Sunday, January 22, 2012

When it Comes to Taxes, We All Have Special Interests

A few days ago, I was asked my views on taxation fairness and was provided with two opposing views of tax policy for comment; one from a New York Times columnist and the other a Wall Street Journal opinion piece. My response follows.

The biggest unanswered question facing all nations with deficits is, “What are we paying for on an individual basis?” In the matter of tax policy each of us, in effect, forms a special interest group. Those of us living in suburbia are in favor of money to be spent on roads and possibly suburban transportation. Our urban friends would prefer that money be spent on mass transit in their cities. When we, our close family and friends are healthy, excessive spending on public health is overdone. However, when any of us are ill, we want the best healthcare available. Only those of us who fear future wars and terrorism are supporters of national defense spending etc., etc. Since we are not able to order our services à la carte, our next problem is how to pay for all the services that we want and pay for the sometimes wasteful spending for others that might have more votes than us. Governments pay for these services through taxes, fees, sale of assets, and borrowing. In the end, borrowing is self-defeating, but perhaps acceptable to many who do not have grandchildren.

One of the lessons from history is that the ability to levy taxes leads a society into certain actions. Think of taxes as the price we pay for services. If the price becomes too high, we will modify our behavior. If we tax income or capital at too high a rate, we will generate less income or capital. Since we have not successfully developed wide scale revenue-generating user fees, we will need to use taxes to pay for all those wanted and unwanted goods and services. Each of us has very good reasons to believe that someone else should pay our share of the expenses. As I believe that as a society we spend too much, I would favor various forms of consumption taxes with an appropriate carve-out for life sustaining items and the poor. Unfortunately the remaining purchases would probably be too small to be a good base for tax generation. There is another risk; that if legitimate user fees get to be too high, we will create a black or grey market with all its socially undesirable characteristics. There are other victims from an imposed tax on “luxury goods.” When we decided to tax large yachts, the yacht building business left the US for friendlier locations.

Because every inhabitant of this great country benefits from our collective government services, each person should pay something. Otherwise, we will continue the situation whereby people who do not pay taxes will want additional services to be paid by others. Thus, I am afraid we need a graduated tax rate approach. My own view is that income should be taxed and deployed capital should not until the capital is producing dividends. The more we adjust these principles to take into consideration legitimate needs of people, or the society as a whole, the more we will create special interest groups who not only want their needs taken care of, but who are willing to trade their votes to support other people’s needs on a reciprocal basis. (If you think sorting out US Federal taxes is difficult, attempt to do it for state and local taxes which have dramatic impact on the attractiveness of local communities. From our standpoint, there is one advantage at the state level: in most cases states are required to have balanced budgets. Thank you, Alexander Hamilton.)

We have often been told that the only certain things in life are death and taxes. Over time, we can learn to deal with those realities. However, there is a third constant in modern society which has caused more upset and bad decisions. The third item, perhaps the third rail, is tax changes, both in terms of rates and application. While I hope the debate between the Wall Street Journal and the New York Times is useful, I am concerned that it will lead to annual tax changes that will retard both social and economic progress.

Investing implications

As mentioned above, from a credit concern viewpoint, General Obligation bonds issued by highly-rated US states make more sense than US Treasury and Agency paper. However, because of the temptation on the part of the politicians (including those at the US Federal Reserve), one needs to be wary about inflation. Thus, in general I would restrict my fixed-income purchases to a portfolio of bonds with current maturities less than twelve years. For many of us who do not have sufficient experience in selecting and owning individual municipal bonds, or don’t have a highly competent advisor, one can use a package approach with (Open End) Mutual funds, Closed End funds (non-leveraged), and possibly Unit Investment Trusts (UITs). The keys in selecting these are restricting the choices to those that indicate that they are intermediate in maturity and have one of the lower current gross yields of the available products. As markets generally price risk into the yields offered, a lower yield may be less risky. The distinction between gross and net yield is the expense ratio on the fund. Other things being equal, a fund with a high total expense ratio (TER) will appear to have a lower yield than a fund with a lower TER.

For those who wish to add to their stock positions, and this may not be a bad time to do so, I would focus on investments in countries with relatively low deficits compared with their Gross Domestic Product (GDP). A number of these are found in Asia, particularly in southern Asia. Very recently, Indonesia has had its credit rating raised back to investment grade, many years after having suffered a downgrade. One must be cautious in using credit rating changes, as most often they are recognition of a change that has happened some time ago. In a forthcoming blog I will share my views as to these Asian opportunities.

Did you miss Mike Lipper’s Blog last week? Click here to read.

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