Monday, February 9, 2009

Economic Stimulus Package

I agree with President Obama that we need to get this bill urgently approved by Congress, signed into law, and begun to be implemented as soon as possible, no later than the middle of next week. That obviously doesn't mean any bill will do. However, given the staggering and growing layoffs and unemployment numbers reported almost daily, a "better" bill in 30 days may not be as effective as the final compromise bill Senate and House representatives should be able to come up with and voted favorably on by Friday or Saturday this week.

I also agree with most of what long-time "MoneyTalk" host Bob Brinker said about the final bill on his radio show yesterday:

1. No pork projects must be allowed to creep into the bill, just because a legislator wants to satisfy lobbyists, constituents or campaign contributors, or any personal ideological view.

2. Infrastructure projects that are not "shovel ready" to stimulate the economy in the short term should preferably not be incorporated, even though they are good projects that are beneficial and appropriate over the medium or longer term. That said, I'm certain there are many needed public infrastructure projects that can be made "shovel ready" on a very fast track to stimulate the economy with tens of thousands of new jobs within a short 3-6 months time frame.

3. Even though it's apparently not being considered in the Congress so far, a temporary reduction in the payroll tax would be a prudent tool because it puts more money in the the hands of both employers and employees, and it would be easy and quick to implement. I'm talking primarily about the 6.2% currently withheld from an employee's pay and equally contributed by the employer for Social Security and the current 1.45% for Medicare .

4. To help stabilize the housing market, I like the idea of a temporary 10% tax credit of up to $15,000 for the purchase of foreclosed properties as a primary residence for, say, the next six months, with the possibility of an extension for the remainder of 2009.

5. Keeping in mind that the U. S. has about the highest corporate income tax rates among the major developed countries, and that this has induced many companies to move headquarters and operating units to lower tax jurisdictions abroad, I think lower corporate tax rates could stimulate near-term investments in new machinery and equipment and reduce pressure for more layoffs.

To the Congress members working on reconciling the respective House and Senate bills in the next several days, I say that the American people expect you to work expeditiously on a bipartisan basis to do what's in the country's best interest. No more politics as usual. Earn your generous pay and benefits! Get it done!


J Wayne said...

A corporate income tax rate reduction from the current 35% to about 24% would place U.S. corporations in a far better position for competing in the global marketplace - it would place U.S. companies in the lower middle range of industrialized nations instead of at the top end. During this evening's press conference, the phrase "attracting private capital" was used by President Obama repeatedly. This could be accomplished quickly with a corporate tax rate reduction AND allowing dividends to be deductible by corporations. A major reason that the financial crisis is impacting investment is the fact that the interest paid on debt financing IS tax deductible, while dividends paid on equity financing is not. This has also created some of the present Wall Street problems. The investment mindset is now oriented toward appreciation of investment rather than true return on investment, driven by the tax code bias that taxes dividends twice. I would be willing to give up the 2003 individual tax cuts as a way to pay for these changes without increasing the size of the stimulus package (and nearly all my income is from investments).

A week ago I sent my 5-page recommendation to the White House and key Congressional leaders via UPS overnight letter. In summary, the four recommendations were:

1. Discourage executive compensation excesses by a change in IRS Code Section 162(m) and by adding SEC rules requiring full and easily accessible disclosure (transparency).

2. Make American firms more competitive in the global market by reducing corporate income tax rates to a level near the lower end of the middle range of OECD nations.

3. Make corporate dividends paid to shareholders deductible for corporate income taxes.

4. Pay the cost of the corporate tax reduction and dividend deductibility by:

a. Eliminating the special tax treatment of dividends and capital gains enacted in 2003.

b. Imposing a 35% corporate excise tax on excess compensation beyond the new Code Section 162(m) limit, in addition to it not being deductible for corporate income taxes.

Viking Views said...

I'm impressed that J. Wayne (is it Mr. Burritt?) felt strongly enough about this subject that he went to the trouble of sending some personal recommendations to the White House and key Congressional leaders.

I agree with the lower corporate income tax rate, but I'm not at all certain that a major reason for the financial crisis adversely impacting investment activity is that dividends paid on equity is not tax deductible, as Wayne maintains. I think it's much more that the great majority of companies lack cash, have limited ability to borrow from banks or the bond market, have balance sheets which are too leveraged, debt ratings are too low, already have excess production capacity, and are very concerned about adequate demand for their products and services down the road, as well as the expected returns on any prospective investment.

I agree that amending Code Section 162(m) can be an effective way to discourage excessive executive compensation, but how should the section be amended? Imposing a 35% excise tax on defined excess compensation that would not be tax deductible is an interesting idea, but it seems to me that the legislation needs to be simplified and made more clear to avoid loopholes and achieve the generally desired effect.

As I think I stated in an earlier posting, when it comes to executive compoensation, the boards of directors need to be much more independent from the CEO and more accountable for their actions. External auditors, regulators, rating agencies and larger shareholder groups can and should put more pressure on the boards to do the right thing.

The blatant partisanship evidenced so far in the stimulus negotiations in the Congress has been very disappointing. Clearly too many members are more concerned with toeing the party line, their upcoming elections, and satisfying provincial interests, than doing what's best for the country. This doesn't bode well for other major legislation needs likely coming up for debate in the next several months.

J Wayne said...

Viking Views: Sending the nine overnight letters made me feel better - I would have been wishing that I had done it if I had not. I will post some additional thoughts about dividends later today - I don't have time to do it now. By the way, I'm not Mr. Burritt.

J Wayne said...

Viking Views: Thanks for your thoughtful response. I’ll begin with your question, “I agree that amending Code Section 162(m) can be an effective way to discourage excessive executive compensation, but how should the section be amended?”

Under the current Internal Revenue Code Section 162(m), a public company's corporate income tax deduction is now capped at $1 million per year for amounts paid to its chief executive officer and each of the next four highest-paid executive officers. My recommendation is to replace the hard-coded “$1 million per year” for amounts paid to the top 5 executive officers with a simple ratio test for all highly compensated persons, irrespective of their job title. Amounts paid to highly compensated persons in excess of 25 times the firm’s median compensation of all its employees, for instance, would not be deducted as an expense and would be subject to corporate income taxation. For example, if the median compensation of a firm’s workforce were $50,000, then annual compensation including bonuses paid to any employee in excess of $1,250,000 would not be tax deductible by the corporation. This is not a change in the current practice; it just makes the IRS Code more flexible. This will meaningfully relate executive pay and that of other highly compensated persons to the median compensation of the firm’s employees, irrespective of the industry, and will provide transparency for shareholders (private and federal) of public firms. SEC rules should require that the TOTAL amount of excess compensation subject to corporate taxation must be disclosed and easily accessible so that the owners of the firm (shareholders like me) have an easy reference for the impact of the firm’s compensation policies and effectiveness of corporate governance. The 35% excise tax on this excess compensation is meant to be a way to both produce tax revenue to help offset the loss in revenue from the corporate tax cut and also discourage excess compensation. Peter Drucker (the 20th Century’s greatest management guru) recommended that executive compensation not exceed 20 times regular worker compensation. You are absolutely correct that Boards of Directors need to be more independent. I also totally concur with your view about the blatant partisanship. A political science professor from Brown University who was a guest on this evening’s Lehrer News Hour on PBS offered a theory about it that was interesting.

I agree with your assessment of the reasons for the financial crisis adversely impacting business investment activity, but I suggest that dividend tax policy is a major root cause of the problem. Dividends are a complex topic that has been studied in academia since Miller & Modigliami’s seminal 1961 paper that asked the question, “Do dividends matter?” I propose that the tax treatment of dividends has distorted investment strategy. Because dividends are not deductible for corporate income taxes, the amounts distributed to shareholders as dividends are first taxed at the corporate tax rate of 35%, and then taxed as income to the shareholders on their personal tax returns, resulting in what is commonly called “double taxation of dividends.” This quirk in the tax code has resulted in much distortion in economic activity, meaning that business decisions are made to minimize tax consequences rather than for rational business reasons. The tax code was changed in 2003 to lower the tax rate paid by individuals on dividends and capital gains to 15%, which did mitigate the impact of double taxation to the shareholders, but did nothing to improve corporate tax efficiency and competitiveness of U.S. corporations in the global economy. When corporations obtain capital through debt financing (bonds and bank loans), the interest on that debt is tax deductible for the corporate income tax calculations. The interest paid to the bond or loan holder represents their return on investment (ROI). Permanent financing of a corporation is accomplished through the issuance of shares of stock, with the intent that a portion of corporate profits will be distributed to shareholders through dividends as their return on investment. However, unlike interest paid on debt financing, the dividends paid on equity financing (shares of the corporate stock) are not deductible for C corporations under the existing tax code, making the payment of dividends inefficient.

An overlooked problem caused by the non-deductibility of dividends for corporations is the bias created toward debt financing as well as a shift in the objective or goal of investing from the simple concept of direct ROI from dividends to placing too much emphasis on capital gains. Many stock market investors pay little or no attention to dividends because their investing strategy is to buy shares of stock at a low price and sell them a higher price, with their realized capital gains being the only ROI considered. They are speculators rather than true investors. They prefer that companies do not pay dividends, but rather reinvest what would have been paid out as dividends in the business or use it to buy back outstanding shares, thereby increasing the investors' percentage share of company ownership. Either way, the value of the stockholders' shares should rise in bull markets, but this increase will only be taxed at the individual level as capital gains when the shares are sold. In my view, the tax code provision of not allowing dividends to be deductible has skewed the fundamentals of investing and made it into a form of gambling. The 2003 tax rate cut simply rewarded the tendency toward gambling and did nothing to improve American corporate competitiveness. Jeremy Siegel and Andrew Metrick, both finance professors at the Wharton School of Business, with Paul Gompers, a finance professor at Harvard, have argued that a simple solution to restoring investor confidence and rationality to the stock market would be to make corporate dividends tax deductible. The professors argue that if dividends were a deductible expense, firms would be strongly motivated to pay out much of their profits as dividends, since retained earnings would be subject to the corporate tax. Firms that did not pay dividends would be viewed unfavorably by investors who feared that the earnings were inflated and that the cash does not exist. The payment of cash dividends would therefore add significant credibility to management's earnings reports. They further argue that allowing dividend deductibility would also eliminate the incentive for management to take on large amounts of debt and risk bankruptcy just to gain the deduction for interest costs. This could help relieve pressure on the stressed financial system.

Viking Views said...

J Wayne makes some very articulate and compelling comments, though most of my readers probably didn't want to know that much. Nevertheless, I appreciate the insights and contribution. He's done his homework.

JimT said...

Wow, J. Wayne certainly has done his homework.

Personally, I don't like the fact that there is such a sense of urgency with passing this stimulus. The economic turmoil we're in now took decades to reach this point, probably beginning around the time of the Community Reinvestment Act and the forced requirement of Fannie and Freddie to give out loans to people who could not afford them. Greed and corruption fanned the flames of the housing bubble for years, and now it *will* take years to recover from it regardless of the stimulus.

Some of the package I do agree with, but the bottom line is you can't borrow your way out of debt. The trillions more we throw at this problem are just going to prolong the recession. Each U.S. taxpayer's portion of the national debt is $80,000 and rising daily (and that will grow as 75 million baby boomers retire).

I don't think waiting another 30 days to put out a better plan would have had a significant negative impact. But, I do hope that I am wrong.

J Wayne said...

I believe that the sense of urgency was justified. However, the stimulus package that was passed would more appropriately be called a safety net package – needed, but not very stimulating. That is why I felt compelled to make my recommendations known to congressional leaders. My hope is that perhaps someone with influence in Washington will wake up. “It’s the tax code, stupid!” I’m not saying reduce taxes – I’m saying make adjustments to stimulate the American economic engine in addition to providing the safety net. Keep in mind that the 3-4 million jobs promised by the package simply means that the rate of job loss will be slowed if the package works – not that 3 million new jobs will be added to the employment level as it stood six months ago. Perhaps the package could have been substantially improved, but how long would it have taken – in any process, the last 10 or 20% toward perfection is usually the most costly and takes the longest.

This week’s Frontline program on PBS had an excellent documentary on the financial meltdown that was precipitated by the subprime mortgage mess to which JimT refers. Greed and corruption certainly fanned the flames of the housing bubble beginning in 2001 after the dot-com bubble popped. In addition to the Community Reinvestment Act, which was one of those well-intended initiatives with seriously damaging consequences, people somehow came to believe that housing prices would go up forever, even if the prices did not make economic sense. The bubble had to collapse – it was irrational exuberance, just like the dot-com bubble. It was further encouraged by TV shows like those on HGTV that showed how to flip a house for big profits. If the government attempts to place an artificial floor on housing prices because people used are “underwater” (their home value is less than their mortgage), a new problem will be created. I am “underwater” with respect to my 1929 home, not relative to a mortgage, but relative to the amount I have spent refurbishing it. I have invested twice as much in my home as it could realistically sell for in my neighborhood, but it is what I wanted as the place to spend the rest of my life. If people are managing to make their mortgage payments, even if they are underwater, they’ll be okay – they just made a mistake and maybe have learned from it. One point in the proposal that the President made yesterday would help them – allowing refinancing of the mortgage at a lower market interest rate if they are credit-worthy, even if the home value is less than the mortgage amount. Recent actions by the Fed have caused mortgage rates to fall.

Viking Views said...

Normally it's probably not a good idea for Congress and the Administration to have too much of a sense of urgency when debating and formulating major new legislation on important issues. But I agree with J Wayne that a sense of real urgency was quite justified in this case, due to the unusually serious economic circumstances we were facing.

My understanding is that the 3-4 million jobs the Administration has maintained the stimulus package would generate over the next two years includes both new jobs and saved existing jobs, the latter, of course, being much more difficult to identify with much verifiable precision.

I think Jim and J Wayne are correct in their comments about the housing bubble, but I'm not sure J Wayne is right about the stimulus package, including the "safety net" aspect, not being "stimulating," though he may have meant "stimulative." When people receive a meaningful tangible financial benefit, whether it's through lower taxes, a lower mortgage interest rate, or even more food stamps, they tend to feel more confident about their situation and are apt to go out and spend more money on such as food, clothes, gas, and entertainment. It seems to me this increased spending serves as an economic stimulus, especially when millions of people are participating.

A stimulus cake can be made with many different stimulating ingredients, though some ingredients are more important than others in coming up with the final product. As long as the cake tastes great, and there are enough slices for everyone who has contributed, we should be reasonably happy. However, I agree that we should preferably be able to afford the cake, and using cash to buy the ingredients is better than borrowing to do it.