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Posts Tagged ‘Congress Inaction

How Tax Increases and Redistribution Really Works

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

It seems every election cycle brings with it the issue of who should bear the cost of government spending and to what degree.  For many, the discussion begins with taking it from the rich and giving it to the poor.  It’s as old as Robin Hood – probably older.  And, since there are more poor people than rich, it plays usually plays well at the ballot box.    

While most voters may not understand economics, they do know when they’re out of work; and they don’t like seeing their jobs going overseas.[i] Unfortunately, the U.S. tax code has become a ‘book of favors’ – a virtual  ‘jobs protection act’ for elected officials primarily concerned with raising money for the next cycle and insuring votes for re-election.  

How do tax cuts really work?  IMHO the following little story[ii] – entirely made-up – provides a good example of how capital follows opportunity.

Here’s our scenario: Every day, ten men go out for dinner. The bill for all ten comes to $100  (I know, that couldn’t happen, but we’ll pretend).  If they paid their bill the way we pay our taxes, it might look something like this[iii]:

  • The first four men (the poorest) would pay nothing.
  • The fifth would pay $1.
  • The sixth would pay $3.
  • The seventh $7.
  • The eighth $12.
  • The ninth $18.
  • The tenth man (the richest) would pay $59.

So, the ten men ate dinner in the same restaurant every day and seemed quite happy with the arrangement, until one day the owner threw them a curve.

“Since you are all such good customers,” he said, “I’m going to reduce the cost of your daily meal by $20.”

Now the dinner for all ten cost only $80.  The group still wanted to pay their bill the way we pay our taxes.
So, the first four men were unaffected. They would still eat for free. But what about the other six, the paying customers?   How could they divvy up the $20 windfall so that everyone would get his ‘fair share’?

The six men realized that $20 divided by six is $3.33.  But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being ‘PAID’ to eat their meal! 

So, the restaurant owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay[iv].

Here’s how it turned out: 

  • The fifth man, like the first four, now paid nothing (100% savings).
  • The sixth now paid $2 instead of $3 (33% savings).
  • The seventh now paid $5 instead of $7 (28% savings).
  • The eighth now paid $9 instead of $12 (25% savings).
  • The ninth now paid $14 instead of $18 (22% savings).
  • The tenth now paid $49 instead of $59 (16% savings).

Seems fair enough.  Each of the six was better off than before.  And the first four continued to eat for free.   But once outside the restaurant, the men began to compare their savings.

“Hey!  I only got a dollar out of the $20,” declared the sixth man. He pointed to the tenth man “but he got $10!”

“Yeah, that’s right,” exclaimed the fifth man. “I only saved a dollar, too. It’s unfair that he got ten times more than me!”

“That’s true!!” shouted the seventh man. “Why should he get $10 back when I got only $2?”   He became upset at the injustice.  “The wealthy get all the breaks!”

“Wait a minute,” yelled the first four men in unison.  “We didn’t get anything at all. The system exploits the poor!” 

The nine men surrounded the tenth and beat him up.  Apparently, tax breaks for the wealthy aren’t popular. 
You can probably guess what happened after that.    The next night the tenth man didn’t show up!   So, the nine sat down and ate dinner without him.   

Alas, when it came time to pay the bill, they discovered something important:  They didn’t have enough money between all of them for even half of the bill!   Oops.

It’s a simple lesson many journalists and college Keynesian-schooled professors have problems grasping, yet this is how our tax system actually works!    Tax laws have historically been used to direct the flow of capital.   And, the ones who get the most money back from a reduction are – or should be – those who paid-in the most to begin with.   

Here’s the lesson of our dinner group story:  

Increasing taxes on those we feel have too much capital, simply because they have wealth, destroys their incentive.  As in our story, they just may not show up “at the table” anymore.   They will remind us all there are lots of good restaurants in China, India, South Korea, Europe and the Caribbean.    They know – and we should too – jobs are created where capital is directed.  If we provide incentives to direct capital someplace else, we will simply be draining capital from the economy and the rest of us will be stuck with a bigger bill.

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The Independent Financial GroupJim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an ACCREDITED INVESTMENT ADVISOR® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  IFG also does not provide tax or legal advice.  The reader should seek competent counsel to address those issues.  Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan.  The Independent Financial You can reach Jim at 805.265.5416 or through the IFG website, www.indfin.com, the IFG Investment Blog and by subscribing to IFG Insights letters for individual investors.  Keep up to date with IFG on Twitter: @JimLorenzen


[i] Recommended reading:  The World Is Flat, by Thomas Friedman, a volume on the economic impact of globalization – the leveling of the playing field –  and America’s new place in this paradigm.  Should be required reading for anyone interested in this issue. 

[ii] Not original and I don’t know the author.  It was relayed to me by a colleague about six years ago.

[iii] This is a hypothetical example of a progressive tax system and its impact on a population of taxpayers.

[iv] The restaurant owner figured, as an example, that if the eighth man was paying 12% of the tax before, he should be entitled to 12% of the savings.  12% of the $20 savings is $2.40.  Since he decided it should be ‘roughly’ the same and to make it easier on the diners to figure the bill, he rounded-up (in this case) and decided man #8 should get $3 of the savings.

Written by Jim Lorenzen, CFP®, AIF®

October 18, 2012 at 8:00 am

We’ve Been Here Before!

IFG BlogIf you’re wondering – and you probably aren’t, and rightly so – why nothing is being done in Washington, it’s because it’s election time; but, most people don’t pay much attention during the summer months because, unlike politicians, they actually have lives.

The news media knows this, too.  That’s why news coverage is about gaffs rather than real issues.

“There comes a time to put principle aside and do what’s right.”

                       (anonymous congressman, most are)

Conventional wisdom says that most people won’t begin paying attention until after Labor Day, which means ‘conventional wisdom’ assumes most Americans can afford to take vacations and doesn’t mind unemployment.

“These are not my figures I’m quoting. They’re from someone who knows what he’s talking about.”

     (anonymous congressman during a debate)

Of course, the current spending debate isn’t new.   Much as we’re accessing capital from China today, we were doing much the same thing as far back as the 1830s, still dependent on British capital despite the Revolutionary War and the War of 1812.  Back then, while foreign capital was used in an attempt to stimulate economic development, interruptions in the availability of credit during times of uncertainty often had ruinous consequences for American borrowers.[1]  The inflow of foreign capital, combined with the expansion of the paper money supply drove up prices making American products less desirable on the foreign market.  At the same time, the profligate spending of several states left them deeply in debt.  This was also a time when Americans felt uneasy about the international banking system – a machine that few Americans only dimly understood.[2]  By the time Andrew Jackson left office in 1837, Eastern cities were experiencing bank failures and factory closings, making the U.S. dependence on foreign capital more apparent than ever. 

We’ve been here before.

“We’ll burn that bridge when we get to it.”

  (Anonymous)

Jim Lorenzen, CFP®, AIF®

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Jim Lorenzen, CFP®, AIF®Jim Lorenzen is a Certified Financial Planner® and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional. 

Additional IFG Links:


[1] Unfinished Revolution, Sam W. Hayes, University of Virginia Press, 2010

[2] ibid

Written by Jim Lorenzen, CFP®, AIF®

August 7, 2012 at 8:11 am

“I’m from the Government and I’m Here to Help You.”

The same people that have been spending your money – some say with a tremendous amount of waste built-in to help guarantee reelection back home – now seem to be talking in the hallways – the first step before talking ‘out loud’ in a committee room – about another way they can raise more money to fund more future spending.

Of course, they won’t be talking out loud before the election; but, there are a few who would like to tax your 401(k) – because, as we all know, apparently it’s only rich people who are investors.  How?  By eliminating deductions and reducing contributions, or some combination thereof.

According to ERISA attorney, Ary Rosenbaum, these proposals in the whispering stage (my description) include:

  1. Capping retirement-plan contributions at $20,000 a year or 20% of compensation, whichever is less-including employer contributions. Currently, the limits are 100% of compensation or $50,000 a year.
  2. Replacing deductions for retirement savings with an 18% tax credit, deposited directly into an individual’s retirement savings account.
  3. Accelerating “automatic enrollment” of workers in retirement-savings plans, along with their default savings rate, and automatically increasing workers’ savings rates each year.
  4. Simplifying the paperwork involved for small employers’ adopting existing types of plans, with the goal of increasing access for more workers.

Actually, #3 and 4 would make some sense.  Most Americans are woefully unprepared for their old age; but, #1 and 2 may be rather short-sighted.  Sure, there’s the up-front revenue generation; but, it’s important to remember that tax-deferred growth is ultimately taxed.  It would seem that a `money grab’ now might just result in a lot less revenue later; but, then, how else could they possibly get reelected?

——————Jim Lorenzen, CFP®, AIF®

Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.  Additional resources:   IFG Investment Blog. Retirement Plan Insights Archive.  Twitter:  @JimLorenzen.  See IFG on Brightscope.

 

Written by Jim Lorenzen, CFP®, AIF®

May 17, 2012 at 8:00 am

The `Downgrade’ is Old News

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

Last Friday’s jobs report looked good on the surface –  over 100,000 jobs were created – over 200,000 people left the workforce and there have been over 200,000 net job losses over the past two months at a time when 250,000 new jobs are needed each month just to break even.  So, it’s still too early to pop the champagne.

While arguments continue in the media over the causes of the current gyrations, my guess is the credit downgrade by S&P isn’t one of them.  After all, not only was the downgrade telegraphed well in advance, but frankly, credit is what it is, regardless of the label provided by a discredited third party, and institutional investors – the biggest buyers of bonds – know what they’re buying.

The bigger `boogie man’ is the underlying issue:  Government debt and the desire to continue spending to add more.  And, the other shoe just may occur in the municipal bond market as municipalities across the country face the music brought on by their own spending.  The same holds true for states like California, Minnesota, and plenty of others.

Maybe the markets have been voting on the government’s ability to manage our money – after all, it is done by committee; and a large one made up of largely of lawyer/politicians, at that.

What should investors do?  Maybe nothing.  Reacting to  news has seldom, if ever, proven to be a sound strategy.  For those still working and contributing to 401(k) plans, this market is very likely a blessing since they can buy more cheap shares on sale for the same money.  Likewise, those not needing to tap long-term investments for living expenses will likely see little long-term effect, provided their allocations are well designed (see below); the Rip Van Winkle pill should work. 

The real impact of stock market gyrations, of course, is on those who need to live on retirement income from their investments.  Few of these people, depending on their financial plan input, probably shouldn’t have a greater than 20% allocation to equities, anyway – a statement of opinion requiring greater explanation than a blog post would permit.  Nevertheless, this is one of the reasons having the proper allocation is so important:  A 40% loss on a 20% allocation. For example, would result in only an 8% impact on total portfolio value, provided values in the 80% bond portion of the portfolio don’t change.   Bond values do change, of course; but, those with short-intermediate bond positions in a separately managed account, are largely unaffected since all bonds in the portfolio can mature at face value, rendering interim price movements moot. 

But, whether in a separately managed portfolio of individual securities or a mutual fund, active management on the bond side of a portfolio doesn’t add much to the expense side and does allow for the potential to manage interest rate risk, something that’s problematic in an index fund or ETF.   Longer term, properly allocated inflation hedges may prove more worthwhile in virtually all allocations.

So, for those with updated plans and allocations, the current market gyrations may likely have lesser impact than being advertised on the media, as well as little long-term effect on reaching overall goals.   Those without a plan or a strategic long-term allocation may find themselves getting ‘whip-sawed’ by the market – selling on emotion (when the market’s down) and buying back in when `confident’ (at a top).  Not a good way to manage money.

Or, if you want to manage money like the government, you could always borrow!   Naaaaaah.

 Jim

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NOTE:  Jim Lorenzen was interviewed by The Wall Street Journal’s Glenn Ruffenach for an article appearing in SmartMoney magazine.  You’ll find it on page 46 in the September 2011 issue now on newstands.

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER™ and an Accredited Investment Fiduciary®  in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Written by Jim Lorenzen, CFP®, AIF®

August 16, 2011 at 7:10 am