A realistic picture of taxes and the economy

October 15, 2010

I just ran across some blog posts from tax professor David Cay Johnston. He has a couple posts in particular that I find interesting because they highlight the disparity between perception and reality when it comes to taxes and the economy.

I find it odd that so many people believe that taxes are unusually high in this country.* From a global perspective, the US government takes in less revenue, as a percentage of total income, than nearly any other developed nation. From an historical perspective, the US government collected a smaller share of total income in 2009 than it has in 60 years. In fact, for 30 years now tax rates have been in fairly steady decline. As a tax professional who looks at tax numbers all the time, this isn’t at all surprising. But it’s amazing that people who aren’t informed about the reality have a very strong perception that things are exactly the opposite of the way they really are.

Anyway, here are a couple of articles I found very interesting…although I’ll warn you that if you’re dead set on believing the government has us on a steady path to socialism then you’ll probably just be really angered:

United in Our Delusion

US Tax Rates: A Bargain Hunter’s Dream?

*In the case of upper-middle income earners making about $80k-106k, I’ll concede they’re probably right to believe taxes are unusually high in this country. If you fall in this income category, you’d probably pay lower taxes overall moving to Canada or Western Europe (plus you’d get free health care thrown into the deal as well). The income tax, when combined with employment taxes that are very regressive, result in a tax code that hits these upper-middle-class earners harder than anybody, and then rates get dramatically lower for higher earners.


The Paradox of Simplifying the Tax Code

April 26, 2010

It’s been a couple months since my last post as I’ve been busy helping people navigate the complicated mess that is our income tax code. And the last couple of years, I’ve noticed an interesting contrast between what people say they want, and what they actually want.

Over and over again I hear from the media and simply talking to people in public the common refrain that our tax code is way too complex. An unnecessarily complicated tax code creates an enormous burden on business and individuals, stifling productivity. Out in the open, you hear almost universal support of the idea of simplifying the tax code. So if we live in a democracy and nearly everybody says they want a simpler tax code, why don’t we have one?

Simple. People don’t tell the truth. Or they simply don’t think things through to the very next logical step.

Everybody says publicly they hate how complicated the tax code is. But privately things are very different. Privately, most people buy tax software or pay somebody like me to search for all the tax breaks they can possibly get. And what is a tax break? It’s simply an exception, a “complication,” to the straight-forward application of tax rates to income. And everybody wants as many as possible when it comes time to do their taxes.

If we want to simplify the tax code, we’ll have to start eliminating all these tax breaks. Who wants to vote for eliminating the deduction for mortgage interest? Who will vote for ending exemptions and credits for dependents? Any takers? Maybe a few, but overwhelmingly people tend to like tax breaks. Sure, most people aren’t big fans of “unfair” tax breaks for “others.” But it turns out when you try to eliminate any tax break, suddenly the “others” turn up to argue their tax breaks are just as “fair” as the tax breaks you receive.

I’m not saying our complicated tax code is a good system. But I am saying that “simplifying” the tax code is one of the most politically difficult things to accomplish in a democracy. Any politician who promises to simplify the tax code is probably blowing smoke.

And let’s consider just how much most people would like the alternative. It turns out our tax code already has built in to it a couple of flat taxes. First, there’s the FICA taxes that come out of people’s paychecks automatically and aren’t subject to deductions or credits. Because they’re almost invisible, most people don’t think much about them (plus only half the amount is shown on your paycheck, the other half truly is invisible to employees). However, self-employed people see this tax directly as it’s not withheld automatically from them. They have to cut a check. And most self-employed people howl about this one when they learn about it. Over and over I have to explain to self-employed people that their medical expenses, their mortgage, their kids…none of those personal deductions make any difference when determining self-employment tax. And self-employed people hate it.

The other flat tax in our system already is Alternative Minimum Tax. Like Self-Employment Taxes, this tax is pretty flat as well. (There’s a 2% higher tax rate at the higher end of the income spectrum, and they can still deduct mortgage interest and charity, but other than that it’s pretty close to a flat tax.) And what tax is universally loathed by upper-middle-income earners who sometimes find themselves subject to it? AMT, of course. Again, people are outraged that their kids, their state income tax, and countless other deductions they get under the normal tax system don’t make any difference for AMT purposes.

Turns out that–privately, at least–most Americans hate a flat tax even more than a ridiculously complicated tax.

Clinical research offers support of a pet theory of mine

February 1, 2010

OK, this one is pretty far removed from the tax/finances world, but it comes from an interesting article I ran across right after finishing the Finance section of The Economist.

I have long had this pet theory that society would be better off if our legislative bodies were generally composed of common citizens chosen by lot. In such a system, the executive branch would consist of people who rise through the ranks of managing successively higher levels of government, just as modern executives in the private sector generally attain their position. But the legislative branch would be a large body–probably at least 1000 people so statistics almost guarantee you’ll get a random sample representative of the whole population–that would function much like a board of directors that wields the ultimate authority to dictate what the executive branch should be trying to accomplish.

Simple observation leads me to believe our system of elected representatives pretty much guarantees that we will be governed by liars and hypocrites whose dominant attribute is the ability to say whatever they believe people want to hear and sound really sincere at it. Government by lot would no doubt produce a number of completely incompetent people (and perhaps there would be the option for popular election or some other method to cull 10% or so from those randomly selected to weed out the truly crazy), but with a large enough sample, the competent people would almost certainly far outnumber the incompetent and allow the incompetent to be steered along. Besides, majority decisions would not require everybody be on board, and a majority requirement would prevent small groups of lunatics from accomplishing anything–unlike our current system, it would appear.

And so, with extreme satisfaction, I read this article in The Economist discussing recently published psychological experiments about the effects of power on people’s moral compasses. The study “primed” people for different states of mind–either a state of mind of one who has earned and deserves power, a state of mind of somebody who does not have power and does not deserve it, and a state of mind of somebody who received power fully aware that they did not deserve it. This is accomplished by having people randomly formed into groups and assigned to write about times in their life when they experienced a situation that made them feel the way the researchers were intending them to feel–a method that has been used time and time again in psychological studies and shown to have significant validity.

After being put into the appropriate frame of mind, the subjects were asked questions or put in situations designed to tease out the subjects’ feelings about ethical behavior as applied to themselves and others. It turns out those who were in a frame of mind reflecting earned power held other people to a significantly higher standard of ethical behavior than they held themselves. Those who felt they had little power generally held themselves to roughly equal ethical standards as they applied to others. And the group that was thinking of a time they’d been given power that they did not deserve held themselves to a significantly higher ethical standard than they applied to others.

It is not hard to see the parallels with our system of government. People who campaign and win an election no doubt tend to feel that they have earned their position of power. As such, psychologists would conclude, regardless of other personal characteristics, that they are likely to feel entitled to cheat the system and play by a different set of rules than apply to “everybody else.” On the other hand, people who are selected by lot for a position of power would not merely be likely to view themselves as equal to others, they would in fact be likely to hold themselves to a higher moral standard than “everybody else.”

Combining the selection method with reasonably high salaries (i.e. keep the current salary/benefit structure, or even raise it a little bit) would increase the “undeserving” feeling for those chosen and would likely increase the effect. Plus high salaries (and the promise of a future pension for service completed proficiently) would help insulate the legislators from the effects of being bought by corrupt parties.

In the comments with the article, there is an interesting comment discussing George Washington. Apparently Washington’s personal diary and other comments recorded at the time indicate Washington felt completely undeserving of his appointment to lead the colonial army. His career prior to that point had been unremarkable and his appointment was largely for political reasons. As such, the research would indicate he would be more likely hold himself to a higher ethical standard than those around him, and be uninterested in seizing further power through any means available. Indeed, that seems to be exactly what happened.

But while Washington’s intentions, and those of many other founding fathers, may have been good, the system they established has turned out to be one that does not propagate leadership by those humble enough to use it responsibly. It would appear that the best way to achieve a system of government “of, by, and for the people” is not through direct election, but by lottery.

Another Stock Bubble Is Well Under Way

December 1, 2009

Just a heads up for anybody with significant stock investments. I’m a tax expert, not a financial advisor, so don’t take this as financial advice. On the other hand, mountains of research has shown that financial advisors aren’t any more accurate than the proverbial dart board, so the truth of the matter is nobody is an expert on this stuff. So with that caveat, here’s an observation.

For some time now I’ve been analyzing long-term data on stock valuations from Robert
Schiller (one of the few economists who never stopped trusting long-term valuations and was therefore able to correctly predict both the stock market bubble of the last decade and the housing bubble). From his exhaustive data I’ve found that every time in the last 130 years that the PE10 of the S&P 500 has gone over 20, an investor would have done better to just pull out of stocks, invest in government bonds, and wait for the bubble to collapse. This last bubble took almost 15 years to collapse, but it did. And an investor who had bought bonds the last time PE10 passed the 20 mark (Jan, 1995) and just waited for valuations to return to the historical average of about 15 (February of this year) before buying into stocks again would have done about 20% better than an investor practicing buy and hold. Today the PE10 passed 20 again for the first time since last year’s collapse.

** (PE10: P/E ratio w/ earnings averaged over the last ten years)

Maybe we’re headed into another decade+ bubble, but staying in at this point means trusting your (or your broker’s) ability to call the top of the bubble, something nobody has ever done with any consistency. Individual stocks may be able to buck this phenomenon, but again it’s trusting your (or your broker’s) ability to be significantly better than average at picking individual stocks, something few “professionals” are able to do with consistency. In fact, the “professional” mutual fund managers do better than average only about 20% of the time, even though by pure luck they should do better than average about 50% of the time.

Draw your own conclusions.

UPDATE: The S&P 500 closed at 1109 on the day this blog was published. In the six months’ since, the index has bounced around between almost 10% up and 5% down, with a closing price today of 1070. We’ll see what happens in another six months…

Why finance professionals earn so much…for knowing so little

November 9, 2009

Years ago I applied for a job as a financial advisor with a large, reputable financial services firm. I have a strong aptitude for math and a strong background in customer service, so I thought this would be a good fit for me personally as well as highly lucrative. I made it through a couple rounds of the process, but was confused by one thing: nobody seemed the least bit interested that (at the time) I had no background in finance. While I felt confident that I could learn this field quickly, I didn’t understand why I was never asked to provide all the answers I had prepared to justify my suitability for this position without a finance background. I finally asked an interviewer how I was supposed to provide the services I was selling when I had little formal background and the training period was only about a month.

His response: you don’t need to know anything. We’ll provide you the basics to sound informed. You just have to project confidence and sell the product. Once you pick up clients and have money to play with, you’ll figure it out as you go along.

I couldn’t handle the ethical implications of selling myself as a “professional” or “expert” so I could get other people’s money to play with and figure things out. It’s too bad, I might have made a lot of money. Instead, I decided to take my interest in economic and financial issues and pursue a career that seemed more genuine. I chose accounting.

Interestingly, as I was recently reading Nassim Taleb’s “Black Swan”, I came across a chapter on the “expert problem”. Basically, some fields have true experts and some don’t. Some “experts” have a lot of facts, but don’t have a genuine understanding that translates into better results than what a non-expert would get through simple chance. Other experts (think surgeons, farmers, engineers) are genuine experts who will consistently deliver results far more useful and accurate than a non-expert could produce. Taleb confirmed my impressions of financial advisors and accountants by putting financial advisors squarely in the “expert” category, and accountants in the expert category. There’s plenty of empirical evidence to back this up, of course…80% of mutual fund managers aren’t able to beat average market returns; in the years prior to the (now obvious) meltdown of securities, most advisors were recommending buy-and-hold for stocks, and buying as much home as you can finance; just to name a couple of the more obvious examples.

So the question is, why are financial advisors and analysts and others in the “expert” category compensated so much better than accountants and others in the expert category? Why do the people who are unable to demonstrate any level of skill beyond what’s easily explainable by pure chance demand so much more compensation than the people who can actually explain what they’re doing and why and how it works?

And recently I realized why there is a disparity. And it’s precisely because accountants practice a consistent method while financial advisors practice alchemy.

One of the pitfalls of the human brain (Taleb, among many others, discusses this at length) is our weakness for the narrative fallacy. We want a theory, a story, a narrative to explain every phenomenon. Even when the best theories are proven wrong over and over again, if nobody suggests anything better, we will assume the best narratives are accurate (even when proven wrong) until something better comes along. We are unable to simply accept that sometimes the only correct answer is, “Nobody knows.”

In accounting, the best practices are known and have been understood and refined for many centuries. As a result, these practices have become broadly taught and can be practiced very systematically. Therefore, many people have been trained to be accountants, and they nearly all deliver consistent results.

In finance, the best practices are unknown. There is no proven strategy that has consistently been proven to perform better than average (of course, such a strategy is impossible, but that’s another discussion). As a result, everybody comes in with their various ideas and narratives about how the market works. Through sheer luck, some will wind up doing much better than average. However, because of our human tendency to see order where there is none, we will attribute this success not to luck of the draw, but the accuracy of the person’s methods and ideas. Over time, most will experience runs of bad luck as well as good, but a small number, by sheer luck, will have a long run of success. If humans were rational, we would see these “successful” stockbrokers, advisors, and analysts for what they are: lucky. But instead, we believe there must be an explanation behind their string of luck, it must be because they are extremely talented. And because this “talent” is so rare (runs of good luck are rare things, after all), the market is willing to pay extraordinary prices for this rare “talent”.

Of course, to somebody considering whether to go into accounting or finance, the decision is easy if you only look at top salaries (or even average salaries for those who’ve been in the field for many years since, after all, only those who remain relatively lucky overall stay in the field). However, if you average in all of those who have “failed” at finance by being unlucky, and therefore left the field altogether, the picture might be very different. Either way, the wisdom of entering one field or the other ultimately boils down to one characteristic more than any other: luck.

Just goes to prove the old adage: It’s better to be lucky than good.

Taxing our way to prosperity

April 4, 2009

This is an odd post coming from somebody whose job it is to reduce individuals’ tax liability as much as possible. Still, in my studies of tax policy, combined with my fascination with history, I occasionally come across things I just have to comment on.

We hear it over and over again, “We can’t tax our way to prosperity.” It’s a mantra of the right. The left doesn’t seem to disagree…they just don’t even address it. Well, history has another message. We actually can tax our way to prosperity. And WWII is the proof.

We entered WWII with massive deficits and a terrible economy. Beginning in 1940, we raised tax rates to 23% on middle-income earners and as high as 94% on the highest earners (http://eh.net/encyclopedia/article/tassava.WWII). We increased government spending to nearly 50% of GDP. And in well under a decade we had a booming economy ushering in one of the longest sustained periods of prosperity in American history.

What’s most amazing about this is the fact the government spending wasn’t even very productive. The popular mantra today is we can’t increase taxes because it will reduce consumer demand and further damage the economy. BS. What’s better for the economy, a smart energy grid or a new big-screen plasma TV in every household? I think the answer’s obvious. Both outcomes would cost tens of billions of dollars, possibly hundreds of billions, and therefore have roughly the same effect on demand. But one of the outcomes can be achieved by consumer spending, and one of them can be achieved by taxation and subsequent government spending. We’re obviously better off in the long-run if we are all taxed in such a way that generates sufficient revenue for a smart energy grid, even though it means giving up a big-screen plasma TV.

But this isn’t just theory. This is exactly the kind of thing that happened during WWII. Americans were asked to sacrifice and make do with less. With increased revenues, the government built lots of bombs and tanks and planes…mostly non-productive assets meant for almost immediate destruction. But part of that money also went to very productive assets, like factories and power plants and transportation networks. It also went to education in the form of the GI Bill. And after the war the government continued to spend on the Interstate Highway System. These productive assets were instrumental in the post-WWII boom that America experienced. And this was accomplished with only a small portion of government spending going into productive assets.

Today the need for military (economically non-productive*) spending is far less than during WWII. Despite our fears of terrorism, there is simply no threat to our national existence like there was during WWII. Our current defense spending is almost entirely discretionary. We could bring all our troops home, leave the terrorist networks alone, and face zero threat to our national existence. Of course, we might face an elevated threat of terrorist attacks. But these are entirely different from the existential threat posed by totalitarian national regimes during WWII. Our military spending today is out of a choice we make that we are willing to spend half a trillion dollars to potentially save a few thousand lives every year. And even making this choice, we are still spending a small fraction of what was spent fighting WWII, leaving a tremendous potential for spending on productive assets. If we spent four years devoting a quarter of GDP to creating productive assets (this would still be significantly less than the spending during WWII), we could probably afford to build a national smart energy grid, install renewable energy on a sufficient scale to power the nation, and build a better national transportation system far faster, safer, and cheaper than the Interstate Highway System. We would have to train people to install all of this, and at the end of four years of spending we could unleash our highly-trained workers and our technology on the rest of the world where we could make unimaginable sums of money bringing this technology to other developed and developing nations.

Of course, to accomplish all this would require Americans to temporarily cut back on big-screen TVs, designer clothes, luxury cars, and all the other perishable goods that we’ve come to love. And I guess maybe we can’t have that.

Of course there are limits to this kind of thinking. Government doesn’t always know best. After the overwhelming success of WWII spending, government tried to solve every problem…an approach that naturally led to problems of its own until the Reagan revolution took the pendulum back the other direction with considerable success for the better part of two decades. But now that the hands-off approach has run its course, and the pendulum seems naturally ready to swing back…it seems like most politicians are still afraid to learn history.

*I use the term “non-productive” in a very specific sense here. I’m not implying the military is not valuable. Providing for the national defense is a very valuable service. But generally speaking, money spent on the military goes to items that are quickly used up and do not produce other items. It’s basically the difference between a company investing in a security system for a factory, or state-of-the-art equipment to produce goods. Obviously, a factory needs security to protect the investment, but the security system doesn’t in itself produce anything of value. A smart company will spend as much as possible on equipment and as little as necessary on security. It’s the equipment that pays for the security, after all.

Are taxes taking more than your employer?

January 26, 2009

I doubt it.

I know people who begrudge every dime of taxes they pay. But while they whine up and down about all the taxes that government takes out of their paycheck, they don’t seem as upset about what their employer takes out of their paycheck. Of course, what the government takes is clearly visible on the paycheck, while what the employer takes is not nearly so visible. For example, Class 5 typically charges $90/hr for most services. Yet the most I could possibly afford to pay an employee to provide those services works out to around $50/hr (and that’s with generous assumptions about how efficiently I can allocate overhead resources). So am I taking half my employee’s income?

Of course that would be absurd to say I’m taking half my employee’s income because I have to pay all sorts of overhead…advertising, office space, insurance, etc. etc. Plus I pay for many hours that aren’t billable. But really, is that so different than the government providing the overhead that makes the economy possible? The government pays most or all of the cost of our education. The government provides nearly all of the transportation and communication infrastructure that makes commerce possible. The government maintains order. It seems to me that government does just as much to provide me with gainful employment as I do for my employees. Why should an employee begrudge the government for taking about a quarter of earnings when employers often keep at least half, or often much more?

It’s unfortunate that people don’t recognize this obvious truth. Maybe if the government was able to take taxes from us before our wages show up on paychecks there wouldn’t be so much outrage.