Canadian Investment Review

What’s Holding Up the Debt Ceiling?

Written by Scot Blythe on Thursday, August 25th, 2011 at 11:35 am

rock arch unstableAt the heart of the U.S. debt debacle is a fundamentally confused understanding of taxes – and if Standard and Poors was premature in marking down the credit quality of U.S. federal debt, it wasn’t premature in marking down the quality of U.S. political debate on fiscal matters.

To raise the debt ceiling – and assure, in somewhat fitful fashion, that investors can depend on the “full faith and credit” of the U.S. government – Congress agreed to a two-part program: $900 billion in 10-year cuts now, and $1.5 trillion in deficit savings in November. Deficit savings would depend on a combination of program spending cuts and higher tax revenues – on an up or down vote, meaning no earmarks, no amendments, just yes or no.

When it comes to spending cuts on automatic entitlement programs, arguably, the U.S. has not fared well. For example, Social Security is financed by non-marketable debt, whilst in Canada the CPP Investment Board is free to invest in assets that have a higher rate of return than government securities  — the ones the U.S. holds as I.O.U.s in a “lock box:” $2.6 trillion paying an average interest rate of 4.4%.

Medicare and Medicaid are different matters as health care seems to be the only spot today where there is visibly high inflation and for years, medical inflation has been running much higher than consumer price inflation, and well ahead of expenditures on health in other countries. A combination of factors may be to blame: higher physician salaries, higher drug costs, higher administrative costs, better technology, more testing and so on.

Complex questions. And highly political ones. But there’s still the revenue side, and the U.S. raises lower revenues than just about all OECD states. Some of that is due to the sad state of the economy. Federal revenues have dropped from an historical 18% of GDP to 14%, thanks to the lingering effects of recession. But some of it is due to tax preferences.

Some in the U.S. are appalled that GE pays no federal income tax. Others suggest it points to the futility of corporate income taxes and there are arguments, for and against – and also in between – that corporate income taxes encourage economic growth (through the deployment of excess capital), impede growth by discouraging risk taking, or come out in the wash, as they mostly act as a charge on labour income.

But those arguments are modelled on equilibrium environments – the fatal conceit in neoclassical economics, which always assumes a can opener for every can the consumer encounters. The reality is far more messy. No one pays posted tax rates. That’s because of tax preferences – subsidies, grants and exemptions and deductions. Hence a cheekily entitled article in the Wall Street Journal: “How You Can Pull A GE on Taxes.

Which is highly important for investors. On the retail level, we’ve seen that with labour-sponsored investment funds in Canada, the genesis of which was to encourage job creation. When they worked, they encouraged entrepreneurial endeavours, not so much jobs as wealth creation. Now some would say there’s too much venture capital money chasing too few venture opportunities, as Mark Suster and Paul Kedrosky have both commented.

Tax preferences can lead to the misallocation of capital. Jack Mintz, the Palmer Chair in Public Policy at the University of Calgary tackles it head on.

The United States needs major tax reform, rather than playing at the edges to make the system more progressive than it is already. U.S. income taxes are complex, inefficient and highly unfair. The statutory rates, once taking into account federal and state income and payroll taxes, are already high, even with the Bush tax cuts. The problem is that too many targeted preferences reduce the amount of taxes paid, undermining economic growth. Let me provide two examples.

“On top of the list is mortgage-interest deductibility for home ownership, one of the sources of the U.S. mortgage-market failure. This policy is likely the most economically harmful policy ever to be adopted (and one that Canadian governments have thankfully avoided). Since imputed income from owner-occupied housing is not taxed (except for capital gains in excess of US$500,000), interest deductibility is a pure subsidy for home ownership. The subsidy encourages Americans to invest in housing, rather than industrial capital. It also leads to excessive prices in the markets, as interest deductions are capitalized in housing values.”

The trouble here, of course, is that many homeowners who are house-wealthy don’t see themselves as rich. Yet, they are compared to the tenant population. And arguably the massive misallocation of capital involved in the housing bubble – encouraged by tax preferences – is at the heart of the U.S. fiscal ailments.

Then there’s the taxation of investment income. That has been a conundrum at least since Ottawa’s Royal Commission on Taxation, the Carter Commission, suggested in 1966 that “a buck is a buck.” Actually, it’s not. Interest income and wage income is taxed once; dividend income is taxed twice, once at the corporate level and again at the personal level. As for capital gains, well, a principal residence is excluded, and small business properties have a limited lifetime exemption.

There are similar discrepancies in the U.S. Current income –carried interest — for hedge funds and private equity partnerships is treated as a long-term capital gain, rather than a short-term trading profit. As Mintz writes.

Another example of needed reform involves the tax preference given to private-equity investors like Warren Buffett, which costs federal and state treasuries more than US$25-billion over 10 years. Typically, those engaged in financial trading as their main business would pay income taxes like any salaried worker. However, in the United States, private-equity investors can have a significant part of their earnings (carried interest) taxed at the capital gains tax rate on the presumption that this will encourage risk-taking. Given that governments share financial trading losses through mark-to-market rules, the risk-taking argument is poppycock. Such earnings should be fully taxed like other sources of income — this would certainly double Warren Buffett’s low tax rate.

“The list of special preferences in the United States is mindboggling and could fill a book on how not to run a tax system. A major tax reform that lowers rather than increases personal and corporate tax rates and eliminates a number of special preferences would make the tax system more efficient and fair, and it would grow revenue over time by growing the economy.”’

Expanding the tax base won’t solve the U.S.’s deficit problems. But it might help. It could even make it possible to reduce statutory rates. But the question is Clintonesque: it depends on what tax is. Is it what you’re supposed to pay, or what you actually pay. Until that question is answered, clever investors will arbitrage the difference.

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