At Arm's Length - A Daily Market Commentary - Before the Bell Rings Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 11.19.04

Taxing Situation

Who wins and who loses when it comes to the administration's efforts at tax reform? The answers, no matter how the change plays out, can be relatively easy to predict.

It is still debatable as to just what kind of plan the President wants to put before Congress. Several options on the table include a flat tax, a sales tax at the national level, and/or the change in how deductions are calculated.

Part of the complication with the code comes with the numerous tax deductions that have become endemic, preventing any real ability for change as the code currently exists. These deductions that run from the high costs for large families, medical expenses and the mother of all deductions, home interest loans have become ingrained in the tax process. One of the easiest and most derisive changes in the code would eliminate these deductions. But would those changes help savings or promote investment? Not likely.

Unfortunately, every tax break is replaced with a shift in the tax burden. Money still needs to arrive at the government level and taxes have become a revenue producing necessity. If investment taxes are reduced, the money that is lost because of that shift will need to be transferred to another segment of society. That shift usually comes at the expense of wages and most of those shifts will be paid for by workers. Those workers are, you guessed it, not at the top pay scale.

Here is the shake down of the two most popular types of tax reform being discussed.

Flat Tax

Savers would win. Unfortunately, that is not the middle and low-income people, who traditionally (and unfortunately) has very little in interest or investment income due to historically low rates of saving
When flat taxes are used, the tax burden, now a progressive system - one that taxes the amount of money you earn at different rates, the higher income brackets being taxed the most - shifts and in doing so, the burden of financing the tax system is largely on the shoulders of the middle income wage earners. While some may win, the majority of this income bracket will lose.
Without tax credits, without savings, and without any exemptions, low income households would lose the most under a flat tax system.

The next plan has many names but it is essentially a throw back to consumption tax.

Value Added Tax

a National Sales Tax

When rates drop for the upper wage earners, they win. Actually they win twice. This group tends to spend less of their disposable income per dollar earned.
Middle income wage earners lose and do so in a big way. Without the income deductions they have used to break even including mortgage exemptions, tax credits and earned income credits, this group will be funding the lion's share of the federal government's operations while earning less. Low income wage earners also spend as much as 93% of their disposable income on goods and services. In many states, a national sales tax would be in addition to state taxes, which would no longer be deductible on a federal return or their own state's sales taxes.
The biggest losers would be those in the lowest income tax bracket. The elderly would lose the largest benefit. After years of income tax contributions, a national sales tax would, in essence, tax them again without any income

The only hope is the amount of changes needed to make the system work, the snail's pace that Congress, even one dominated by the GOP, would act, and the historic time frame it takes to get this job done.

On Oct. 22, 1986, President Reagan signed into law the Tax Reform Act of 1986. This ambitious effort was one of the most far-reaching reforms of the United States tax system since the adoption of the income tax. In an attempt to remain revenue neutral, the act called for a $120 billion increase in business taxation and a corresponding decrease in individual taxation over a five-year period. It took almost three years to enact and was restructured in his second term because of its failure to keep the deficit down. This was achieved by increasing the taxes on the wealthy.

With only the wish to change to the code and no real plan on the table, much of this is left to speculation. But if the current administration's record is any indication, it will happen quietly and with the certainty that the losers will be most of us.

At Arm's Length: 11.16.04

Lame Duck Spending

Congress meets again this week for a session often referred to as a lame duck. There are 13 spending bills on the docket, left over from a pre-election effort to take the focus off of the big spenders that this legislative body has become. The Republicans of smaller government has not materialized as they will approve another $80 billion plus in war funding, raise the credit ceiling for the federal government and finish funding a good deal of the agencies they left hanging.

Meanwhile the dollar declines. The erroneous thinking that a weaker dollar will lower the hemorrhaging trade deficit is bound to create more problems than it solves. The trade deficit is a many faceted problem with only one face being the underlying currency that is pinned to it. American goods are not being bought - or made for that matter - overseas as fast as we buy their exports. They buy raw materials that are priced using the dollar and a weaker currency means higher overall profits for their products.

The effects of such thinking will result in lower living standards with reverberating increases in inflation, expected to rise slightly when both the Producers Price Index and Consumer Price Index (without food and fuel) report this week and the rising cost of borrowing money.

Those costs (of borrowing money) has more or less kept those pesky deficits from fixing themselves. As long as the government continues to crave overseas investors to finance their oversized budgets, countries ponying up the investment are not spending that available currency in making their own economies vibrant.

It all falls squarely on the shoulders of Washington to change policy - stop spending - and Europe to find a way to get out of the funk they have wandered into - lower interest rates - and lastly, replace John Snow with a proactive economic steward.

The previous week's articles.

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