Two Bad Choices in Tax Debate

I found this article very informative and I think it is worth sharing.

 

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By Patrick Watson

Remember when everyone wanted to cut the federal deficit? Fiscal policy was much simpler back then: balanced budget good, deficits bad. Times change. Now the House and Senate are considering tax legislation that, according to their own numbers, will add $1.5 trillion to annual deficits over the next 10 years.

This is okay, we’re told, because the tax cuts will stoke economic growth, thereby delivering added tax revenue that offsets the rate reductions.Note the bigger point here. Republicans still say they don’t like deficits—but apparently, this particular plan lets them cut taxes without adding more debt. It’s a miracle.

Is their claim really true? Will the GOP tax plans boost economic growth?

That’s the 1.5-trillion-dollar question.

Theory vs. Reality

The Republican plan’s centerpiece is a reduction in corporate tax rates from a 35% top bracket to only 20%. That would put the US more in line with other countries.

What you seldom hear is that most other developed countries also have value-added tax (VAT), a kind of consumption tax. The US doesn’t. Our tax system will remain different, and not necessarily better, under the new proposal.

Anyway, the theory is that lower tax rates will entice businesses to bring back operations they currently conduct overseas. They will build new factories and hire more US workers. Those workers will spend their higher incomes on consumer goods, and we’ll all be better off.

Unfortunately, that thinking has several flaws.

For one, as we saw in the NFIB Small Business Economic Trends report that business owners say that finding qualified workers is their top challenge right now. Reducing corporate tax rates won’t make new workers magically appear, nor will it improve the skills of those already here.

What increasing labor demand might do is spark that inflation the Federal Reserve has wanted for years. There’s also a good chance it could spiral out of control, forcing the Fed to hike interest rates even faster than planned—which could offset any benefit from the tax cuts.

Fortunately, such added labor demand will appear only if businesses respond to the lower tax rates by expanding US production capacity.

Will they? Let’s ask.

“Why Aren’t the Other Hands Up?”

This month, in one of its regular business surveys, the Atlanta Federal Reserve Bank asked executives, “If passed in its current form, what would be the likely impact of the Tax Cuts and Jobs Act on your capital investment and hiring plans?”

Here are the results.

Image: Federal Reserve Bank of Atlanta

Only 8% of the executives surveyed said the bill would make them increase hiring plans “significantly.” Only 11% said they would significantly increase their capital investment plans. A solid majority answered either “no change” or “increase somewhat.”

Other surveys reached similar conclusions.

White House Economic Advisor Gary Cohn had an awkward moment last Tuesday at a Wall Street Journal CEO Council meeting. Sitting on stage to promote the tax cuts, Cohn watched as the moderator asked the roomful of executives whether their companies would expand more if the tax bill passed.

When only a few hands rose, Cohn looked surprised and said, “Why aren’t the other hands up?”

So maybe they were distracted or needed a minute to think. Fair enough. A few hours later, White House Economist Kevin Hassett appeared at the same event and asked the same audience the same question.

He got the same result: only a few raised hands.

Pocketing Profits

None of this should surprise us. Tax rates are only one factor businesses consider when deciding to expand. The far more important question is whether consumers will buy whatever the new capacity produces.

Think about it this way: if you’re a CEO and you have difficulty selling your products profitably now, why would lower taxes make you produce more? Even a 0% tax rate is no help if you lack customers.

Former Brightcove CEO David Mendels explained how big companies view this:

As a CEO and member of the Board of Directors at a public company, I can tell you that if we had an increase in profitability, we would have been delighted, but it would not lead in and of itself to more hiring or an increase in wages. Again, we would hire more people if we saw growing demand for our products and services. We would raise salaries if that is what it took to hire and retain great people. But if we had a tax cut that led to higher profits absent those factors, we would ‘pocket it’ for our investors.”

By “pocket it,” Mendels means executive bonuses, share buybacks, or higher dividends. That’s what 10 years of Federal Reserve stimulus produced. A corporate tax cut would likely have a similar effect.

Choose Wisely

As I’ve said for months, I don’t think the House and Senate can agree on any significant tax changes. The two chambers have different political incentives they probably can’t reconcile.

So I think we’ll be stuck with the current tax system. The economy will limp along like it has been and eventually go into recession. The hope-driven asset bubble will pop, hurting many investors.

If I’m wrong and the GOP plan passes in anything like the current form, we will get higher deficits but little additional growth. The tax cuts will flow to asset owners and shareholders, probably blowing the market bubble even bigger. That will make the inevitable breakdown even more painful.

 

Do you agree with Patrick?

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Scary Financial Facts for Halloween

 

It’s that time of year when scary things come out on Halloween. However, when you open your door on October 31, will you be confronted by anything scarier than these hair-raising financial horror stories?

Will debt destroy your future?

  1. Student loan debt has reached $1.45 trillion dollars in the U.S. and $42.9 billion in Canada. U.S. graduates owe on  average of $37,712 and $27,000 for Canadians.
  2. Credit card debt is increasing in both countries. Americans carry an average of $16,000 and $4,100 for Canadians
  3. 107 million Americans have auto loans for a total outstanding debt of $1.2 trillion. It is estimated that 40% of the 120 billion dollars in auto loans in Canada are financed for 7 years or longer.
  4. Mortgage debt in Canada is a bigger problem than the U.S. because mortgage interest is not tax deductible. Average mortgage in Canada is around $200,000 (much higher in cities like Toronto & Vancouver) and $192,000 in the U.S.

Will someone steal your identity? 

First we find out that the Yahoo hack in 2013 exposed the information of every single one of their 3 billion accounts and then we find out that a data breach at Equifax exposes the personal information of 145.5 million people. Is there a single American who hasn’t been hacked yet?

The odds are great that your personal information is for sale to identity thieves or already in their hands. Can you foil them with credit freezes and other ID protection measures before it’s too late? Is it already too late? Does your VISA card contain mysterious purchases for 10 large screen TVs from Best Buy?

U.S Health Care Nightmare

Who knows what horrors await you if you become sick and your insurance premiums are too high for you to afford? Average out-of-pocket medical costs continue to rise, topping $10,000 in 2016. Meanwhile, premiums continue to rise on the health care exchanges.

Over the past four years, premiums in the individual marketplace have more than doubled. As insurers back out of some markets and political uncertainty reigns, premiums on the state insurance exchanges continue to rise rapidly. For example, rates in Georgia are up by 57%.

Scary lack of retirement savings

According to a report from the Economic Policy Institute (EPI), the mean retirement savings of all working-age American families, which the EPI defines as those between 32 and 61 years old, is $95,776. Almost 40 million households have no retirement savings at all.

Only 65% of Canadians are saving for retirement and on average have about $84,000 in retirement accounts. (RRSP & TFSA)

Frightening Canadian Energy Policies

  1. No access to foreign markets for oil & gas (besides the U.S.)
  2. Cancellation of Energy East pipeline (buying oil from the Middle East, selling discounted oil to the U.S.)
  3. Construction delays in Trans Mountain & Keystone XL pipelines
  4. No accountability for carbon tax revenue (how is this money spent?)
  5. 4 billion dollars of extra interest payments for reduced hydro rates in Ontario

Release the Nukes

What list of potential horrors would be complete without the prospect of nuclear war? The current tense relations between the U.S. and North Korea make that horrible concept more plausible and in addition to the terrible death toll and destruction of property, the financial impact on the world economy would be hard to imagine.

Remember the famous quote of Albert Einstein, “I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones.”

Now remember the leaders who have their fingers on their respective nuclear buttons. ARE YOU FRIGHTENED YET?

HAPPY HALLOWEEN!

 

Ignoring investment rules to achieve income

 

A few months ago, I asked readers for advice regarding a $300,000 inheritance. The couple are in their late fifties, debt free with little savings. Although, they are very fugal, they live paycheck to paycheck due to lack of steady full time work. Few companies want to hire older workers when they can hire young people for a lot less.

Being very good friends, they came to me for some free advice. After a few meetings, I realized that traditional investment strategies just wouldn’t work this couple. They have been dipping into their retirement accounts to pay bills. I recommended putting $100,000 back into their retirement accounts. The $200,000 into a joint investment account with a discount broker in order to split the income and save on fees.

Disregarding Asset Allocation guidelines

Based on their age and proximity to retirement, a 60% equities and 40% bonds mix would have been appropriate. However, investing in bonds with low interest rates, inflation and taxation doesn’t give them very much income.

Disregarding Diversification guidelines

Being Canadian, foreign dividends are taxed like interest payments similar to Canadian bonds. Plus, foreign assets are subject to currency fluctuations. The increased value of the Canadian dollar has wiped out all U.S dividends and most of the capital gains from owning U.S. stocks.

Disregarding suitability guidelines

This couple’s investment knowledge is very limited, their only investments have been in mutual funds with high management fees. After explaining how high fees will reduce their income, they agreed to take more risk in owning some individual stocks and exchanged traded funds.

Constructing a portfolio to maximize income and minimize risk

  1. I invested $61,418 in four Canadian Reits that generates $418.16 per month or $5,017.92 per year. The Reits income will be a combination of interest and capital gains. Compared to investing $120,000 in bonds yielding 3% per year or $3,600.00
  2. I invested $63,329 in three Canadian dividend stocks that generates $330.00 per month or $3,960 per year. Due to the couple’s low income, these dividends will be tax free income.
  3. I invested the balance of $75,253 into four covered call ETFs that generates $392.00 per month or $4,704 per year. The covered calls will produced capital gain income and the ETFs also has some dividend income in their monthly distributions.

Grand income total works out to $1,140.16 per month. The average annualized return on the $200,000 portfolio is 6.85% with a minimum amount of risk.  

This is only a temporary solution to achieve some monthly income until their work situation changes. Sometimes investment guidelines have to be broken because one size doesn’t fit all.

A reality check on Trump’s tax reform agenda

Still etched in my brain was the great income trust debacle that took place on Halloween of 2005. The Canadian conservative government won re-election promising not to change the tax preferred treatment of income trusts. That promise was broken and Canadian investors lost billions of dollars overnight. The value of my income trust holdings fell by 40% instantaneously.

Needless to say, as an investor in U.S. stocks, failure to appeal and replace Obamacare (ACA) makes me very nervous. Trump’s promise of massive tax cuts and infrastructure spending will need support from the Freedom Caucus (tea  party) who want a border adjustment tax to offset some of the loss revenue.

There is also a complicated Senate rule that would prevent Democrats from blocking the tax bill. Under the rule, the bill cannot add to long-term budget deficits. That means every tax cut has to be offset by a similar tax increase or a spending cut.

‘‘Yes this does make tax reform more difficult,’’ said Ryan. ‘‘But it does not in any way make it impossible.’’

Nevertheless, Treasury Secretary Steven Mnuchin said Friday the administration plans to turn quickly to tax reform with the goal of getting an overhaul approved by Congress by August.

House Republicans have released a blueprint that outlines their goals for a tax overhaul. It would lower the top individual income tax rate from 39.6 percent to 33 percent, and reduce the number of tax brackets from seven to three. The House plan retains the mortgage interest deduction but repeals the deduction for state and local taxes.

However, nearly 34 million families claimed the mortgage interest deduction in 2016, reducing their tax bills by $65 billion. Also, more than 43 million families deducted their state and local income plus personal property taxes from their federal taxable income last year. The deduction reduced their federal tax bills by nearly $70 billion.

On the corporate side, the plan would repeal the 35 percent corporate income tax and replace it with a 20 percent tax on profits from selling imports and domestically produced goods and services consumed in the US. Exports would be exempt from the new tax. (border adjustment tax)

The general goal for Republicans is to lower income tax rates for individuals and corporations and make up the lost revenue by reducing exemptions, deductions and credits. Overhauling the tax code is actually hard because every tax break has a constituency and the biggest tax breaks are among the most popular.

Over the past week, some investors are starting to doubt that the tax cuts will get passed. The value of the U.S. dollar has weaken and ten year bond yields have fallen  from 2.62% to 2.4%. Eight of the ten sectors that make up the S&P 500 were negative for the week. The biggest losers were U.S. financials (-3.72%), energy (-1.78%) industrials (-1.75%) and materials (-1.3%).

There is a lot of money on the sidelines that missed the Trump rally and are waiting for a stock market correction. I took some profits before the Canadian federal budget that hinted at tax increases so I also have some money to re-invest. The Canadian conservative government taught me a valuable lesson back in 2005. What government promises to do and what they actually do can have a negative affect on your investments.

 

Still doing tax returns for my adult children & their spouses

Every year I ask myself, should I continue to offer to do tax returns for my adult children and their spouses? All of them have university degrees and are smart enough to file their own tax returns. My daughter was willing to do it one year using tax preparation software with only a little help from me.

Part of my problem is Canadians are not even aware of how much tax they pay. Plus we keep voting for governments that buy votes using our tax dollars. The average Canadian family will pay 42.9% of their income in taxes imposed by all three levels of government in 2016. (Federal, provincial and local) Tax freedom day was June 7, 2016 if Canadians paid their total tax bill up front. Our U.S. neighbours tax freedom day was April 24th and they will only pay 31% of their income in taxes.

There are a number of reasons why I continue to offer to do tax returns for the whole family. Having worked as a financial advisor, tax planning is a key element when putting a financial plan together. My tax knowledge and skill comes from working many years with accountants and tax lawyers ensuring that my whole family pays the least amount of tax.

Plus, the Canadian tax system is very complicated and is constantly changing with every federal and provincial budget. For example: many tax credits that were given by the Conservative government have been taken away completely by a new Liberal government.

For the 2015 tax year, the Liberals cancelled income splitting for families, a maximum tax credit of $2,000 for transferring up to $50,000 of income to a spouse with a lower income if they had a child under 18 years of age.

Some changes for 2017 include the elimination of the following credits:

  1. Education and textbooks credit
  2. Children’s fitness credit
  3. Children’s arts credit
  4. Public transit tax credit

Now, most retired Canadian seniors who don’t have a pension from their former employer are not even aware of a $2,000 pension credit. It requires opening a RRIF account, transferring $2,000 from their RRSP and then taking it out. They don’t have to wait until they reach the age of 71 in order to open a RRIF account. Plus, RRIF income can be split with your spouse if both of you are 65 years of age which could potentially add up to $4,000 of income tax free per year.

The Federal Liberal government will introduce a new budget on March 22 and there are rumors of more tax increases. Three things that Canadians should worry about;

  1. Higher capital gains inclusion rate from 50% to 75%
  2. Reducing the dividend tax credit
  3. Taxing your principal residency 

I will end this post with two well known proverbs. ” In this world nothing can be said to be certain, except death and taxes.” & “A penny saved is a penny earned.”