Bubbling Up...1/24/13

1) Hit the “Defer” Button, Thanks… by David Merkel @ The Aleph Blog

This is why I believe that the biggest issue in restoring prosperity globally, is finding ways to have creditors and stressed debtors settle for less than par on debts owed.  Move back to more of an equity culture from what has become a debt culture.  A key aspect of that would be making interest paid non-tax-deductible for corporations, housing, etc., while making dividend payments similar to REITs, while not requiring payouts equal to 90% of taxable income.  Maybe a floor of 50% would work, with the simplifying idea that companies get taxed on their GAAP income — no separate tax income base.  Would certainly reduce the games that get played.

Anyway, those are my opinions.  The world yearns for debt relief, but governments and central banks argue with that, and in the short-run try to paper over gaps with additional short-term debt that they think they can roll over forever. They just keep trying to hit the “defer” button, avoiding any significant reforms, in an effort to preserve the “status quo.”

Woj’s Thoughts - After reviewing the results of my 2012 predictions, I mentioned:

My main takeaway is that politicians are far more determined to maintain the status quo than I had expected. The underlying economic (and social) problems have once again been kicked down the road for future governments to handle.

Although David’s policy recommendations are becoming increasingly pervasive, they unfortunately remain nowhere near the level necessary for governments to test uncharted waters. 

2) Can Germans become Greeks? by Dirk @ econoblog101

The ECB as well as other policy makers and politicians do not understand economics. They think that a simple recipe like “decrease government spending, export more” is enough to solve the euro zone crisis. The increase in government debt is a symptom of the crisis, not a cause. The cause of rising government debt was negative economic growth and bank bail-outs. These are the two problems which must be tackled. They are intertwined, so solutions should address both. Households cannot pay their mortgages in Spain and Ireland at the existing unemployment levels, and that is due to a lack of demand as households consume less and save more. This downward spiral must be stopped and turned around, since at negative growth rates even a government debt of €1 is too high.

It seems that instead of Greeks becoming Germans now the German are becoming Greeks. That means that without government spending Germany will not have positive growth rates. While this will come as a surprise to many, it shouldn’t be.

Woj’s Thoughts - Germany managed to run a slight fiscal surplus during 2012 that ultimately came at the expense of growth. In the fourth quarter, German GDP shrank by 0.5 percent. Meanwhile, attempts at structural reform (i.e. fiscal consolidation) in the European periphery appear to be speeding up the rise in unemployment and decline in growth. This dynamic is neither economically or socially sustainable, therefore the governments and ECB must either substantially change the current course or wait for countries to eventually exit the Eurozone.

3) Did We Have a Crisis Because Deficits Were Too Small? by JW Mason @ The Slack Wire

The logic is very clear and, to me at least, compelling: For a variety of reasons (including but not limited to reserve accumulation by developing-country central banks) there was an increase in demand for safe, liquid assets, the private supply of which is generally inelastic. The excess demand pushed up the price of the existing stock of safe assets (especially Treasuries), and increased pressure to develop substitutes. (This went beyond the usual pressure to develop new methods of producing any good with a rising price, since a number of financial actors have some minimum yield -- i.e. maximum price -- of safe assets as a condition of their continued existence.) Mortgage-backed securities were thought to be such substitutes. Once the technology of securitization was developed, you also had a rise in mortgage lending and the supply of MBSs continued growing under its own momentum; but in this story, the original impetus came unequivocally from the demand for substitutes for scarce government debt. It's very hard to avoid the conclusion that if the US government had only issued more debt in the decade before the crisis, the housing bubble and subsequent crash would have been much milder.

Woj’s Thoughts - The scenario laid out by JW sounds equally plausible and compelling to me. Changes in tax policies during the 1980’s and 1990’s set the stage for massive increases in real estate loans and the corresponding housing price boom. Then the unmet demand for safe-liquid assets prompted both the rise of shadow banking and the dispersion of U.S. housing assets to the rest of the world. So as the last sentence attempts to make clear, the “crash would have been much milder” but a similar crisis would likely have occurred.

Points of Public Interest

This week’s best and most intriguing for your weekend reading:

1. Krugman on (or maybe off) Keen

A Nobel Laureate is taught the limit of his own assumptions. Others pile on: Philip Pilkington: Krugman Makes Accusations of Fundamentalism to Defend His Own Dogma and Debt, Income and Aggregate Demand: Scoring Krugman vs Keen

2. Why Some Multinationals Pay Such Low Taxes

Insight into Google’s use of a “Double Irish Dutch Sandwich” and many other clever practices being used by GE, Microsoft, Apple, etc.

3. WHY MINSKY MATTERS: Part One

A former student of Minsky’s elegantly outlines the important aspects for understanding the reality of our financial and economic system. More on Minsky: Was 'Post-Keynesian' Hyman Minsky an Austrian in Disguise?

4. The worst anti-regulatory travesties in the financial sphere have had broad, bipartisan support

Without much fanfare, the “fraud-friendly JOBS Act” passed Congress this week with overwhelming support. William Black, a professor of law and economics, offers a history of anti-regulatory bills over the past several decades. If history is any guide, the JOBS Act will be front and center as having aided and abetted massive frauds during a financial crisis in the not too distant future. More on the JOBS Act: Bill Black: “The only winning move is not to play”—the insanity of the regulatory race to the bottom

5. Liberating The Hunger Games and What Happened to Liberty in the The Hunger Games Movie?

What can I say...talk of The Hunger Games is everywhere these days!

6. The Real Leadership Lessons of Steve Jobs

The bottom 99% fall further behind:

Source: NYT

Facebook's $500 Million Tax Refund and The BIG Political Lie

Over the next nine months, leading up to the Presidential election, conversations about optimal tax rates are certain to play a major role. Much of the recent media focus has already addressed the low effective tax rates paid by both Warren Buffett and Mitt Romney (although the light in which the two are held is a world apart). Current debate generally regards the low level of taxes paid by both men as being “unfair,” leading to calls for higher income tax rates on the wealthy. Although this proposed solution seems obvious, the reality is that neither Buffett or Romney will end up paying significantly more even if income tax rates return to the levels during the Clinton era.

How could this be? Behind this confusion lies innumerable intricacies within the US tax code, where rates differ for varying types of income and the laws are littered with various deductions, credits and provisions. Facebook’s upcoming IPO displays a perfect example of the unintended consequences of US tax laws. In Options and Taxes: Is a "Facebook" tax next?, Aswath Damodoran (NYU finance professor) comments that:

“Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him.”*

On the surface, this seems reasonable since Zuckerberg will be paying nearly 40 percent between federal and state income taxes. The criticism stems from the corporate tax deductions that Facebook is permitted based on the exercise of employee stock options, including Zuckerberg’s. As WithumSmith + Brown states in Tax Aspects of the Facebook IPO (Alternate Title: Mark Zuckerberg Could Buy Most of Europe With His 2012 Tax Bill):

“Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to enough to wipe out the comany’s 2012 taxable income, but also –according to the prospectus — to generate an NOL [net operating loss] that will be carried back to generate $500 million in tax refunds.”

From a distinctly corporate perspective, Facebook, which may earn upwards of $2 billion in pre-tax income this year, will not only owe nothing in taxes but may actually receive a $500 million refund. How is it that an extremely profitable company ends up with a sizable tax refund? Why has GE and numerous other companies not paid taxes during the past decade despite earning substantial profits (G.E.’s Strategies Let It Avoid Taxes Altogether)? Why does Warren Buffett pay a smaller effective tax rate than his secretary?

When these questions are posed, a typical response suggests these outcomes represent the natural workings of a free-market system. Sadly this could not be farther from the truth. As Mish Shedlock points out in Is Romney to Blame for Paying Low Taxes or is 72,536 Pages of Tax Code to Blame? What's the Real Solution? Thanks to AMT, Man Pays 102% Tax Rate, “from 1984 until now, 46,236 pages of tax code have been added.” (shown below) Anyone would be hard pressed to find an economist who believes this level of complexity is either efficient or representative of a free-market economy. 

click on chart for sharper images
Image from Tax Law Pile Up

The reality is that consistent increases and alterations of US tax code, over the years, is primarily intended to benefit a special group or class. A rational choice perspective of public policy and administration implies that much, if not most, of this tinkering is done at the behest of groups with the largest political sway (funding capacity and desire).

Improving the tax system is possible both from the perspective of reducing government intervention and increasing progressiveness. Unfortunately the right (conservatives) has been persuasive in convincing individuals across the political spectrum that a complex tax code is part of a free-market system. In The End of Loser Liberalism: Making Markets Progressive, Dean Baker expresses his feelings on this subject noting:

“the vast majority of the right does not give a damn about free markets; it just wants to redistribute income upward.”

It’s important to note that the left (liberals) has also been complicit in this false perception, frequently adjusting the tax code in regressive ways to garner political funding and support.

Heading towards the election, both political parties will try to represent the current US tax system as “unfair” in an effort to push new laws that will “right” the system. Adding more layers of complexity, however, is unlikely to make the outcomes either more efficient or progressive. Overcoming the current trend requires exposing the truth that our current tax codes do not represent a free market. Hopefully both sides of the political spectrum can join together in encouraging politicians to create a far simpler, progressive tax system.

*Zuckerberg plans to exercise options for 120 million shares with an exercise price of $0.06. The nearly $5 billion profit assumes a per share value of approximately $40.

Poor Premise Supports Corporate Tax Holidays

In Foreign Income Rising, I discussed the potential for another corporate tax holiday to allow repatriation of foreign income. This evening, Andrew Ross Sorkin discusses the matter along with a recent proposal to reduce the employer portion of Social Security taxes (link below). Sorkin reaches a similar conclusion that temporary tax breaks are unlikely to result in significant job growth but will increase the federal deficit. While the source of the proposals (Chamber of Commerce) should make clear which group's priorities are being considered, it's important that politicians recognize the source of our current economic weakness. Business are not hiring because demand for their goods is not significant or stable enough to warrant new employees for increasing production. Demand stems primarily from individuals, who are currently overburdened with debt and choosing to pay down debt rather than increase spending. If temporary tax cuts are desired, the focus needs to be on individuals.

The Fallacy Behind Tax Holidays: Corporate America and Wall Street are engaging in a form of horse trading - tax cuts for jobs. There is one small problem: temporary tax cuts rarely result in new jobs and always result in less tax revenue.

Foreign Income Rising

In Converging on the Horizon (courtesy of John Mauldin), Ed Easterling explains that pre-tax corporate profits as a percentage of GDP are expected to set new record highs in 2012. As reported earnings per share (EPS) are also significantly above normalized EPS based on both Crestmont’s and Shiller’s methodologies. Continuing strength in these figures plays a major role in buoying bullish viewpoints and frustrating bears. Easterling does a wonderful job using historical evidence to support his view that mean reversion of corporate profits is likely nearing. Agreeing with Easterling’s basic outlook, attempting to understand the reasons behind this profit levitation seems a worthwhile endeavor.

Various explanations currently circulate within investment and economic research regarding the superb corporate margins. One theory points to an increasing share of profits accruing to corporations instead of employees. Stagnating wages, a less unionized workforce and regulations increasing barriers to entry all support this notion. Another consideration holds that strong emerging market growth has made up for weak economic growth in developed markets. While probably true to some degree, with U.S., U.K., EU and Japan’s (50%+ of world GDP) growth flat-lining, it’s hard to foresee this trend continuing. A less widely discussed topic deserving attention is the growing percentage of foreign income being deferred from US corporate income taxes.

Over the past several weeks publicly held corporations have been filing their second quarter reports. While firms continue beating expectations at a strong clip (this happens during bear markets too), the reasons behind stronger earnings appear to be changing. During the first portion of this recovery, cost cutting through layoffs boosted margins. As Russ Winter points out in Corporate Tax Avoidance (courtesy of Zero Hedge), diverging effective tax rates are more recently producing larger margins. Just last week Microsoft reported a 7% decline in their effective tax rate as foreign income rose to 68% of the quarter’s total. That’s correct, based on income Microsoft is primarily a foreign company and they’re not alone.

Apple, darling of US investors and techies alike, is only slightly more American than Microsoft. During the most recent quarter, 33% of Apple’s reported income came from the US. The following section from their quarterly filing explains the decrease in effective tax rate (emphasis mine):

“The Company’s effective tax rate for the three- and nine-month periods ended June 25, 2011 was approximately 24%, compared to approximately 24% and 26% for the three- and nine-month periods ended June 26, 2010, respectively. The Company’s effective rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S..” (Apple, 10-Q, 2nd qtr 2011, p.33)

As stated by Apple, an increasing portion of their earnings are never intended to be reinvested in the U.S. through higher wages, larger dividends or any other manner.

While Apple and Microsoft represent only a minute sample of U.S. corporations, my presumption is that further research focusing on large multinationals will find similar patterns of decreasing effective tax rates and increasing undistributed foreign earnings. For investors, the pertinent question is whether or not effective tax rates will remain or continue moving lower. Investors should also recognize that a significant portion of cash on these companies balance sheets is held abroad and cannot be reinvested in the U.S. without incurring income taxes. A broader concern of this tax policy focuses on its potential long-term economic impact.

In 2004, the U.S. allowed domestic corporations to repatriate undistributed foreign profits at significantly reduced tax rates. Congress hoped this “one-time” tax break would result in firms spending their extra cash to increase domestic jobs. Data largely implies that the special tax break had no visible effect on employment. Unsurprisingly, a more direct effect appears to have been a growing number of firms and percentage of earnings being classified as undistributed foreign profits. With unemployment remaining high, large U.S. multinationals are once again pressing Congress to allow repatriation of foreign profits at a minimal tax rate (5%). Despite historical evidence, several Democrats have supported the proposal. As companies become more confidant in another “one-time” tax break, undistributed foreign profits may experience another surge.

Congress is currently struggling to compromise on a debt limit deal that cuts future spending and reduces deficits for the next decade. Given this debate, a good question regarding corporate taxes would be “why are domestic companies allowed to avoid corporate taxes with undistributed foreign profits?” Jesse’s Café Américain (courtesy of The Big Picture) directs us to ten charts from the Center for American Progress displaying the vast decline in corporate tax revenues:



Corporate tax revenue this year (1.3% of GDP) is near all time lows despite record corporate profits and a supposedly uncompetitive corporate income tax rate of 35%. As chart 9 shows, the effective tax rate for U.S. corporations is only 13.4%, well below most OECD countries. Tax breaks and loopholes not only reduce tax revenue, but heavily favor large corporations. Rather than consider more tax breaks, Congress would be well advised to focus on corporate tax reform.

Corporate tax reform that eliminates breaks and loopholes, while reducing rates, holds the key to several issues plaguing Congress and the current administration. Small businesses, which typically create the most new jobs, will benefit from lower tax rates. Federal tax revenue will increase as far greater sums of income are taxed. Consumers will likely benefit as increased business competition drives down prices and encourages innovation. Although this idea seems simplistic, it has a unique benefit of being both a market-oriented solution (for the right) and more progressive tax system (for the left).

Unfortunately these type of drastic overhauls rarely occur outside a crisis and are in direct opposition of numerous parties with invested interests (as well as significant cash to spend on lawyers and political contributions). Regardless, moving in the opposite direction by allowing another “one-time” tax break is almost certain to hurt economic growth, employment and federal debt in the long run. Hopefully after the senseless debt limit debate ends, the country will begin discussing more valuable issues including tax reform.