Congress Should Address Corporate and Capital Gains Taxes Differently

Tax policy is going to be a hot debate in Congress once President-Elect Obama’s term begins in January. Although Obama won the tax debate with McCain in the voter’s eyes (polls show voters preferred Obama’s plan, despite McCain’s continuous attacks on it), his administration will still have to work across party lines to pass tax reform next year.

Two areas getting a lot of attention are capital gains taxes and corporate income taxes. The argument for the former is that lower tax rates induce more investment capital into the system. For the latter it is that companies with extra cash flow will hire workers and buy new equipment. I actually don’t think either one of those arguments is true to any significant degree.

For instance, I don’t know anybody who has not invested in the stock market because of the 15% capital gains tax. The notion that if we lower that rate to 10% it would cause billions of dollars to rush into the market seems downright silly to me. Conversely, if Obama was to raise the rate to 20%, it should not result in excessive selling of financial assets because it is hard to argue 15% is fine but 20% is overkill given the small differential. Tax rates are simply not a core determinant of whether people invest or not, at least not when the rate changes we are talking about are so minimal (if tax rates were 50% and dropped to 10%, then my opinion might change).

On the corporate side, it is my belief that a tax cut alone does not directly result in additional hiring and capital expenditures. A corporate executive does not decide to hire more people or invest in new projects just because they have the money available to do so. There needs to be a business reason for the move, i.e. the demand for their products is growing, which makes the investment in new people and equipment worthwhile in return on the investment terms. I disagree with the idea that tax cuts cause job creation. Real increases in demand from a growing economy results in job creation because more people are needed to meet the demand.

All of that said, I think that given a choice between the two, a cut in the corporate tax rate would be far more beneficial than reducing the capital gains rate. Simply speaking, lower corporate taxes directly impact stock prices positively by increasing corporate earnings. Since a majority of Americans own stocks (I think the number is between 60 and 70 percent, I can’t recall the exact figure), lower corporate tax rates would benefit most Americans.

Many people make the same argument for reducing the capital gains tax rate, but it ignores a very crucial fact. While it is true that 60 to 70 percent of Americans own stocks, the vast majority of those people hold their investments in IRA and/or 401(k) plans, which of course are not subject to capital gains taxes. More often than not, those who own stocks in taxable accounts to any significant degree are the wealthiest Americans (entrepreneurs who retained large ownership stakes in the companies they founded, or executives who were granted stock options are part of their compensation plans).

Since our country has seen an acceleration in the recent trend of the rich getting richer while the poor get poorer, I would much prefer to help the majority of Americans through a corporate tax reduction, versus helping the top 5 or 10 percent of the country, who would see most of the benefit from a reduction in the capital gains tax rate.

Now, one can certainly make the case that personal income tax rate reductions would have a more positive impact on the economy (boosting incomes will increase end demand for products that corporations sell to consumers, thereby boosting job creation and new capital projects), but given the budget deficit problems we are facing, a corporate tax cut would be far less costly. The U.S. gets the bulk of its revenue from personal income taxes, whereas corporate tax collections are a much smaller fraction of overall federal revenues.

Readers Were Right, Paulson Nixes Asset Auctions

Has anyone else noticed that whenever Treasury Secretary Henry Paulson speaks the market goes down? Today is no exception, as we learned that Paulson has abandoned the idea of using the TARP funds to buy bad assets from banks using a reverse auction process. When the idea of auctions first came to light I was very keen on the idea, but others preferred direct capital injections into the banks, in return for preferred shares as well as common stock warrants. Readers pointed out that there was no assurance that an auction would actually happen. They were right.

Instead, TARP money was used to buy stakes in banks and now Paulson says the auctions are no longer a priority. I still believe that auctions address the core problem far better than direct capital injections. As we have seen, the financial institutions can do whatever they want with money if you just hand it to them. Heck, they might even use it to buy other banks or invite their top salespeople on expensive resort getaways. That wouldn’t go over too well, would it?

The root cause of the problem, huge losses resulting from bad loans (and the need to raise more capital after losing much of what they had), could be addressed by buying the assets from the banks for pennies on the dollar. Future bank losses would be reduced because the assets causing the largest losses would be jettisoned, and the banks would have cash to make new, hopefully better, loans. The direct capital injections have done nothing to reduce bank losses or help the housing market.

At this point, the remaining TARP money would be best-served by tackling the problem directly. If the Treasury prefers not to go the auction route, then you have to do something to address the home foreclosure problem. On that front, why don’t we just use the money to pay mortgage servicers a fixed amount for each loan they modify for borrowers who are struggling to make their monthly payment? Such a move would incentivize the lenders to work with their customers and stem the housing downturn, which is a major impediment to financial stability in the system.

It is in the best interest of everyone involved if the banks agree to take a little less money back on their loans rather than become a real estate developer by foreclosing on properties. If home supply and demand imbalances are corrected, and home prices stabilize, the economy would benefit tremendously.

Why An Obama Victory Does Not Foretell Economic & Market Gloom

I rarely blog about politics here, but it is very difficult to get the full truth (from either party) during a presidential campaign. Since I started this blog in 2004 I have commented once each election cycle on a certain lie that always makes the rounds before we head to the polls. Most of you have probably heard from partisan people that an Obama victory tonight would kill the economy and the stock market. After all, isn’t it true that Democratic administrations are known for taxing and spending, which wrecks our country’s economy?

One of my favorite quotes goes like this, “Numbers don’t lie, people do.” It fits perfectly here, as the numbers provided below will show. The truth is, most meaningful economic statistics (GDP growth, unemployment rate, inflation rate, growth in federal spending, budget deficit level, to name some of the big ones) have historically been stronger under Democratic presidents than Republican ones. You can refer to my October 2004 post entitled “Do Elections Affect the Stock Market?” for the detailed statistics.

As goes the economy, so goes the stock market. This is not only a recent trend (8 years under Clinton, market up 203%, 8 years under Bush, market down 28%). According to Ibbotson Associates (a market research firm), inflation-adjusted stock market returns have been 100% higher under Democrats since 1926:


I point this out not to insist that an Obama presidency assures the market will be strong, but simply so investors know the truth, in case they are partly basing their vote for president on economic data. It is important to note the common statistical mantra “correlation does not equal causation.” These numbers do not mean that a Democratic president causes the market to go up twice as much as a Republican president (it could be any number of factors, or a combination of them). What it does mean, however, is that the common contention that the economy and stock prices do better under Republicans is actually completely backwards.

Regardless of historical statistics and putting your political allegiances aside, remember one thing. It’s your right to vote, so be sure to go to the polls today if you haven’t voted already.

Part of TARP Finally Ready To Go

In recent weeks there has been plenty of talk about the Treasury’s TARP initiative, but little progress on its actual implementation. On Friday we got news that PNC Financial (PNC) was the first bank to get a capital infusion from the TARP, and would use much of the cash to help fund its acquisition of troubled banking competitor National City (NCC).

I have previously written highly of PNC stock and this deal only furthers my bullish long-term view on the company. They are paying about $2 per share for a bank that traded at nearly $40 last year and fits their geographical footprint very well. PNC’s track record on successful acquisition integration is outstanding. As with the other strong banks buying weaker ones, loan losses will rise with the deals and that trend will continue for a while, but long term the buyers will only enhance their competitive positions in a marketplace that will have far fewer players overall when the dust settles.

Today we are learning about more banks raising capital through the TARP, Capital One (COF) and SunTrust (STI) among them. Don’t be surprised if Capital One makes an acquisition in coming months as well. They have indicated they are looking at potential deals and have raised money twice in recent weeks.

Hopefully the equity market can begin to gain some traction as some of these plans are not just announced, but more importantly, actually implemented.

Full Disclosure: Peridot was long shares of COF and PNC at the time of writing, but positions may change at any time

Nixing Mark-to-Market Accounting Is Not The Solution

I am a little confused. How will removing the mark-to-market accounting rule, an idea that is rapidly gaining traction, help solve the problem? If balance sheets are not prepared with market prices, it will allow companies to arbitrarily assign a price to the illiquid assets it holds. What kind of price are they going to select? Obviously, a high one!

To me, this will just lend less credibility to bank balance sheets because investors will assume the banks are choosing artificially high prices for the assets they get to assign values to. Will sovereign wealth funds, private equity funds, and hedge funds all of the sudden start to offer new capital injections into firms that are doing this? I highly doubt it.

One reason why WaMu, Wachovia, and Lehman Brothers went under was because nobody trusted their balance sheets enough to invest in them. Marking up those toxic assets arbitrarily would hardly result in more confidence than there is today.

Full Disclosure: No position in any of the companies mentioned at the time of writing

An Alternative Bailout Plan

Now that both sides of the U.S. House of Representatives cannot agree on Hank Paulson’s $700 billion TARP package, the need for an alternative idea is clear. One of the ideas I have heard sounds pretty interesting to me.

Essentially, rather than buying $700 billion worth of mortgage-backed securities, the plan would be to have the government issue insurance on them and guarantee the holders against realized losses. How is this any better than the current plan? From what I can tell, in at least two ways.

First, it would cost far less to insure mortgages than it would to buy them outright, so the taxpayer would save money versus the current plan. Many people believe the current prices these bonds are fetching (if trades occur at all) are not reasonably reflecting the ultimate losses from the mortgages underlying the securities. If that is true, the losses that the U.S. would insure against would be far less than the current marks on these mortgages are predicting.

Second, and perhaps more importantly, if we woke up tomorrow and these mortgages were insured by the U.S. government, there is a very good chance that demand for them would increase significantly. All of the sudden a market for these securities would not only exist (essentially one does not now), but prices would likely rise and the banks could reverse some of their mark-to-market losses and write-up the value of their assets. With more clarity on the value of these assets, even more capital raising would occur in the banking sector.

So, what do you think? Would such an idea convert some of the naysayers of the current plan?

Thoughts on the “Bailout”

A reader asks:

“Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?”

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bailout Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers’ expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional (typo, corrected and replaced “nominal” with “notional” -CB) value. By doing so, we are converting unrealized losses on the banks’ balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn’t functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn’t want to do that anyway since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don’t understand why anything needs to be done or are misguided in their belief that all we are doing is “bailing out Wall Street.” The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.

Americans: Add AIG To Your Investment Portfolio!

As one of ~300 million Americans, we each now own about 0.000000002663333% of AIG.

I think the Fed did the right thing here by requiring some financial benefit in return for such a huge loan. Not only do taxpayers get a 79.9% equity stake in AIG, but we also are collecting some hefty interest on the deal, to the tune of LIBOR plus 8.5 percent.

Was Senator Edwards Being Hypocritical by Working at a Hedge Fund?

I’m curious what readers think about this. After coming up short in his bid to become Vice President in 2004, Senator John Edwards worked for Fortress Investment Group (FIG) as a consultant. Given that Edwards has been focusing his political campaigning on helping solve the poverty problem in our country, is he being a hypocrite by working for a hedge fund, whose main job is helping rich people get even richer?

I’m not sure where I fall on this issue. At first blush it does seem like a questionable decision on his part. However, does the fact that he worked for Fortress really mean he is somehow abandoning the poor? Fortress is going to do what they do regardless of whether or not Edwards is there. There is no way his role at the firm had any financial benefit for Fortress clients. He might have given them a well respected politician in their corner, but he didn’t boost their investment returns, so he didn’t directly help the rich get richer. That is going to happen regardless.

Of course, Edwards is going to say it was, in part, a learning experience. He clearly doesn’t have much financial markets knowledge. But he did admit that the money was nice too. Does someone who supposedly wants to help the poor have to purposely avoid earning a nice living because of his political platform?

It’s an interesting topic. I’m curious to hear what you all think. And I know it’s a political discussion, but let’s keep it polite, not partisan. We can speak in terms of politicians in general, regardless of party affiliation.

Dow Hits Record on Democratic Sweep

Doug Kass, managing partner of Seabreeze Partners, predicted a Democratic sweep on CNBC’s Kudlow and Company program yestertday afternoon. The result, he thought, would be a severe sell-off in the market. Much like Kass’s calls for doom and gloom on Wall Street have been wrong in recent months, they were wrong this time as well. Now you can say that the Rumsfeld resignation helped boost stocks, which I cannot dispute, but the Dow was only down 25 points or so before that news hit the wires.

So why the positive reaction on Wall Street? There are weak spots. Healthcare stocks are down. Pfizer (PFE) down 2 percent is attractive. Sallie Mae (SLM) got hit too, as the Dems want more affordable college loans. But other areas, such as oil, are actually up and in some cases up strongly. Fears of a windfall profits tax are overblown. The idea is silly in a market-based economy. I’m glad that the Dems really aren’t pushing hard for it. As much as I don’t like the fact that big oil is getting tax breaks (I think that is one place the Dems can try and raise taxes and not take heat for it), passing on some of their profits to the government during good times is not a viable idea.

Anything truly outlandish would likely get vetoed by President Bush. The Dems will want to get things done, and if Bush shows any willingness to compromise on anything, we might get a handful of things done in Congress over the next two years. That is more than we can say about recent memory, so that is a positive development for the American people, and the stock market.

Regardless of what the Republicans say, Democrats are not bad for the economy and stocks. The numbers simply don’t support that view, in fact, they show the opposite. My very first post on this blog two years ago looked at the market and the economy under Democratic and Republican administrations. Economic growth, employment, fiscal responsibility, inflation, and stock market returns are all better under Dems. Now I know that Bush is still President, but the point is made merely to refute the idea that Dems having more power with respect to policy means lower stock prices. It’s simply untrue.