Laments my friend, David Kotok:
Taxation Without Representation
January 21, 2013, Inauguration Day
“Taxation without representation” says the text under the Washington, DC license plate of President Obama’s inaugural limo. Citizens of DC argue they are not represented when the Congress decides on their taxes. One has to ask how well the rest of us are represented. We will get to that with some detail in a moment.
First a short report. We had the opportunity over the weekend to do an interview with Vincenzo Sciarretta. Vince is an experienced Italian journalist and business writer. He is also the coauthor, with me, of a book titled Invest in Europe Now. Vince and I wrote this book years ago when the outlook for Europe was upbeat. Our book was originally a success … until Greece blew up and everything else we wrote about collapsed. Readers are advised not to buy the book; it is out of date. If you want one, email me with your address and I will give it to you, free.
Vince and I discussed the political situation in Italy and the outlook f
Book received with thanks.
or its budget, debt-to-GDP ratio, taxation levels, and weakening economy. We compared the Italian situation with the outlook for the US – its budget crisis, bumbling political figures, rising taxation, and weak but positive, economic recovery. Vince and I laughed over what might happen in both countries if we swapped political leaders. Imagine Biden or Boehner swapped for Berlusconi or McConnell exchanged for Monti. Oh, well, enough silliness.
As far as Italy is concerned, we think there is continued political risk that will evidence itself over time as Italian politics “advance” into the post-Monti phase. Remember, Italy is the third-largest debtor in the world. We in the US are the largest. Japan is second. Italy’s debt-to-GDP ratio approaches 130 percent of GDP. Japan’s is much higher. The US is at about 100 percent if gross federal debt is counted. Of course, much of our federal debt is held by our central bank and our so-called trust funds. My colleague Bob Eisenbeis and I have both written about the Social Security Trust Fund and what a sham it is.
Italian government debt is denominated in euros and held in portfolios worldwide. The European Central Bank (ECB) essentially guarantees the short-term financing of governments like Italy. Therefore, in the short-term funding markets, sovereign debt is able to “roll.” In the longer-term funding markets, the outcome is unclear.
A serious “little” problem in Europe involves the recapitalization of the banks in Cyprus. By itself, Cyprus is an economic speck. Its banks are not. The Cypriot banking system is 4 times the size of Cyprus’ economy because the country is a banking haven. And the banks are tied to Greece. Watch this one closely since funding in any eurozone banking system is linked to all the rest of the zone.
Let’s segue to America, where we are about to launch the 2016 presidential campaign and the 2014 congressional election contests. Actually, the antagonists started well before President Obama was officially sworn in for a second term, yesterday morning at 11:55. The debt-limit amount, sequestration deadline and overall fiscal fight are the next theatrical acts to be taken up by the gladiators. The Democrats would like to attack and re-attack the Republicans, in hopes of grabbing a majority in the House in 2014. If President Obama can get a majority in both legislative chambers, he can bypass the Senate filibuster rule with a budget reconciliation bill and pass it with simple majorities in both Senate and House. Political consultant Norm Ornstein calls that prospective bill “the mother of all legislation.” I shudder to think how much pork would be in it.
The Republicans are reeling from their stupidity in the last campaign. They should be. Run candidates who claim that a rape doesn’t impregnate a woman and what do you expect? That is a surefire way to lose a Senate contest and to weaken a presidential nominee. Republicans succeeded in losing seats in both chambers of our national legislature. If they continue to allow themselves to be painted as obstructionists, they will lose again. The country wants reasoned explanations and honest debate, not arrogance. Pay attention, Mr. Cantor; arrogance doesn’t win elections.
House Leader Boehner and Majority Leader Cantor indicated they are prepared to extend the debt limit by 3 months in order to give the Senate time to pass a budget. They want to force the Senate to make big spending cuts. It is not likely. The Senate hasn’t passed a budget resolution since 2009 even though it is required under current by law. To paraphrase Albert Einstein, insanity is doing the same thing over and over and expecting a different outcome. Our leaders demonstrate Einsteinian insanity. Thus, we expect the politics of confrontation to dominate 2013.
So what did the last Congress and the first Obama administration leave us to ponder? Lots. We face a weakening economy because of the actions of both of them.
Cumberland has recently reduced our expected growth rate for the US economy. We believe higher taxation will have a negative impact on the wealthy, on personal trusts, on Sub-S corporation independent businesses, etc. Those higher taxation rates will take a few tenths out of the GDP growth rate. The new tax structure can only restrict the speed at which the US economy grows its way out of the financial-crisis-induced recession. There are now combined state and federal, marginal tax brackets that exceed 50 percent in states like New York, New Jersey, and California.
What is worse is that the political leadership of the US imposed a two-percent payroll tax hike. They did it by means of this farcical charade of the “restoration” of the Social Security Trust Fund (SSTF). My colleague Bob Eisenbeis has articulately described how the SSTF is an entity that receives cash and hands it over to the Treasury. The fund then receives an “IOU” from the Treasury. The assets of this trust fund are thus claims on the US Treasury. It would be different if the trust fund actually consisted of investments in infrastructure bonds, corporate bonds, municipal bonds, mortgage-backed securities, or other assets that were secured by, or were interests in, some productive investment. The SSTF does not do that. All it does is act as a conduit of cash to the US Treasury.
Anyway, we are saddled with a two-percent payroll tax hike in the US. It will impose a permanent $125 billion cost on the working poor and working lower middle class. It taxes everybody who earns $113,700.00 or less. This is not a tax on the wealthy; this is a tax on the workers of the country. When you impose such a tax suddenly rather than gradually, and permanently, you reduce the growth rate of the economy. This tax increase will take about a half point out of the GDP growth rate.
We think the combined tax bill with all its impacts reduces US 2013 growth by about ¾ of 1 percent. That means the first half of 2013 is likely to see a growth rate close to one percent. The second half might be a little less weak. The growth rate for the entire year will be somewhere between 1 and 2 percent.
This is not a robust economic recovery. Such a growth rate is not likely to raise the number of employed at a rapid pace. Therefore, the job-creation statistics for 2013 are likely to continue to be tepid. The result of the low rate of job creation will be to keep the unemployment rate higher than is desirable. It is likely to stay way above the Federal Reserve’s 6.5 percent target for the entire year of 2013. That means the Fed will probably extend its period of stimulus well into 2014. We expect the Fed to be in some form of QE for the entire year.
If we are right, those who are worried about an immediate rise in interest rates are likely to be wrong. There is a lot of time in front of us before we reach stabilizing levels in the US. We do have a gradual recovery. It will accelerate slowly in the US. It has received a setback because of our poor political leadership – a “double whammy” – and the imposition of the “tax barbell” on both the working people of America and the affluent.
The risk and the fear is that the tax structure is so onerous that we may have triggered a recurrence of the 1937 recession that came on the heels of the Great Depression. Will this 2013 political fumble result in the modern-day equivalent? Time will tell. The culprits who delivered it to us are both Democrats and Republicans. They include the President and Vice President of the US, the Senators and members of the House of Representatives of both parties, their leaders, and their rank and file members. They are responsible for economic weakness if it unfolds. They have devolved into a hyper political system of governance that sets an impoverished example for the world. They continue to dig in ever deeper, attacking each other in the most partisan, negative ways.
Let me conclude with a list of pork that was composed by John Mauldin, MauldinEconomics.com. In John’s recent Special Report, he gave examples of the top pork elements that found their way into the so-called Taxpayer Relief Act. That is the law that hiked the payroll tax on working Americans by $125 billion, and that law has over $60 billion in identified pork. Beneficiaries range from sports-car racers to Hollywood film makers. Below is an excerpt from John Mauldin’s list.
According to the Congressional Joint Committee on Taxation, the cost of these additional tax breaks will cost US taxpayers more than $63 billion just in 2013 alone. Here are the main pork beneficiaries:
Pork Barrel #1: Tax Breaks for Offshore Loans. Section 322 of the bill provides an “Extension of the Active Financing Exception to Subpart F.” “Active financing” is a fancy phrase that allows manufacturers and banks to defer taxes when they engage in special types of financial transactions. In short, it rewards firms to loan money to foreigners instead of American companies.
For example, the active-financing exception permits big banks like Morgan Stanley to avoid the 35% corporate tax rate on interest income from money lent overseas. Multinational companies with financing arms, such as Ford and General Electric, will benefit from this exception to lower their tax bills.
The exception is worth a mountain of money to a handful of corporations. It even has its own lobbying coalition – the Active Finance Working Group – which serves as a prime example of how important the 20 or so companies that benefit from the exception consider it.
Pork Barrel #2: Tax Breaks for Offshore Jobs. The fiscal-cliff deal gives huge tax breaks to American companies that sell their products through overseas affiliates.
Called a “pass-through” exemption, this loophole allows American companies to set up a new corporation in a tax haven, like the Cayman Islands, and to sell that new offshore company its valuable patents owned by the US parent company.
The royalties on overseas licensing of that patent that are earned would then be subject to no taxes.
Pork Barrel #3: Luxury Condos for Wall Street. Section 328 of the bill extends tax-exempt financing for the “Liberty Zone,” the area around the former World Trade Center, for another year. This tax break is supposed to help fund reconstruction after 9/11, but some have found that the bonds have mostly helped finance new luxury apartments, not to mention the construction of Goldman Sachs’ new headquarters.
Pork Barrel #4: Boxcars of Free Railroad Money. Section 306 of the fiscal-cliff bill gives a juicy tax credit to railroad companies to provide maintenance on their own lines. This credit costs about $165 million per year and will survive another year.
Pork Barrel #5: Thank you, Hollywood. The fiscal-cliff bill renews “special expensing rules for certain film and television” productions. Movies and television studios can deduct up to $15 million of their costs if more than three-fourths of a project’s production takes place in the United States. The incentive will cost an estimated $266 million in 2013.
Pork Barrel #6: Tax Breaks for Hedge funds and Private Equity. The mainstream media characterized Mitt Romney as an evil, job-killing private-equity pirate and loudly criticized the favorable tax treatment -called “carried interest” – that he enjoyed on his Bain Capital profits.
The bottom line is that hedge fund and private-equity moguls will continue to be taxed relatively lightly after the new fiscal cliff legislation.
The profits from investing other people’s money – AKA carried interest – will continue to be taxed as long-term capital gains for hedge fund and private-equity managers.
Pork Barrel #7: The Answer, My Friend, Is Blowing in the Wind. It is no secret that the Obama White House is very friendly toward the green-energy industry, so it should not surprise you to learn that there is a big tax credit for the wind power industry. The fiscal-cliff deal gives wind producers a 2.2-cent tax credit for every kilowatt hour they generate in their first 10 years of operation. In broad terms, this credit is worth about $1 million for every large wind turbine.
Those are just the most egregious pork recipients, but the list is a lot longer and includes:
• Mine rescue team training credit (Sec. 45N)
• Fifteen-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements (Sec. 168(e))
• Election to expense mine safety equipment (Sec. 179E)
• Temporary increase in limit on cover-over of rum excise taxes to Puerto Rico and the Virgin Islands (Sec. 7652(f)); and
• American Samoa economic development credit (Section 119 of the Tax Relief and Health Care Act of 2006, P.L. 109-432, as modified)
John Mauldin concludes, and I agree, “These giveaways of taxpayer money make my blood boil, as they should for you too. We’re at the endgame of the government’s wasteful spending, and they have yet to address it. Washington’s debts are going to explode and crush our government; they’re also going to distort the free markets for years to come. I see nothing wrong with most of these projects and support them. Who isn’t for mine safety? And expensing of development costs makes sense. I am all for fixing railroad lines. But why on taxpayer money?
Thank you, John.
Dear readers, we are about to start the next round of musical chairs in Washington. It will be ugly. We have no reason to believe or expect otherwise. There will be eleventh-hour negotiations and political brinksmanship aplenty. That’s how it is, whether we like it or not.
The only predictable policy is that of the Federal Reserve. The Fed has told us what they are going to do, and the economy is weak enough that we can believe them for a while. Very low interest rates are with us for some time to come. That is true worldwide. That is bullish for asset prices, including financial assets, real assets, collectible assets, property assets, and precious assets. Persistent cheap money in all major countries means rising asset values.
We remain fully invested.
David R. Kotok, Chairman and Chief Investment Officer
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