Is the US Tax System Efficient?

 (Including side comments about the US Federal Budget)

The following facts were excerpted from the July 13-19th, 2013 edition of The Economist.

1. The US tax code isn't simple. 90% of US taxpayers use an accountant or commercial software to file their returns.
2. Americans spend at least 6.1 billion hours each year complying with tax rules. This time could have been spent more productively. (See below for an interpretation.)
3. Interestingly, tax revenues would remain unchanged by getting rid of all loopholes and by allowing individual income-tax rates to fall a whopping 44%. (See below for an interpretation.)
4. Each year $1.1 trillion in tax revenues is foregone through countless deductions, exemptions, and credits. To put this in perspective, total federal tax revenues are only $2.8 trillion each year.
5. Corporate tax rates are the highest in the rich world: add state and local taxes to the 35% federal rate and they reach 39.2%.
6. The top individual tax rate is 39.6%.

Commentary on Fact #1

The US federal tax code is 73,954 regular 8-1/2" x 11" sheets of paper long. (source: Google search). This would be a stack of paper that's about 30 feet tall or as tall as a 3-story building.

Commentary on Facts #3 & 6

If the 39.6% top individual tax rate were to fall by 44%, it would become 21.4%.

Commentary on Fact #2

Assuming 115 million households in the US, the time spent on tax filing translates to 53 hours per household or 6.6 eight-hour work days per household. (Source: http://quickfacts.census.gov/qfd/states/00000.html)

If the time spent on tax filing were valued at $20 per hour, it would be worth $122 billion. Valued at $100 per hour, it would be $610 billion. To put this in perspective, the US defense budget for 2013 is $672 billion and is the largest discretionary line item in the federal budget. (Source: http://en.wikipedia.org/wiki/2013_United_States_federal_budget.)

Interesting facts about the 2013 US federal budget are (a) the annual rate of tax increases budgeted for the 2012-2022 period, (b) sources of US tax revenue, and (c) composition of US federal budget. Here are some excerpts.

Growth rates. The highest annual rate of increase among major tax revenue categories belongs to individual income taxes, at 8.4%. The highest annual rate of increase among major spending categories belongs to interest payments on Public Debt, at 14.2%.

Revenue composition. Corporations pay 12% of tax revenue while individuals pay 47%.

Expenditure composition. The top 5 spending categories in the federal budget account for 76% of spending and are, in descending order:

1. Medicare, Medicaid
2. Social Security
3. Defense
4. Interest payments on Public Debt
5. Agriculture

Some questions to think about: 

• If interest payments on Public Debt are growing so fast, what does this mean in the long run? 
• If corporations pay a smaller percentage of tax revenue than individuals, does this mean that individuals are disadvantaged?
• How fast is the US federal budget growing relative to the general economy?

For answers, please visit my next blog entry.

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Has QE Been Effective?

Former banker and author Satyajit Das answered this question in simple terms as follows.

"In the US, it now requires a government budget deficit of about $600 billion, augmented by injection of about $1 trillion in liquidity from the Federal Reserve, to create about $300 billion of growth."

In input / output terms, the government and the Fed are inputting $1.6 trillion into the economic system annually and in exchange, the economic system is outputting $300 billion of newly created economic value. The output-to-input ratio is under 19%.

Quantitative fund manager John Hussman argues that "the present course of Fed policy is destabilizing the global economy by contributing to a financial environment that encourages the allocation of scarce savings toward speculative activity, not productive investment." Source: http://www.hussman.net/wmc/wmc130527.htm.

Satyajit Das is a former banker and author of Extreme Money, and Traders, Guns, and Money. The above quote is from an article that appeared in the Financial Times on June 18, 2013, page 22.

QE stands for quantitative easing. It refers to the injection of liquidity into the financial system by the US Federal Reserve. Currently, the Fed has been injecting to the tune of $85 billion per month through the purchase of various assets. This translates into just over $1 trillion over the course of 12 months. To give a sense of how big this amount is, it's equal to $7,850 per household, assuming 130 million US households.


Afterthought 1:

History of QE. There have been three rounds of QE. QE1 started in Nov. 2008 at which time the yield on the 10-year US Treasuries was under 3.5%. QE2 started in Nov. 2010 at which time the same yield was under 3%. QE3 started in Sep. 2012 at which time the same yield was above 1.5%. Prior to any QE and right before the first signs of financial troubles emerged, which was in mid 2007, the same yield was it its highest at above 5%.

Today, June 21, two days after the Fed announced plans for tapering QE3, the same yield stands at 2.4%. The Fed indicated that QE tapering could start as early as in September of this year and that QE was likely to end by the middle of 2014. The Fed said it didn't plan to raise interest rates until the middle of 2015.

In the last couple of months, the 10 year US government bond yield hit a low of about 1.6%. The move from 1.6% to 2.4%, which is a rise of 80 basis points, translates into a price drop of about 6-8% (depending on the bond's actual coupon). The smaller the coupon, the higher the bond's duration, and therefore, the larger the price drop in relative terms.

The relationship between bond yield changes and bond price changes is captured by duration. See for example the Wikipedia article on bond duration. For example, the duration of a bond maturing in 10 years is somewhere around 5 to 7 years, depending on the coupon. The larger the duration, the more sensitive is the bond price to interest rate changes.

Question: What is the duration for stocks? Stocks have a much longer duration than bonds, perhaps 6 - 30 times larger. See for example the Wikipedia article on stock duration. This means that they are that much more sensitive to interest rate changes. All else being equal, a rise in interest rates due to Fed tightening could send the stock market down more than one would think.


Afterthought 2:

Question: How much liquidity have the developed world's central banks injected into the economy in aggregate?

Answer: G7 central banks have collectively put some $10 trillion of additional liquidity into the system since 2008, according to JP Morgan and Deutsche Bank estimates.

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3D Printing Accelerates Product Development

3D printers lay down particles of plastic, metal, or wood in thin layers to build up into solid objects. 3D printing is also called additive manufacturing.

German athletic shoemaker Adidas has said that 3D printers have reduced the time it needed to evaluate a new prototype by four to six weeks to one or two days. Before 3D printing, Adidas prototypes were handmade by 12 technicians. With the new technology, no more than two people are required to produce them.

American athletic shoemaker Nike seems to agree. Within six months, they were able to go through 12 rounds of prototype iterations for a boot for professional American football players.

The three biggest makers of 3D printers are:

1. EOS of Germany
2. 3D Systems of US
3. Stratasys, a US-Israeli company whose clients include Adidas, Nike, Reebok, New Balance, and Under Armour.

Mass shoe production via 3D printing has not arrived yet due to the slow speed at which printers produce items. Currently, it takes a Stratasys machine about two hours to produce a single shoe.

The above is an excerpt from an article that appeared in the Financial Times on June 10, 2013, page 15.

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Fund Manager's Career Risk,

 or Why the Stock Market Acts Irrationally Every so Often

The following is an excerpt from a September 2011 essay by Dylan Grice, formerly of Societe Generale.

Early in my career as an economist , I remember being taken around to see clients with a certain gloomy strategist known as Albert Edwards. It was early in the spring of 2000 and tech hysteria was fever pitched. Talk was of a “new paradigm” and madness masqueraded as wisdom. Albert had been going around, with me in tow, arguing that the madness was, well … mad … but most meetings were hostile and Albert’s views were felt to be too extreme. But one meeting stands out in my mind, making a deep impression on me ...

The fund manager who’d taken this breakfast meeting listened to Albert begin his argument but seemed agitated. Then, after only a few minutes he interrupted. “Look,” he gasped, “I know it’s all crazy, but what do you want me to do? If the bubble inflates like this for even one quarter and we don’t participate, we’ll lose half our assets. I’ll be out of a job!” [Highlight added after the fact.] Here was someone who could see the fraud all around him but felt powerless to resist. Bad fund management practice was driving out good.

Reference: http://www.scribd.com/fullscreen/123487201, pp. 157-158, January 2013.

[Side note: This time in history, i.e. May 2013, is a rare instance of a US equity market that is overvalued, overbought, and overbullish, according to quantitative fund manager John Hussman. Its cause, according to many, is QE (quantitative easing). Investors are being driven into risky assets because the yield on safer assets is so low because the yield on US treasuries is so low because the Fed is buying assets to the tune of $85 billion a month in order to encourage economic growth.]

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Ailing Copper Price,

 or Disconnect Between Stock Markets and Economic Reality

The fund management section of the Financial Times had an interesting article on May 13, 2013 discussing the disconnect between the stock markets and economic reality.

It took the view that the markets are in thrall to the unconventional measures pursued by the developed world's central banks, which have encouraged investors to take on more risk and hunt for yield.

As an example, Rwanda attracted orders worth nearly half of its $6.8 Bn gross domestic product for its recent $400 Mn bond issue. The yield on this 10-year bond was 6.875%. [Side note: the 10 year US Treasury bond is yielding 1.9% as of May 15, 2013.]

The reliably bearish Albert Edwards, strategist at Societe Generale, argues that the ailing copper price has been giving early warning that central bank liquidity will not save risk assets. He suggests bailing out of equities now and being overweight in government bonds on a short-term cyclical view that recessionary forces remain powerful. His longer-term argument is that we are only one short recession away from outright Japanese-style deflation, which will prompt further central bank hyperactivity and ultimately, rapid inflation.

Warren Buffet declared at the recent Berkshire Hathaway annual meeting that all this quantitative easing has been very clever policy, "but the unwind of it has got to be more difficult than buying."

For fund managers, the question is where to be. In equities the least bad place remains the US. Meanwhile, valuations in real estate look less stretched than in equities and most bonds, according to the article.

See full text of article here:  http://on.ft.com/19dSXph (I learnt after the fact that FT may restrict access to non-subscribers ...)

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Hedge Fund Bears

 as reported in the Financial Times on May 10, 2013

In the week of May 10, 2013, some of the biggest names in the hedge fund world met to share investment tips at the Ira Sohn Conference, a high-profile gathering in New York.

The differences between the fund managers were in their degree of pessimism.

Underlying the various calls was one theme: the effects of emergency action taken by governments and central banks since the global financial crisis erupted five years ago.

Ben Bernanke, chairman of the US Federal Reserve, loomed large as the greatest distorter of markets. His bond-buying programs have boosted prices for government debt, the effects of which, according to the speakers, had trickled into asset markets of all types.

Stanley Druckenmiller, lieutenant to George Soros and head of Duquesne Capital Management and without a losing year in 30 years, opined that the recent retracement in commodities markets was no mere cyclical swing. "The commodity supercycle is over. It is not a correction; it's the beginning of a trend."

Jeffrey Gundlach of Doubline had an ominous warning: "I recommend you take all the money out of any bank account you have."

Pointing to Cyprus - where depositors saw 40-60% of their savings used to pay for a bank bailout - he said such a move was unlikely in the US, but why take the chance? "Many are likely to say Cyprus is just one country, to which I say the Lusitania was just one small boat." [Side note: Lusitania was one of the largest passenger carrying ships of its time. It was a British ship sunk by the Germans in WWI.]

Paul Singer of Elliott Management, notorious for his attempt to impound an Argentine ship amid a battle with Buenos Aires, said, "Everyone wants a safe haven. There is no such thing in today's markets, and that's one of the elements of the distortion."

There was also a consensus that it was foolish to challenge the Fed. Mr. Gundlach said that investors must realize there would be no end to quantitative easing, at least in the near term.

Kyle Bass of Hayman Capital, however, has bet against the Bank of Japan. He sees in its recent actions signs of stress that he has been predicting for three years. "The beginning of the end has begun."

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Japan, On Path to Inflation or Hyperinflation?

On March 21, 2013, the Financial Times featured an article by Scott Minerd, chief investment officer at Guggenheim Partners. 

In that article, he speculated as to what would happen if rising domestic inflation, which Japanese authorities have recently worked into policy, runs amock.

Link to that article which is entitled "Japan risks sliding down slippery slope to hyperinflation". ((I learnt after the fact that FT may restrict access to non-subscribers ...)

If capital were to flee Japan, which is what he suggests, there's always the US where it could flee to -- the ultimate safe haven. The bigger question is the following: If capital were to flee the US, where would it flee to?

haditaheri is also on twitter