Playing the Tax Credit Card

In the day following an historic election, we take a moment to examine just what an Obama presidency will mean to the United States – what we have to look forward to, and how he will deal with our current financial crisis. And according Jim Davidson, some of the numbers just don’t add up.

One of Obama’s prime campaign planks has been his promise to mercilessly raise taxes on the "rich," a group initially defined as those making more than $250,000 per year. This was later dropped to $200,000 per year, and more recently has been defined as those Americans making more than $150,000 annually.

Setting aside the precipitous downward slide in the definition of "rich," there is ample reason to suspect that Obama’s tax changes portend much higher, if not confiscatory taxes on the most productive Americans. Obama has strongly argued for higher taxes as a way of employing government to alter the pre-tax distribution of income, which he believes has concentrated too much of the gains from productivity in recent years in the hands of the very rich.

He seems to think that the "very rich" are a closed caste of more or less fixed membership, which changes little from year-to-year. This figures in his concept of "fairness," which supposes that it is perfectly just to burden a small fraction of the population with a majority of the costs of running the Federal government. This was detailed in a New York Times article on "spreading the wealth" by David Leonhardt. He wrote of Obama:

"He would then pay for the cuts, at least in part, by raising taxes on the affluent to a point where they would eventually be slightly higher than they were under Clinton. For these upper-income families, the Tax Policy Center’s comparisons with McCain are even starker. McCain, by continuing the basic thrust of Bush’s tax policies and adding a few new wrinkles, would cut taxes for the top 0.1 percent of earners – those making an average of $9.1 million – by another $190,000 a year, on top of the Bush reductions. Obama would raise taxes on this top 0.1 percent by an average of $800,000 a year. ‘It’s hard not to look at that figure and be a little stunned. It would represent a huge tax increase on the wealthy families. But it’s also worth putting the number in some context. The bulk of Obama’s tax increases on the wealthy – about $500,000 of that $800,000 – would simply take away Bush’s tax cuts. The remaining $300,000 wouldn’t nearly reverse their pretax income gains in recent years. Since the mid-1990s, their inflation-adjusted pretax income has roughly doubled.’

"To put it another way, the wealthy have done so well over the past few decades, with their incomes soaring and tax rates plummeting, that Obama’s plan would not come close to erasing their gains. The same would be true of households making a few hundred thousand dollars a year (who have gotten smaller raises than the very rich but would also face smaller tax increases). As ambitious as Obama’s proposals might be, they would still leave the gap between the rich and everyone else far wider than it burdensome on the young entrepreneur who was making his first millions as it would on the aging plutocrat who actually had enjoyed the prosperity of the past-quarter century since Reagan cut marginal tax rates."

An October 13 editorial in The Wall Street Journal clarifies the mysterious arithmetic of Obama’s sweeping claims to cut income taxes for millions who currently have no income tax liability and pay no taxes:

"For the Obama Democrats, a tax cut is no longer letting you keep more of what you earn. In their lexicon, a tax cut includes tens of billions of dollars in government handouts that are disguised by the phrase ‘tax credit.’ Mr. Obama is proposing to create or expand no fewer than seven such credits for individuals:

"- A $500 tax credit ($1,000 a couple) to ‘make work pay’ that phases out at income of $75,000 for individuals and $150,000 per couple.

"- A $4,000 tax credit for college tuition.

"- A 10% mortgage interest tax credit (on top of the existing mortgage interest deduction and other housing subsidies).

"- A ‘savings’ tax credit of 50% up to $1,000.

"- An expansion of the earned-income tax credit that would allow single workers to receive as much as $555 a year, up from $175 now, and give these workers up to $1,110 if they are paying child support.

"- A child care credit of 50% up to $6,000 of expenses a year.

"- A ‘clean car’ tax credit of up to $7,000 on the purchase of certain vehicles.

"Here’s the political catch. All but the clean car credit would be ‘refundable,’ which is Washington-speak for the fact that you can receive these checks even if you have no income-tax liability. In other words, they are an income transfer – a federal check – from taxpayers to nontaxpayers. Once upon a time we called this ‘welfare,’ or in George McGovern’s 1972 campaign a ‘Demogrant.’ Mr. Obama’s genius is to call it a tax cut.

"The Tax Foundation estimates that under the Obama plan 63 million Americans, or 44% of all tax filers, would have no income tax liability and most of those would get a check from the IRS each year. The Heritage Foundation’s Center for Data Analysis estimates that by 2011, under the Obama plan, an additional 10 million filers would pay zero taxes while cashing checks from the IRS.

"The total annual expenditures on refundable ‘tax credits’ would rise over the next 10 years by $647 billion to $1.054 trillion, according to the Tax Policy Center. This means that the tax-credit welfare state would soon cost four times actual cash welfare. By redefining such income payments as ‘tax credits,’ the Obama campaign also redefines them away as a tax share of GDP. Presto, the federal tax burden looks much smaller than it really is."

After all the sloppy definitions are parsed, one point remains clear. The top 5% of U.S. income earners, who presently pay 60.14% (2006 figures) of all income tax, are destined for a huge federal tax increase under Obama.

One of Obama’s specific proposals is to raise the capital gains and dividend taxes to 25%, which will sharply increase capital confiscation as increasing percentages of "gains" will reflect inflationary depreciation of the currency. In the U.S., an investor must pay tax on the difference between the sales price of an asset and it purchase price, with no adjustment for inflation. Consequently, when the tax rate and inflation are high, a large portion of the "capital gain" is illusory. Any asset that appreciates by less than the rate of inflation will result in its owner losing purchasing power and having to pay taxes on the illusory gains. At Obama’s higher tax rates, (he has suggested that capital gains and dividend taxes should be hiked to as much as 25%,) capital confiscation would result from modest levels of inflation.

And the Great Credit Crunch implies that inflation will be far higher than in recent experience.

Setting aside whether it is moral or equitable to force a small fraction of the population to essentially pay for the whole cost of government, much of which entails the shuffling of checks to purchase votes of various aggrieved groups, there is a bigger question. Can it be wise for the whole fiscal regime to stand on the shoulders of a small group, like a pyramid tottering on its point, so that any tribulation which undermines the prosperity of those who pay would promise to bankrupt the state?

It is a worthwhile question to ask if you have considerable assets. In light of the worldwide credit crunch, which has deflated assets of all kinds, the prospect of burgeoning prosperity at the magnitude required to enable one-in-20 Americans to become "Super Rich" benefactors of Big Government is vanishingly small. There won’t be enough rich people to fill the role assigned to them in Obama’s scheme. The result to be expected, in addition to confiscatory taxation, is a dramatic shortfall of revenues. This, in turn, implies surging deficits and deficit financing requirements that will rapidly swamp the capacity of the Treasury to borrow.


Jim Davidson
for The Daily Reckoning
November 05, 2008

James Dale Davidson has enjoyed astounding personal success founding new companies in a variety of industries. A graduate of Oxford University, Mr. Davidson is also a renowned venture capitalist and the author of bestsellers such as Blood In The Streets and The Great Reckoning.

As Dick Tuck put it, after losing a California State Senate election:

"The people have spoken…the bastards."

America’s voters spoke yesterday. And they said, "Give us Obama."

And it came to pass that the man called Obama was given unto them.

"America is a place where all things are possible," said the man himself in his victory speech.

And yes, it is possible for a half-black man to be elected. But no, all things are not possible. It is not still not possible to get rich by spending money. Nor is it possible to save a man from too much debt by giving him more credit. And you still can’t trust a politician…or his money.

The election "changed everything," shouts the headline on today’s International Herald Tribune. But the eternal verities still apply; Barack Obama is not going to change them.

And that means that a slump caused by too much debt cannot be made to disappear. You can disguise it. You can delay it. You can push the losses onto someone else. But you can’t escape it.

And now, thanks to an economist with the Nomura Research Institute in Tokyo, we think we have a clearer idea of how this downturn is likely to turn out.

We’ll get to that in a minute. First, a quick look at what is going on the world of money.

The Dow rose 305 points on Election Day. Investors are looking for any bit of flotsam or jetsam they can find to buoy them up. Anticipating an Obama victory, they thought things might change. The price of gold shot up $39. Gold buyers have their suspicions too.

"Post election rallies" are more myth than reality. Stocks rose strongly following Reagan’s first election to the White House…and again when Bill Clinton was elected. But neither Bush, pere nor fils, boosted stock prices.

Still, an Obama rally is probably on its way. Investors are ready for it. Practically every major investment guru is calling for it. "Stocks are cheap," they say. "This may be the greatest investment opportunity of our lifetimes," they add. Even the ‘contrarians’ are getting aboard. "Investors are frightened," they point out. "Confidence is down," they explain. "There’s blood in the street," they clinch the argument.

All over the world, people look to Washington with hope in their hearts…and humbug in their heads.

"A New World Dawns" proclaims Britain’s Daily Mirror.

People look at Obama and think they see a young Kennedy…they think they’ll be about to rerun the tape and do a little editing – a New Frontier without the Vietnam War…a Camelot without Lee Harvey Oswald.

But it’s not a New Frontier that America faces…it’s an old, worn out flimflam. It’s not a new dawn at all – a dark night is falling.

Our old friend Adrian Day, originally from London, England, now from Annapolis, Maryland, explains:

"The position of the United States today is approaching that of Britain at the end of World War II. Britain had been the world’s dominant economic, political and military power, with the world’s reserve currency. But by 1946 it was militarily stretched beyond its capacity, and highly indebted. The U.S. took over the #1 spot and the dollar became the world’s reserve currency, with the pound falling from five-to-one in 1946, down to parity four decades later.

"The problem with being the world’s reserve currency is that more money is created than is necessary for the domestic economy’s needs. For decades, the United States has created far more dollars than it needs, but it didn’t matter so long as other countries were prepared to buy and hold those dollars. But those dollars still exist. As other countries lose confidence and diversity, those dollars eventually come back…"

Yes, dear reader…a man must always compensate for his strengths. The U.S. had the world’s strongest and most reliable currency for half a century. It was our greatest strength and our biggest export. But this much IS changing: the dollar is no longer our biggest strength; it is becoming our biggest weakness.

*** Yes, we are figuring it out, dear reader. And the clearer the picture becomes, the more we realize we were right all along – almost.

"You really got the Japan story right," said Theo Casey, a London-based colleague yesterday.

Theo had just read our book, Financial Reckoning Day, written in 2002. In it, we suggested that America was following in Japan’s footsteps. At the time, we wrote so much about it in The Daily Reckoning that readers begged us to change the subject. And then…the subject changed on its own. Instead of beginning a Japan-style correction, the U.S. economy took off in an American-style bubble.

But now the bubble has popped. What now? Want to know? Just look at Japan!

Richard C. Koo has prepared a remarkable report: "The Age of Balance Sheet Recessions – What Post-2008 US, Europe and Japan Can Learn from Japan 1990-2005."

His argument is not far from the one we made six years ago. In the 1980s, Japan ran up stock and property prices in a spree of debt and leverage. Then, when the bubble popped, the usual monetary stimulus didn’t work. The Bank of Japan cut rates to almost zero…still, few people were willing to borrow.

The economy did not recover; instead, it got worse and worse until 2005 – 15 years later – when stocks had lost 72% of their value, land was down 81%, and golf course memberships had sunk 95% from their peak.

The problem, he explains, was that it was a "balance sheet recession," not a typical business cycle downturn. Companies, banks, and individuals had to pay down the debt that they had accumulated in the boom; they did not want to borrow more money, even at zero interest rates. For 7 years, from 1998 to 2005, net business borrowing went negative – meaning, businesses were paying off more debt than they were taking on.

This came as a shock to modern economists. Japanese officials were flummoxed. U.S. economists accused them of not acting swiftly enough…or not having the stomach to let the big banks fail. But almost no one seemed to understand what was really going on. They should have. Irving Fisher described it back in 1933, observing that when people who are deeply in debt get into trouble they usually sell assets. He called it a "stampede to liquidity." Investors dump stocks and property for any price they can get – desperate to pay off their debts before they are dragged into bankruptcy.

This is the phenomenon known to economists as the "fallacy of composition." What is good for every individual investor – cutting expenses, paying off debt – turns out to be bad for the economy itself. Asset prices fall. Sales fall. Unemployment rises. The slump deepens.

In Japan’s case, combined capital losses from land and stocks grew from 1990 until 2002, at which time they reached $15 trillion – or 3 years worth of Japan’s GDP.

You can do the math yourself, dear reader. America’s GDP is about $14 trillion. Multiply that times three and you get $42 trillion. So far, the U.S. has lost about $4 or $5 trillion in housing prices…and maybe another $6 trillion in stocks, for a total of about $11 trillion, maximum. A long way to go…

Tomorrow, we’ll explain why the U.S. will follow Japan’s lead – but only to a point. In short, Japan didn’t have the world’s reserve currency. And Japan also had savings – mountains of savings. The initial conditions are very different in the United States; the outcome will be different too. More tomorrow…

*** "The Joy of Thrift" is the cover story on this weekend’s Sunday Times Style supplement. As predicted, suddenly, thrift has become stylish.

"It dawned on me that nothing was going to change unless I made fundamental changes in my life," writes India Knight, describing her close encounter with bankruptcy. And then…the damascene conversion:

"Five years ago, buying stuff I didn’t need was my idea of bliss. But these days my treat of choice comes from a yarn shop in north London…and if I want to give someone I really care about a present, I may actually – gasp! – make them something. And here’s the clincher: I would consider the something as chic and stylish as anything a department store could have produced. Chicer, sometimes…

"There is something really gross about wanting something and buying it, just like that…thank you, AMEX."

*** Thrift has not exactly become chic in the Bonner household, but it is perhaps less out-of-style than it was a few months ago.

We are all skyping, rather than using the telephone. Our gardener has been given notice: no more overtime. No more fancy restaurants either; the Italian dive across the street will do just fine. And hold the $50 bottles of wine; we can’t tell the difference anyway.

So you see, we are roughing it. In this time of national hardship, everyone has to make sacrifices.

Your editor has dramatically reduced his commuting expense. Rather than buy a subway ticket for 1.6 euros, he rides a bicycle. These two-wheeled, unmotorized, non-electronic vehicles are big moneysavers.

To begin with, we don’t have to buy gasoline. And a bicycle costs you almost nothing to maintain – just adjust the brakes yourself; it’s easy. And you don’t need expensive auto-insurance.

Best of all, there are no costly repairs to make after a fender-bender – especially if you’ve fixed the brakes yourself. You’ll have no lawyers to pay. No points on your license. Almost all encounters between delivery vans and bicycles are fatal to the fellow on the bicycle. What a savings!

Until tomorrow,

Bill Bonner
The Daily Reckoning