UAW troubles a harbinger of things to come

While we watch the slow death of the big three from the weight of massive liabilities due to excessively generous pension and health care benefits, it should be noted that the automakers are just an illustration of what will be happening at an even larger scale across the company with another large segment of the workforce:   government employees. 

State employees have pension and health care benefits comparable to what the UAW has extorted from the Big 3.  However, the key difference is that state employees have near iron clad job security.  The Detroit News had a great report on how the Michigan Teachers' Pension plan will bankrupt many districts from their overly generous benefits (see here, here, here).  This is not just a Michigan problem.   Almost every state has this issue, and it will get worse over time.  Most governments will not tackle this because of the power of the state employees unions (see the budget crisis in California and how there are no layoffs, just tax increases).

The difference between the Big 3 and the state governments is that we have no choice in funding the state employees.   We do not have the option to not pay taxes.   The solution has a ton of up front costs and would ensure a huge political and legal fight.   The fair way to deal with this is to convert all defined benefit plans into defined contribution plans (e.g. 401(k)).  It would apply to all workers under a certain age or seniority.   Current retirees or those close to retirement would be exempted.   The same actuaries that run the pension plan would figure out for each plan contributor what their current pension would be if they retired on the conversion date, and the state would pay a lump sum into their 401(k) equal to the amount necessary to buy an annuity at conversion date rates to fund that.   From that point on, the risks are transferred to the employees from the taxpayers.   This would need to be coupled with a plan that makes retirees responsible for their own health care expenses at retirement (like pretty well everyone else who is not a union/government employee).   

This would be the mother of knock down/drag out fights, with legal challenges galore - but it has to be done.  During these tough times, perhaps some forward looking state politicians will start demanding change before the structural costs cripple the economy.

UAW bailout - debating point du jour

I have been listening to a lot of talk radio about the auto bailout the past few weeks, and it is always interesting when I hear some of the arguments made by UAW members as to why their perks should be subsidized by the American taxpayer.   One that I have heard a few times is that it is OK for the Feds to bail out the big three because Southern States have been giving tax money to the foreign automakers to build in their states.

Is it true that foreign car makers get unfair tax incentives from Southern state governments?   This is kind of half true.   Now, for the record, I am not in principle a big fan of "targeted tax relief" in the form of incentives, as it reeks of state governments picking winners and losers.  Plus, I think sound tax policy focuses on making taxes as low as possible for all business, not just big ones looking to invest in your state.     That being said, it is true that Tennessee, Alabama, Georgia, Mississippi, and South Carolina have been very aggressive in putting together attractive tax packages to lure factories in their states.  

But what is also true is that the Big three have been playing this game for years in the Mid-West and Canada.  When Chrysler mulled expanding Jeep production, the State of Ohio and the City of Toledo made sure that there were ample incentives to expand on their existing site there.   When the automakers consider scaling back production in Ontario.   The Canadian government and the province of Ontario are there with massive packages of tax credits and loan guarantees.  The state of Michigan and the City of Detroit gave some generous tax breaks when GM bought and moved its headquarters into the Renaissance center. So, when your UAW flack talks about the "unfair" tax subsidies that foreign automakers got to locate in the South, tell them they were just following the lead of the big three.

Into the Crystal Ball

After being to a few investment symposiums (one of the benefits of having the CFA charter) and doing my own overview of the markets, here are a few things I think are probable:

1. Long term interest rates will go up significantly while short term rates will stay low (i.e. a very steep yield curve).   One of the reasons is because of all the debt the U.S. government will have to issue over the next few years.   Currently, the 30 year bond is yielding 3.66%.   Warren Buffett got 10% yield on his preferred interest on his investment in Goldman Sachs.   The Chinese, with their massive dollar reserves, will be financing this, like it or not.   They will not accept a 3.66% return on their money if Buffet is getting close to 10%.   The yield on a 30 year bond will be hitting 8% over the next year or so in order to pay for the TARP program and whatever else Congress dumps on us.
2. If we are looking at a 8% 30 year bond rate, the stock market will drop to a level relative to this.   If we assume a 3% dividend yield (a bit on the hight side) to make the math earlier and a 30% risk premium, the S&P combined earnings and dividend yield (i.e.  dividend yield plus the inverse of P/E) should be roughly 13%.   That implies an earnings yield of 10% or a P/E of roughly 10.  S&P 500 earnings will likely drop by about 30%, so that gives an implied index level of 450 as the bottom - so a worse case scenario of a 40% + drop.   Mind you, that is a worse case scenario, but I can see it dropping down below 600.
3. Commodity prices will continue on a short term downtrend, and will start back on an upward swing  once the markets start to recover from their bottom.
4. There will be another major bank failure in the next year.

Tax Planning tips for the new administration

I have talked to CPAs who are advising this already.  The consensus that taxes are going to go up a lot starting in 2009.  The tax planning for anticipated rate hikes is the 180 degree opposite of traditional tax planning, which are:

1. Make any anticipated capital asset sales now while the 15% capital gains tax rate is still around.
2. If you have a C corp, and are anticipating distributing Earnings & Profits - make the dividend now while 15% dividend tax rate will be around.
3. Accelerate all revenue streams (i.e. complete contracts, etc) to have as much in 2008.
4. Exercise any employee stock options now  - it might be better with 15% tax rate in a crappy market than 25% in a good market.  Then again, we don't know where the dividend rates are going, they might go back to the top marginal rate.
5. Accelerate your gifts for 2008 and consider electing to pay gift tax.   Minimize the estate and gift out as much in anticipations to changes to gift and estate taxes.

This is some of the things that people are doing right now.   Miami Dolphins owner Wayne Huizenga has already said that he will now attempt to sell his remaining 50% interest in the team in 2008 rather than in risk substantially higher promised future capital gains tax hikes by the democrats.   Huizenga said " He wants to double the capital gains tax, or almost double it.   I'd rather give it to charity than to him."

Remember, this is generally one of the reasons why increase in marginal tax rates don't work - people with the means to plan accordingly, do so.    Hint to the Democrats - if you really want to raise revenue, expand the base and lower the rate.  But then again, Obama has said that he will forego revenue in the name of "fairness".

Well, the bright side is that CPA's like myself will continue to be employed and see additional work as people try to figure out the inevitable tax changes that are being anticipated.

Barrack Obama = Pierre Elliott Trudeau

It has been almost 25 years since Trudeau left 24 Sussex drive, and we are still dealing with the wreckage of his policies (Constitution, NEP, welfare state).   Their lives are parallel in many ways.  Check out the wiki post on PET.  Ignore the Liberal hagiography of his political accomplishments - ask any Albertan about the NEP.   

America, you've been forewarned.   

A modest tax proposal

We have heard enough about what the candidate's tax plans are.  We know the current system is complex, and distorts economic decisions, and on some levels - unfair.  

Ideally, I think the 16th Amendment should be repealed.  Washington should not have been given the ability to tax income because it gives too much money, and thus too much power to meddle in our lives.    Ideally, a 10% VAT, excise taxes, and modest duties should cover the duties that are the prescribed powers of the federal government per the constitution.   But let's just admit that is not happening any time soon.  Sorry fair taxers, we're stuck with the income tax for a while.

So what principles do we want for an income tax system.  I would propose the following:

1. That it raise sufficient revenue to cover necessary government expenditures (sorry - this would probably mean a realistic downsizing of the Washington - i.e. no more department of education.
2. Not distort economic decisions - it should try all types of income the same - a person making $100K/year only as salaries should pay the same amount of tax as someone who makes $100,000/year on dividends.
3. Everyone should pay a de minimis tax.   I do not believe that people should not have to pay tax if their income falls below a certain level - citizens should all bear a minimum burden for the government they want so that they do not become detached from the costs of running it.   
4. Not be burdensome on those of modest means.
5. Simple to administer (this is tricky, you will still need a ton of volumes to define things, even a simple income tax needs to determine a lot of things).

So this is kind of what I came up with.

1. Income tax with one bracket of 20%.
2. All income taxed at same rate - interest, dividends, capital gains, wages...
3. Capital gains is determined with a CPI adjustment in order not to be taxed on inflationary changes in prices.  
4. Capital losses are 100% deductible immediately.
5. Only itemized deduction is charitable contributions - but with no income limitation.  No more deduction for state and local taxes (subsidizing those living in high tax states) and mortgage interest (no more distorting the housing market and putting renters at disadvantage).
6. Standard deduction of $10,000/filer and $5,000 per dependent.  Married filing joint with two children have $30,000 deduction.
7. Minimum tax is $250 - regardless of income.
8. Contributions to tax deferred retirement accounts deductible - no limitations.  However, early withdrawals subject to 15% penalty.

James Grant on the credit bubble - WSJ

James Grant is one of my favorite market commentators. Read his article in the Wall Street Journal on the confidence game that is the US dollar and credit markets. The key passage in my opinion:

But it wasn't the vigilance of monetary policy that facilitated the construction of the tree house of leverage that is falling down on our heads today. On the contrary: Artificially low interest rates, imposed by the Federal Reserve itself, were one cause of the trouble. America's privileged place in the monetary world was -- oddly enough -- another. No gold standard checked the emission of new dollar bills during the quarter-century on which the central bankers so pride themselves. And partly because there was no external check on monetary expansion, debt grew much faster than the income with which to service it. Since 1983, debt has expanded by 8.9% a year, GDP by 5.9%. The disparity in growth rates may not look like much, but it generated a powerful result over time. Over the 25 years, total debt -- private and public, financial and non-financial -- has risen by $45.1 trillion, GDP by only $10.9 trillion. You can almost infer the size of the gulf by the lopsided prosperity of the purveyors of debt. In 1983, banks, brokerage houses and other financial businesses contributed 15.8% to domestic corporate profits. It's double that today.

The dirty secret of Obama's job creation tax credit

So Obama is now proposing a temporary tax credit of up to $3,000 for firms that hire new workers.   I'll tell you why it is a scam, and is typical of the sound goods on the stump/sucks in reality:

1. The full credit doesn't kick in till $75K.   Most new jobs are well below that.
2. If they business is a S-corp/partnership - Obama's proposed income tax increase and FICA limit increases will not be offset by this credit.
3. If you are a Schedule C/S-Corp/Partnership - the credit in all likelihood will not be creditable against AMT.   Most tax credits are not good for AMT for individuals.  So, you might get the credit for regular income tax, but then it'll be taxed right back under AMT.

Basically - the credit is useless for small business.   When taxpayers normally talk about tax credits - they never work because the bulk of them are not creditable against AMT.

To John McCain: Campaign advice from Herm Edwards

There are opportunities in the markets

What I love about panics like this, is that there are some great companies now on sale.  I see many well run companies now at valuations where I can envision buying them.   I have become, though experience a Graham/Dodd value investor.   For those of you who aren't familiar - this is classic value investing - placing emphasis on a strong balance sheet and buying stock priced with a "margin of safety".

We have been due for a sustained bear market for a while.  We haven't had a real one since the 70's.   The media and most people do not remember what a sustained bear market is like, as most of us were too young or not born yet to fully grasp it.   It is a bit of a shock, as too many people have been conditioned to think of perpetual growth in the markets with minor dips here and there. 

Everybody needs to chill out, and just understand that it is not the end of the world.   The markets will eventually sort itself out as they find natural support levels and stabilize.   The best things people can do is save, pay off your debts, and start looking for investment opportunities in the markets.

To paraphrase the great emerging markets manager Mark Mobius - "the best time to buy is at the point of maximum pessimism".   Keep that in mind when watching the market.   Those who keep their heads on a swivel and have cash available will reap the rewards.