Student Loan Reform

The Obama administration has proposed a solution to the student debt fiasco. From Yahoo News:

Obama will also call for caps on some student loans, limiting a borrower's payments to 10 percent of his or her income, and forgiving all remaining debt after 10 years of payment for those in public service work — and 20 years for all others.

This cap and forgiveness program is similar to the student loan program in the UK. The model helps reduce some of the asymmetries associated with student loan debt (really easy to obtain, hard to predict rate of return, and almost impossible ability to discharge) by ensuring there is a finish line to the loan race and by encouraging people to obtain higher education.

I fully support such a system. Education, particularly legal education, is a huge financial gamble. The current student loan system relentlessly punishes those who lose the bet until the day they die. This alternative model better helps apportion the risk of obtaining an education. While the individual who ultimately receives the education gets the most benefit (and correspondingly, should pay for that benefit), there is a huge societal interest in educating the masses. Because both the State and the student benefit, they should rightly split some of the risk/cost. Simply loading the debt onto the student without the possibility of discharge ensures that such a student will be held back financially for the rest of his life (hard to get credit if you can't pay your $3500 a month student loans).

This is a sensible solution. Let's hope it goes somewhere.

IRS Commissioner on Tax Code: It's too Damn Complicated

Said the Commissioner of the IRS today. From The Hill:

IRS Commissioner Douglas Shulman does not file his own taxes in part because he believes the tax code is complex.

During an interview on C-SPAN's "Newsmakers" program that aired on Sunday, Shulman said he uses a tax preparer for his own returns.

"I've used one for years. I find it convenient. I find the tax code complex so I use a preparer," Shulman said.

I don't blame him. During my Fed Tax I class, one of the exercises was to try to determine your annual tax liability using only the code and regulations. The exercise can take hours even for what is a relatively mundane return. What did the exercise teach me? That just like Commissioner Shulman, I too should use a tax preparer.

Google Tax

The French have solved the problem of Internet piracy: tax Google. From the AP (via Yahoo):

The report, handed to Culture Minister Frederic Mitterrand on Wednesday, says Google and other Internet portals should be slapped with a new tax on their online ad revenues in France to fund the development of legal outlets for buying books, movies and especially music on the Internet.

Essentially, France wants to subsidize media purchases (read: French media purchases) with a tax on the Internet companies who provide easy access to pirated media. The idea behind this Robin Hood-esque plan is that young people would then find legal avenues to purchase this subsidized and relatively cheap media rather than use Google to find it for free (albeit, illegally). Of course, the opposition cites the parade of horribles that would result from such a tax:

'Where does it start and stop? The argument is that Google has culpability for declining music revenues because people start searches for illegal files often by Google,' said Mark Mulligan, vice president of Forrester Research. But 'what about the computers? Because without the computer people wouldn't be able to download. And then what about the electricity that powers the computer?'

There may be a hint of truth in this slippery slope. A tax on search providers (like Google) is bound to be "leaky". Essentially, if the French are only going to tax Google's French revenues, Google will simply rework its advertising contracts to other EU member states to dodge the tax (the EU is a common market, it can be pretty easy to avoid these kinds of taxes, particularly when they do not involve physical goods in the country). Google will still get its revenue and France will not collect its tax. And if you can't collect the cash from Google - well then just go after the items that cannot easily be moved (like the electricity to the computers that steal the music).

While I sincerely doubt that the French will implement an electricity tax to pay for young people's (French) music tastes, I do believe that France will ultimately set up this type of tax and subsidy scheme. The French have a habit for such interventions into the marketplace, a system affectionately known as dirigisme. But as discussed above, this tax-subsidy system will probably not work and in all likelihood, will wind up driving online advertising revenue away from France.

So why would France bother with such a potentially useless tax? Simple - because it's broke. With record deficits plaguing the developed world, new and novel taxes will begin cropping up to help contain some of the fiscal destruction. The more of a "moral" label a country can place on a tax, the more likely the tax is to be implemented. The French have found a convenient enemy in search providers: they are the gateways to broad-based theft. What better justification to tax someone than the fact that you will use the revenues to right a wrong. A little hint: with 10%+ of GDP deficits, that tax money is just going to wind up in the general fund.

I hope Congress isn't following the French news.

A Current Look at the Deficit and Proposed Tax Changes

Time for an update on our nation's deficit. As you may know, the United States' total debt is limited to a statutory ceiling set by Congress. Currently, this ceiling is $12.1 trillion. As of Friday, November 13, 2009, our nation's debt stood at $11.99 trillion. At our current rate of cash burn (something like $100 billion a month), we don't have very long before we hit the ceiling. Congress will likely increase the ceiling, albeit with some huffing and puffing from deficit hawks, because a failure to do so would constitute a default by the United States and would shut down the government (that being said, such a situation happened before in 1995).

Increasing the debt ceiling may keep the wheels of government spinning, but it does nothing to fix the underlying problem: the gargantuan chasm between spending and revenue. Recognizing this, the Obama administration is floating some interesting proposals for dealing with the epic mismatch:

1) Domestic agencies will likely face a 5 percent cut or a freeze of their budgets;

2) Excess TARP money may be used to reduce the debt (somewhat circular in that TARP is all borrowed funds to begin with);

3) The roughly $47 billion a year Medicare fraud industry will (hopefully) be attacked.

Congress is also looking at ways to "generate more revenue" (read: raise taxes) to not only reduce the deficit, but also to pay for new domestic programs such as health reform. For example, the recently passed health bill contains a 5.4 percent surtax on individuals making over $500,000 and families who make over $1,000,000. Interestingly, unlike most of our tax brackets, this surtax is not indexed for inflation. That means, essentially, that more and more people are subject to the tax as their nominal incomes increase into the area covered by the bracket--a phenomenon called bracket creep.

As currently implemented, the surtax would affect 0.3 percent of taxpayers in 2011 and due to the lack of indexing, 0.5 percent of taxpayers in 2019.

My Dad Makes More Money Than Your Dad

Probably not true (Social Security doesn't make for a lavish salary), but it would be easy to find out that kind of information in Norway. From Yahoo (via AP):

It's the moment nosy Norwegian neighbors have been waiting for — the release of official records showing the annual income and overall wealth of nearly every taxpayer in the Scandinavian country.

In a move that would be unthinkable elsewhere, tax authorities in Norway have issued the skatteliste," or "tax list," for 2008 to the media under a law designed to uphold the country's tradition of transparency.

Cash for Condos

The first-time home buyer tax credit is due to expire next month. Anticipating the death of the credit, first-time buyers rushed to the market and helped to push up September home sales. Of course, commentators anticipate that home sales will collapse as soon as the credit expires (call it the cash-for-clunkers effect). From Bloomberg:

The $8,000 credit for first-time buyers, due to expire Nov. 30, has probably pulled sales and construction forward, signaling housing may cool in coming months. While Congress is considering extending the incentive, lower prices and mortgage rates have also contributed to steadying a market that endured the worst slump since the Great Depression.

“The rush to take advantage of the tax credit is obviously pushing up sales,” said Michael Gregory, a senior economist at Capital Markets in Toronto, who forecast sales would rise to a 5.5 million pace. “Although this is going to be temporary, it does absorb some excess supply and helps bring the market into balance going forward.”

A Farewell to Stimulus?

The IRS' UBS prosecution is working. In fact, it is working so well that the IRS has decided to open up shop across the globe to ferret out secret accounts held by US residents.

From Bloomberg:

The IRS will open offices in Beijing, Panama City and Sydney in connection with the probe, which has revealed accounts held in 70 countries and every continent except Antarctica, he said. The agency also intends to hire more than 800 new employees in the next year and add staff to eight existing overseas offices, including Hong Kong and Barbados.

So is this a good thing? It seems clear that the current administration is bent on closing the tax gap by actually enforcing the existing tax laws (Hint: recent estimates put the tax gap, the difference between what is owed and what is collected, at well over $300 Billion). Good. Better to collect from people who under pay now rather than punish compliant taxpayers with higher rates in the future (for instance, through the imposition of a crippling Value Added Tax).

But there is a dark side to the IRS' increased enforcement efforts. The IRS will be draining private investment funds to pay the US' ballooning debt obligations. In effect, money will be moved out of the capital markets and (theoretically) productive investment opportunities to the black hole of government spending. Translation? An effective tax hike.

Of course, in any normal times, requiring taxpayers to pay what they already owe is not a controversial position. However, when an economy is in a recession, government generally acts to stimulate private industry back into action. This stimulus is usually accomplished by issuing debt, expending funds, and hoping the multiplier effect does the trick (essentially, allowing the money to flow through to private entities who spend it on other items which helps boost GDP).

But when government simultaneously increases the effective tax rates, it acts to damper the stimulus and can prolong the recession. Some argue this is exactly what happened in Japan in 1997: Japan prematurely increased taxes which helped prolong its asset price bubble recession. Nothing about what subsequently happened in Japan is something we want to happen in the US.

So while the IRS' collection efforts are warranted, perhaps they are badly timed. Of course, it could turn out that the IRS' bounty will amount to a mere pittance. But if it is any serious amount of cash, the government may just be shooting its stimulus package in the foot.

More Bad News for the Golden State

Things have not been going well for California. Despite the State's efforts to balance its budget and reform its tax system, revenue is still declining.

From Bloomberg:

Revenue in the three months ended Sept. 30 was 5.3 percent less than assumed in the $85 billion annual budget, state controller John Chiang reported yesterday. Income tax receipts led the gap, as unemployment reached 12.2 percent in August.

And this is after drastic shock treatment:

The latest figures show that California is facing resurgent fiscal strains brought on by the U.S. recession. Since February, Schwarzenegger and lawmakers have cut $32 billion from spending, raised taxes by $12.5 billion and covered $6 billion more with accounting gimmicks and borrowing. Even with those actions, state budget officials predict an additional $38 billion in deficits in the next three fiscal years combined, including $7.4 billion in the year starting July 1.

Other than Professor Stark's novel proposal, no one seems to have a good solution for what ails California. Meg Whitman, the former CEO of eBay and a candidate for governor, suggests that California should fire 40,000 state employees to help reduce spending. Of course, firing that many politically well-connected people smells a bit of unreality to me.

Alas, without further spending cuts and with a legislature unable to secure public approval for more tax increases, it looks increasingly likely that California will need a constitutional convention to save itself from the poor house.

Stay tuned for an article about what the California constitutional convention would entail and how it would reform the State's budget system. Creating a government from scratch? It's a law student's delight.

Nearly Half of America Pays No Federal Income Tax (TTT)

Yes, it is true. According to CNN, 47% of Americans will pay no federal income tax this year. Perhaps even more shocking is that:

Nearly 22% of those making between $50,000 and $75,000 end up with no federal income tax liability or negative liability as do 9% of households with incomes between $75,000 and $100,000.

Can a country running a $1.6 trillion deficit really allow so many of its citizens to escape the burden of taxation? Should all citizens be required to remit a portion of their earnings to the treasury as the cost of their citizenship, even if only a token amount?

Whatever your feelings, expect to see that 47% number to drop considerably in the very near future.

I'll be Taxed

Time for me to chime in on the tax reform proposals in the Golden State. California's budget system is broken. The recent patchwork by the legislature failed to fix the fundamental problem in California's revenue system: volatility.

California uses a steeply progressive income tax to generate the bulk of its revenue. In fact, the system is so progressive that:

More than half of California's income tax revenue is paid by those with incomes of $200,000 or more.

That is an awful lot of revenue generated from a very small group of people. That small group ("the Rich") tends to generate their income from volatile investment activities in the form of capital gains (i.e. gains on stocks, bonds, hedge funds, etc.). When asset performance degrades, the Rich tend to take the brunt of the losses and ultimately remit less money to the treasury. Conversely, when assets perform well, the Rich tend to make enormous gains and treasure flows from Sacramento to the rest of the State.

California (and to a similar extent, the federal government) have placed a leveraged bet on the Rich. When their income goes up, the State profits handsomely via capital gains taxes and high marginal rates while sparing the rest of the taxpayers. When the Rich's income declines, however, the leveraged bet collapses (a dollar lost on someone who is taxed at 20% is a bigger hit to the State than a dollar lost on someone who is taxed at 5% or has no capital gains income to tax at all). A downward movement in the Rich's income creates an enormous drop in revenue that devastates the State's finances.

This is exactly what happened this year in California. With the demise of the Rich, so went California's budget.

The proposed solution is a fairly simple one: abandon steeply progressive rates in favor of flatter rates on more types of income (e.g., instead of 20% and 5% income brackets on individuals income, have a 10% flat rate and add a flat tax on businesses). If the State had a broader tax base and a flatter rate, volatility would decline. Of course, the odds of giving the Rich a tax break during a fiscal crisis, particularly in California's notorious Legislature, seem like a snowball's chance in...well...you know.

Perhaps there is a better way. Professor Kirk Stark at UCLA School of Law has come up with a novel suggestion. To reduce volatility, require the State to apportion out capital gains taxes over a period of years. The Professor explains his idea quite elegantly:

But rather than reducing taxes on wealthy investors, why not just unhitch the timing of their tax payments from the boom-bust cycle of the market? This could be done quite simply by giving taxpayers who incur capital gains taxes the option of claiming a "capital gains tax credit" that would be recaptured over the ensuing three years. As an example, let's assume that the amount of the credit is 75 percent of the capital gains taxotherwise owed in the year of the sale. In our example above, Mickey would be entitled to a credit of $1,500 (i.e., $2,000 multiplied by 75 percent) in the year that he sells his Disney stock. His tax liability for the year of the sale would be $500 ($2,000 minus $1,500) rather than the full $2,000. This credit would then be recaptured (i.e., paid back) in three equal installments over the next three years, with the result that Mickey would add $500 to his tax bill for each of the next three years. The bottom line is that a $2,000 tax bill would be paid over a period of four years.

The net effect of this system - i.e., combining an upfront tax credit with a recapture rule - is that capital gains tax revenue would drip into the state in smaller increments rather than surging during the boom years and later drying up completely. It also bears noting that this system offers something of a preference for capital gains, since it operates like an interest- free loan from the state to taxpayers who would otherwise have to pay the capital gains tax upfront all at once.

Tax the rich, reduce revenue volatility, and entice people to invest? I think the Professor is onto something. Perhaps he should run for office.

Your Friends and Mine. . . .

Happy Labor Day! Now on to the post:

While the details of any health bill are still being hammered out, there will be one certain outcome of any bill: the IRS will have a whole lot more power.

Here is a laundry list of the (likely) new powers Congress will bestow upon the Service should any health care legislation pass:

1) You will have to report your health insurance status to the IRS;

2) Your insurer will have to report your health insurance status to the IRS (you thought they would trust you?);

3) The IRS will be responsible for fining you if you fail to purchase adequate insurance;

4) The IRS will be responsible for administering a web of subsidies and tax credits to help low-income individuals obtain health insurance, including releasing your tax information to a central authority who will determine if you are eligible for those credits and subsidies.

That last point is one of the scarier ones. If you thought having Progressive Auto Insurance watching you from the skies was unsettling, just imagine your earnings history, address, social security number, and any other juicy tax tidbits suddenly finding themselves spawned across several government computer systems.

But that's not all! Not only will your information be spread throughout the "system," but the government is also planning to use your tax returns to advertise other government services to you:

In H.R. 3200, the IRS would be required to provide taxpayer information to the Social Security Administration for the purpose of helping Social Security officials find qualifying seniors who can then be encouraged to enroll in the prescription drug program. 'There is no precedent for using taxpayer information for the purpose of identifying people to go out and advertise to them,' says the House expert.

Should your information really be used this way? Tax returns have generally been treated with a high degree of confidentiality. This confidentiality seems reasonable considering that everyone is required to provide their annual earnings information to the government (Tip: Your 1040 is not optional). Essentially, the government acknowledges they are invading your privacy, but in exchange, they promise to keep your information safe (theoretically). Maybe we are witnessing the end of that grand bargain.

Check your mailbox, the government may have sent you a notice indicating that you are eligible for their cheese.

The Taxman Cometh

Hello everyone, I will be (one of) your new bloggers here at BBL. I have a particular interest in tax law and economics so I found the following article interesting.

According to Bloomberg, Wegelin & Co., Switzerland's oldest bank, is requiring customers to dump their U.S. assets or close their accounts. As you might have guessed, Wegelin's decision has to do with the recent battle between UBS and the IRS. Essentially, Wegelin believes it will be less onerous to require its customers to dump their U.S. assets rather than comply with the ever increasing reporting requirements demanded by the I.R.S.

While the I.R.S. has a legitimate interest in collecting tax owed to it from U.S. citizens and certain foreign persons holding U.S. based assets, its efforts may cause more foreign banks to follow in the footsteps of Wegelin. And that my friends, is a bad thing.

Offshore financial institutions hold approximately $7 Trillion in assets. If these institutions start insisting their clients dump a certain asset class, the supply of that asset will increase and its price will tend to decline (assuming, like all economists, we ignore many of the realities of the universe). Thus, if offshore institutions start dumping lots of U.S. assets (likely a healthy chunk of that $7 Trillion dollars), U.S. asset prices will begin to decline.

Normally, it is not such a big deal that U.S. assets are getting cheaper. However, we are currently in the midst of a financial crisis that was precipitated in large part by the fall of asset prices. It is difficult for U.S. financial institutions to raise sufficient capital and "get healthy" unless the value of their assets begins to increase. Dumping large quantities of U.S. assets onto the market will make any financial recovery just a bit more difficult.

Should the IRS continue to pursue its crack down on tax-shelters? It depends. Does the short term gain of more (badly needed) revenue outweigh the potential cost of propping up more financial institutions in the future? The I.R.S. and our current administration certainly seem to think so!