They likely already pay far higher tax rates on the income that they get from their jobs than most people.  The money that they are investing has already been taxed at a higher rate when they earned the money.  No investment pays a return without some amount of risk.  So they are taking a risk and investing in the hopes of earning some more.

Men Are Not Mountains

People change their behavior.  They do so for any number of reasons.  This is a fundamental characteristic of all free people.  There is a great Russian expression (there are many of them) that says “A man is not a mountain.”  The expression means that men move about of their own free will and implies that you should treat them reasonably because you cannot be certain whether or not you will meet that man again in a different time or place.  People tend to act in a manner in what they perceive to be their own best interests.  They will change course, make decisions, move about, and reorganize their lives in response to conditions and the vagaries of their choices and respective condition.

All of us do this.  It should be axiomatic.

The Laffer Curve LivesSimple Laffer Curve

Some (lesser) economists and media pundits mock the concept of the Laffer Curve these days.  They do so at their own peril.  You can follow the link to read more about it if you wish, but the gist of it is that increasing tax rates does not always increase the amount of taxes paid because … drum-roll please … people will change their behavior based upon the conditions around them.  Sometimes you can increase the amount of taxes collected by actually decreasing tax rates.

Generally speaking I am always in favor of lower tax rates by reflex.  But I am also always willing to do the math and yield to economic reality.  But the concept that increasing rates might result in lower actual taxes paid is counter intuitive to most people.  Let me prove it to you.

I created a dynamic spreadsheet to prove the point.  Let’s start by saying that I did my level best to be fair and my sources are cited in the spreadsheet.  No doubt someone will get picky about an amount or reference, but this is not a dissertation.  The information proves the points at hand well.  I created a hypothetical investment case using current tax rates and various long-term return trends using the longest time-frame references at hand.

You can see the results in Example 1, where I allocated a $4 million investment portfolio across four investment types.  Hard data sets are shaded in red, investment variables and tax rates are shaded in green, and real results are shaded in blue and adjusted for inflation.  You may note that the base tax rate that I chose for normal income is 28%–covering the large swath of those earning over $100 thousand per year in income (the end results are even more dramatic if adjusted to “top rates”).

Investment Tax Analysis Example 1

In Example 1, note importantly that the amount invested is distributed across the four investment types for yield while maintaining some risk diversity and emergency cash reserves in the form of a CD.  This is a very common type of allocation for a working individual who is still a decade or more away from retirement–it is geared for growth.  The amount of real yield is just over $134 thousand dollars (3.84%) and the amount of taxes paid is just over $42 thousand (real current tax rates).

You will also see a series of numbers labeled “Risk Premium.”  These numbers will be important to us going forward.  Since some investments are inherently more risky than others, these are some standard amounts that investors require as an additional return on their investments to compensate them for the risk of the investment when compared to others (a company can go belly-up and its stock become worthless, but government bonds are more secure).  Note that the return on stocks after taxes and inflation is just a bit higher than the risk premium–about 0.9% higher.  This difference is the reason that people take chances on stocks at all–because they believe that in the long run they will benefit a little more than taking a safer route.  This applies to all kinds of people.  In fact, it applies to everyone who invests in the markets at all.

There is another fascinating tidbit.  Note that after taxes and inflation–federal bonds have nearly a “0″ yield over the long term (actually a shade negative).  Federal bonds–when not used for speculation–are generally accepted to have the lowest risk possible of all the world’s investment options.  Since there is no real return without risk, it should be no surprise that the long term return is, in fact, just about zero.  But let’s move on.

Let’s say that we implement the so-called Buffet Rule and raised the tax on capital gains and dividends to 30%.  What happens to our simple, but elegant scenario?

Investment Tax Analysis Example 2

Now we see what we hoped for, right?  The amount of tax paid is now nearly $84 thousand and the grubby rich guy still gets almost $93 thousand in real return.  This is the rosy scenario on which media forecasters pin their glowing endorsements of the Buffet Rule.  So, what’s the problem?  Note how the average return of all those stocks is less than the amount allocated for risk premium?  This is very important.  When you take risk into account, the actual return is less than municipal bonds, and municipal bonds generally have much less risk.  In fact, it should be expected at this point that a few stocks would under-perform to the point that the investor would start to lose money.  The real net return would fall below zero more often than not.

The issue is that people move and change … a man is not a mountain.  The reason that the money was invested in the first place was to get the best yield possible for the investor relative to the amount of risk he takes on.  If he was not looking for a higher yield he might have left all that money in the bank or a safe or just purchased things with it.  The allocation is no longer doing its best for the investor and he is not being compensated for his risks.  What would you do if you were this investor?

If you were this investor, you would logically and reasonably reallocate the types of investments you hold based on these numbers.  Certainly your financial adviser would encourage you to do so.  What might that look like?

Investment tax Analysis Example 3

In Example 3 you can see that by reallocating the amounts invested in each category the savvy investor can still stay diversified but maximize his return relaltive to the risks involved.  Now the investor keeps (after taxes and inflation) almost $75 thousand and pays about $29 thousand in taxes.  By doubling the tax rate, we have incentivized the investor to react—to make changes.  Those changes have resulted in more than a 30% reduction in the amount of tax collected and given him a greatly lower return.  Everyone loses.  The investor is not being mean or vindictive.  He just cannot afford to invest in more risky assets like stocks to the same extent.  There is not enough return to keep his head above water if/when a stock goes South. Roulette Wheel

Let me put this in another, perhaps humorous way.  The more cynical among us sometimes refer to the financial markets as a casino.  So let’s extend that analogy.  In a casino you can play Roulette or you can play Blackjack.  In Roulette, there are 38 spaces on the wheel.  If you play only one number, the payout for a win is 36 to 1.  If you play Blackjack well, the odds are just a little less than 50/50, so the payout is double.  On all of these the odds are shaded a bit in the favor of the casino (which is why the longer you play in Vegas the more certain the casino operator is of taking your money).  My point is that no one would ever place a bet on Roulette–risk their money–if the payout was the same as Blackjack.  The amount of payout has to be “commensurate” with the level of risk.

If we increase the taxes and thus reduce the potential real payout on certain investments we must assume that some people will just not like the new odds and refuse to play the game.  Or at least play it less.

There Are Lots of Other Factors

Now, I get it.  Really.  This is a micro-economic example.  The additional demand for municipal bonds would impact the rates paid.  But also, the less money invested in corporate stocks would retard the overall economy more, resulting in the general stock returns being less too, and additional levels of taxation are added incentive to move money offshore, etc.  And there are other kinds of investments to consider, such as real estate, corporate bonds, etc.  But none of that extra complexity alters the power of our examples to prove the point at hand.  Namely, that individuals will alter their investments and other behaviors in meaningful ways when we tinker with the incentives.

What Do We Want?Warren Buffet Medal of Freedom from Obama

Even in the deepest darkest Gulag of the former Soviet Union, individuals generally acted in a manner that they perceived was in their own best interests first.  Then they think about other things.  This is not bad or to be shamed.  Certainly people can become completely self-centered, but that is not what we are talking about.  We are talking about what individual people do with their time and resources—often without even being fully aware of it.  This undeniable fact of human nature is part of the reason Warren Buffet has been so successful and why he is talking about tax policy now.  But I do not want to get into an armchair psychological analysis of the man himself at this time.

Do we, as a nation, want people taking risks and investing in businesses and paying more actual tax dollars?  Or do we want to feel good about them paying a higher rate, but less real money?

I am not suggesting that we have discovered the Nirvana of tax rates in their current condition.  I am also certainly willing to consider that we might adjust the tax rate to find a better balance between reasonable revenue collection, the needs of the economy, and the primary “good” of individual freedom.  Even further, I am eager to engage the greater taxation debate from a practical and moral perspective and from what, to me, is the obvious core issue–that we do not have a taxation problem … we have a spending problem. Warren Buffet pushing away

But I am saying that the Buffet Rule that would blindly double the rates on certain types of investment income is poorly-considered public and political pandering at best.  Warren Buffet has earned the sobriquet “Oracle of Omaha” due to his ability to see into the investment future, but he is demonstrating a distinct lack of foresight regarding economics … why people do the things that they do with their own money and resources.

Thanks for reading.

The Devil You Say?

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Investing on the Dark Side in the EU

There are lots of things competing for our attention right now.  Sure, we have the campaign season with all of the bickering and biting that such entails.  And yes, many of us still have thinly closeted fury over the betrayal and sophistry of Chief Justice Roberts regarding Obamacare.  We even have the partially sidelined, but important and historic, contempt charge against Attorney General Eric Holder.

Celebrity-watchers are avidly following Tom Cruise’s rather predictable split from Katy Holmes over the … Well … Because Tom Cruise is downright creepy and who, were he not a famous and passably talented actor, might otherwise be that crazy cousin living in his aunt’s garage amongst his comic books and tattered UFO posters.

These among all the other vainglorious topics of the month competing for our time and masquerading as important news.

Something Important, this way comes

But a very rare thing happened in France this week that should not slip by unnoticed.  Sovereign bonds of the French national government were purchased today at a negative interest rate of .005%.

OK … This may not have the apparent salaciousness of Mr. Cruise’s capped teeth and his Alien vs. the Predator pseudo-religious sci-fi cult.  But it is pretty heady stuff for those of us economically minded.

To review, bonds are, quite simply, loans that investors give to companies and governments.  Investors usually expect a positive return on this investment.  For government bonds the return is, on average, pretty low because there is perceived less risk than other investments (Governments can tax at will and even print money wholesale to cover their debts).  But a return of some amount is always expected because; well … why else would you tie up your money for any length of time at all?  And governments sometimes do fail to repay under certain circumstances, so there is a small risk of lost capital.

A few days ago, billions of euros were loaned to the government of France by predominately Euro-based investors at an open auction where the government of France gets to legally and fairly pay back a bit less than they were given.

Think about that.  Some group of investors were saying, in effect, that a small but guaranteed loss was better even than locking the money up in a bank for the next 30 days.

Now lest you think that the investors were just expressing some long latent nationalistic altruism to loan money under the most favorable of terms to their beloved government, remember that this was an auction where all were bidding (in these auctions the bidding starts at higher rates and then the bidding goes down–the lowest bidders “winning” the ability to make a purchase at the rate of their winning bid).  The purchasers of those bonds this week had to vigorously compete for their guaranteed losses.

I am not saying that I agree with the judgment of those investors, but let that thought sink in for a moment.

The Greatest Trick of the Devil …

I am not going to get all alarmists on you, but there is a very old expression that says, “Better the devil you know than the one you don’t know.”  In the desperate fear of the unknown legion lurking just over the horizon, there is a large set of well-healed and connected investors that opted to go with a well-known devil indeed.  All this begs the question, what are they seeing or suspecting that might encourage them to make a deal with that devil?

Thanks for reading, be well.

References:

The Wall Street Journal,
Associated Press

To Live and Die in the EU

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There, But for the Grace of God, Go We … Aye, There’s the Rub

Yesterday I saw this article on The Drudge Report that caught my attention.  Evidently the forward-thinking Dutch are in the process of establishing an officially sanctioned mobile euthanasia service.  The mind reels with tragic humor as the Grim Reaper extends his brand to home delivery and one fights-off the urge to draw comparisons to pizza vendors (“End your life in 30-minutes or less–or it’s free!” – “Ask for the Socretes Special!  A free order of rooster wings with every dose of Hemlock for a limited time!”).

Gallows humor … literally in this case … we laugh or we cry I guess.

Beethoven’s famous 5th symphony contains the famous “DA DA DA DAAAAA!” movement eponymously titled “Death Knocking at The Door.”  In the Netherlands this is no longer a metaphor.

To My Friends in the Netherlands
I have many friends and business associates in the Netherlands–Amsterdam in particular–and I ask them all for their indulgence.  It is a wonderful country and nothing I write here takes one ounce of greatness–past or present–from their culture or tradition.  But in this important instance the traditional Dutch permissiveness and tolerance might be seen as playing against their other admiral qualities and a little thrid-party analysis might be appropriate.

Where I am and Where America Is
Now to those who know me well, my opinions on palliative care, suicide, and euthanasia are no secret.  Neither are my personal life experiences and those of my family, which, it may be noted, are in many important respects specifically relevant.  But I want to talk about the bigger picture here.

In America we may appear a bit duplicitous on the matter (it is hard to get 300 million people to agree on anything at all).  We have laws against attempting suicide, but no law that I am aware of against accomplishing it.  This seeming contradiction allows society to intervene to prevent someone from ending his or her life rashly or in a particular moment of emotional anguish or pain.  But ultimately we believe in Freedom (with a capital “F”), so if one is successful in the attempt, one does not necessarily die as a criminal.  Likewise, if one succeeds in suicide for medical reasons or suffering, not only is the fruition of the act not a crime, but I have yet to come across one of my fellow citizens who would not think it a shame, perhaps worry about their spiritual outcome, but still understand it and allow for a person’s behavior to be modified when pushed to their extremes.  I am not saying that no one here would harshly criticize, I am only saying that they are likely more rare.

But we also have laws that prevent third-party participation.  Notably, we had Jack Kavorkian–a medical doctor–who went about offing his patients, or at least helping them to do so, when he thought it prudent.  Whether you agree or not with that practice, many of us personally could not help but detect a bit of glee in his work.  He was more of a Perky Reaper than “grim” and his apparent delight in the tasks was unsettling.  We sent him off to prison–good riddance if you ask me–whether his patients were temporally grateful or not.

But Americans also have a soft spot for those truly suffering.  Our sense of the value of the individual person and the “root for the underdog/never give up/it’s not over until the fat lady sings” aspects of our culture are balanced against our compassion and notion of personal and individual liberty.  Our juries and judges have acted mercifully and either acquitted or dealt lightly with close friends and family members who–under the most extreme of cases–have felt compelled to speed the departure of one that they truly loved.  But we take a REALLY good look at it because we have found more than a few dastardly murders and the truly insane hiding in medical coats and behind false, sorrowful eyes.

But we are talking about deeper things than personal choice and individual acts of benevolence.

Morning Chill in the Air
Reading this article from Holland gave me a chill.  While it is very tempting to imagine a band of benevolent and caring medical professionals making a last, merciful house call upon a needy patient in the context of established relationship and trust, the truth of the matter, our remembrance of history, and our collective human nature should give us pause.  Rather than benevolence, we might more reasonably expect a dystopian decent–more Orwell and Soylent Green than mercy.  Such is the way of man and the governmental bodies he creates.

“Actual People?”

Just a few days ago I saw another article on Drudge that I cannot help but tie together with this one.  This earlier article made ethical arguments for the justified killing of newborn children–the limits to which were, perhaps intentionally, not fully defined.  If you read both articles your first reactions might be like mine; namely, wishing fervently over a stiff drink that, rather than scientific discussion, you were reading the plot to a coming Wes Craven horror flick.  Or perhaps a Tim Burton or Quiton Tarrantino blood-spattered satire.

Once you have finished that stiff drink and re-read the articles you might either consider the wisdom of acquiring a prescription for antidepressants or focus your mind to stare upon the dark oblivion of the subtext.  Doing so, you will note powerful similarities in the two article threads; the same cold calculation, the same Euro-liberal pragmatism, the same ad hominem plea toward preventing economic harm and suffering, the same … lack of humanity.  Both are dryly written in London newspapers via print and placed online next to well targeted Google ads and above photo links to salacious stories about sexy celebrities, lending, as it does, an air of mendacity to the seriousness of the topics at hand.

By Any Other Name
Another similarity between the two articles and topics is the sophistry of the presentation.  In the first case notice the attempt to change the language from euthanasia to the less-threatening, almost banal term ”Life-End services” (Levenseinde).  In the second, according to the authors, we are no longer talking about infanticide. Rather, we are asked to slide the now culturally acceptable term and practice of “abortion” a few months later in the cycle of human development to the “morally irrelevant,” freshly minted and palatable phraseology ”after-birth abortion.”

One practice slides the end of life a bit earlier, the other slides the start of life later and we therefore redefine “actual persons” [emphasis added].  In my limited but dedicated study of our five thousand years of recorded human history, each time any group, society, culture, or empire has redefined the concept of “person” or “human” into something more expedient to their purposes it has ended very poorly.

I once wrote, and still believe, “The noblest intents of grace, charity, and Christian brotherhood are transformed by government programs into jealousy, theft, and tyranny.”  As we consider the sanctioning of Netherlands’ growing euthanasia industry, made more efficient though the use of mobile technology and home delivery, I suggest that it might be foolish to assume that this time it is any different.

Be well,

 

There and Back Again: Comparing the economy of the 1970s and now

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Comedian George Burns was asked once how it felt to be so old.  His response was that it beat the alternative.

Working in and being steeped in the technology industry and now being a mere 47 years old myself, I often find myself as “the old guy.”  Hey … it is what it is.  But achieving that distinction also adds a few advantages, not the least of which is a little perspective.

It was the best of times; it was the worst of times
It drives me a little crazy when I hear the current chattering about today’s economy being “the worst since the Great Depression” (or similar).  Do not get me wrong, things
are bad—especially in the construction and finance segments.  But I have always maintained that we have been here before.  The problem is trying to explain this to someone who never experienced a real recession before (by real I mean serious).  For most of the people I work with on a day-to-day basis, what the United States is going
through right now is “The Recession” of their lives.

The first thing that I want to share is how similar things are now to how they were 40 years ago—and in some ways they are far better now.  Take a look at the graphic I created
(click to enlarge).  It’s a little spooky.

Secular / Cyclical – Tomato / Tomàto
Think of cyclical periods as shorter term—meaning 2 to 5 years.  Cyclical trends bounce up and down inside of larger secular periods.  Secular trends in this context generaly last 12 to 20 years.  There were secular bull markets (good growth) from the late 1940s through the early 1960s and from the early 1980s through the 1990s.  This does not mean that there were not a few cyclical down periods in those times—just that the overall long-term trend was up.  There were secular bear markets (bad to flat) demonstrated in this chart from the mid-1960s through 1982 and what we are seeing now.

What’s the same?

  • Note how the recessions straddle the stock market lows.  This means that the markets generally recovered before the whole economy does.
  • Note the positioning of the recessions from the initial market peak.
  • Both of deepest lows had remarkably similar statistics.  This chart shows recessions of similar length and depth and almost identical declines in stock values on a percentage basis (~42%).
  • There were also almost identical drops in consumer spending and GDP declines (not shown).
  • Note the general political landscape as well—very similar, but tying those together can be problematic.  I include it for reference only at this point.

What’s different?

  • The unemployment rate is marginally higher–for a longer period–than previously, but there are far more two-income households now which means that it is likely that fewer households have “0″ income (no current stats available).
  • There are no shortages.  Back in the 1970s I remember waiting for literally hours in line with my Mom to buy 1/2 a tank of gas.  Seriously.
  • Inflation is not here … yet.  I think that we will see some inflation before this thing is over.  But we had double digit inflation in the 1970s that stripped value from the money in your pocket faster than you could spend it.
  • Interest rates are way low compared to then.  In fact, they are still at historic lows.  This cannot last, however.  Interest rate simply have to go up, which will make borrowing a bit more expensive in the medium-term and, when they do, they will drag on the economic recovery.  But, in my opinion, because of the way that the Federal Reserve has injected money into the system and the added experience of economists, they will not have to go up as high as they did in the 1970s to keep inflation in check.  This is a VERY important item that MUST be considered going forward (a gold/silver commodity bubble is raging!).
  • Note how the two time periods in the chart are aligned to start date, but are on the same time scale.  This reveals that the volatility we are seeing in the markets now appears to be a bit less than previously.  Again … nothing new, and perhaps a bit better now than then.

I still maintain that now is not as bad as then … at least not yet.

What does this mean?
OK … I am intentionally taking a very simple approach (this is a blog post, not a book).  But everything I see in the data (not all included here) and geopolitically indicates to me that the stock market has a little bit of short-term upside to it (next month or so), but that we might anticipate another major stock decline and recession starting in 2012.  The stock market decline will happen first and, consistently, end first.

Further, governments like to tinker with things, but it takes more than a decade to absorb and recover from the kind of economic destruction that we have experienced over the last few years.  The government can make it take longer and be worse, but recovery takes time and always has.  It always will.

If we let the healing happen and take a few reasonable, temperate, cautious, and gentle actions in the direction of capitalistic-centered regulation and general freedom, it WILL get better as part of its natural cycle.

Until next time,