The REAL Rate of Return

A few days ago, I came across an article about "The Law of Zero Return", which is a concept that was partly attributed to me. (See http://members.cox.net/mathmistakes/zeroreturn.htm)

The concept is that the combined impact of inflation and income taxes consumes all of the return from an investment.

But that's not exactly what I said or intended to say.

For any kind of investment there is a rate of return, which can be positive, negative or even zero. For example, a bond issuer may offer to pay interest at the rate of 5% on the face value of the bond. This is sometimes referred to as the investment rate or gross rate of return.

Most investors are also well aware of the concept of the "real rate of return", which is defined by investment professionals as the investment rate of return minus the inflation rate. Generally, the inflation rate is assumed to be the same as the rate of change in the Consumer Price Index. If the investment rate of return is 6% and the inflation rate is 2%, the real rate of return in 4%.

Most investors are also aware of the after tax rate of return. This is defined as the investment rate of return minus the rate of tax as a percentage of the investment. And it varies from one investor to another depending on their own marginal tax bracket. For a taxpayer who is paying the maximum 35% federal income tax plus a 5% state income tax on his/her investment income, the combined income tax is equal to 40% of the investment rate of return. So if the investment rate of return is 6%, the income tax rate on the investment income is 40% times 6%, or 2.4%. Thus, the after tax rate of return is 3.6%.

But few investment advisers like to talk about the after tax real rate of return. Perhaps that's because it is a very depressing concept for any fixed income investor.

If the rate of inflation is 2%, and the after tax rate of return is 3.6%, then the real rate of return after taxes is 1.6% on an investment that is paying a gross return of 6%.

Now here's the "fun" part.

If the rate of inflation increases, what usually happens to the gross rate of return?

It goes up, because the people who have money to lend don't want to get repaid in cheaper dollars.

So, let's assume that the expected rate of inflation increases from 2% to 4% and the gross rate of return increases from 6% to 8%. How will that affect the after tax real rate of return?

The taxpayer is still in the 40% federal and state marginal tax bracket, so his 8% is cut down to 4.8% after taxes. But now the rate of inflation is 4%, so the after tax real rate of return is 0.8% instead of 1.6%.

And if the rate of inflation rises to 8%, the investment rate of return would increase to about 12%. The tax rate would be 4.8%, leaving an after tax rate of return of 7.2%. But now the inflation rate is 8%, so the after tax real rate of return is - 0.8%.

The result is that as the rate of inflation increases, the investment rate of return generally increases by an equal percentage and the after tax real real rate of return will decrease.

Like many other elements in investments and economics, there isn't a perfect correlation between inflation rates and rates of return on fixed income investments. However, I did a study in 1986 of various fixed income rates and the CPI inflation rate from 1940 to 1986 and the correlation was very high. The difference is due to the fact that investment rates are set by investors who add the expected rate of inflation to the interest rate that they require. Thus, the inflation adjustment is based on projections of the rate of inflation by investors. The actual rate of inflation will turn out to be more or less, depending on how the Federal Reserve attempts to deal with the problem.

But whatever the Fed might choose to do, it's not a good idea to wish for higher interest rates because higher rates are usually an indication of increasing rates of inflation in the economy. During periods of low inflation rates, investment rates of return are generally very low. And when investment rates of return are very high (as in the late seventies), the rate of inflation is also high.

Vern

www.offshorepress.com

Rethinking the Tax Refund Argument

For many decades, tax accountants and financial planners have argued that overpaying your withholding during the year in order to get a big refund doesn't make financial sense.

if you underpay your estimated taxes, you may have to pay interest to the IRS. But if you overpay, you don't get any interest on your refund. Overpaying your withholding is like making an interest free loan to the IRS.

But a great many taxpaayers prefer to get a big refund because it's a pile of money that is often large enough to do something significant. They may use it to pay for a cruise or other kind of vacation. They might use it to buy some appliances or to make renovations in their home. Some of them will put it in the bank or a Section 529 plan to save for their children's future college expenses.

By contrast, it's difficult to do anything significant or satisfying with a few extra dollars each day or each week. A $3,000 refund will amount to $8.21 per day, $57.53 a week or $250 a month. In today's investment market, money market funds are paying about 1% interest. If the excess tax withholding was received each week and put in a savings account. it would generate about $15 of additional funds at the end of the year. However, that interest would be subject to income taxes. For a middle income taxpayer in a state that imposes income taxes, the tax would be close to 30% or $4.50 -- leaving a meager $11.50 of extra after tax money.

I've argued for over 40 years that getting a tax refund is wasteful. But when short term interest rates are below 1%, I can certainly understand why a lot of taxpayers prefer to overpay some taxes in order to get a bigger refund each year.

Making good financial decisions is important, but sometimes there are other important considerations.

Vern

The Income Tax Multiplier

If you haven't heard of the "money multiplier" or "fractional reserve banking" I encourage you to spend a few moments looking at the definition of each at Wikipedia. (See http://en.wikipedia.org/wiki/Money_creation#Money_multiplier and http://en.wikipedia.org/wiki/Fractional-reserve_banking)

Very briefly, it's the process by which banks can expand the money supply because -- as a group -- they are permitted to loan a percentage of the money they have on deposit. The Federal Reserve establishes a reserve ratio, which is about 10%. When a bank gets a deposit of say $1,000, it is allowed to loan as much as $900 to various borrowers. What do the borrowers do with the money? Well, they deposit it in another bank. The second bank is allowed to loan as much as 90% of $900. The third bank in the chain can then loan as much as 90% of $810. And so it goes until the original $1,000 has been expanded by a factor of 10. So the banking system now has $10,000 of deposits from various customers. If the reserve ratio were set at 20%, the multiplier would be 5 to 1 instead of 10 to 1.

But what about the income taxes that are collected by the government on those multiple deposits? Well, it depends on whether the money that is received and deposited is defined as "income" by the tax law.

For example, assume we have an average income tax rate or a flat tax rate of 20%.

Taxpayer # 1 gets $1,0000 of income and he deposits $1,000 in the bank. Then he writes a check for $200 to the IRS. The first bank is now able to make loans of 90% of $800. But wait, The second bank that gets the tax dollars is also able to make loans of 90% of the $200 in taxes. So the banking system still gets to expand the money in circulation by the same amount.

Two taxpayers now borrow the $900 from the two banks that received the money from the first taxpayer and from the IRS. They spend the money on non-deductible personal expenses -- but the people who receive that $900 have to treat it as income. They therefor deposit the $900 in their local banks and then send a combined total of $180 to the IRS.

So the original $1,000 circulates through the economy and expands the money supply by 10 to 1. But the IRS also benefits from the money multiplier because they end up collecting $2,000 -- which is 10 times the original $200 of tax on the initial $1,000 of income.

So the next time you have to pay the IRS $200, you should know that you have actually contributed about $2,000 to the government coffers through the income tax multiplier. ANd if you don't spend the money you borrow on things that generate income tax from the people you pay the money to, then the tax multiplier doesn't work. So if you don't want the IRS to get more money, invest your borrowed money instead of spending it.

Vern

Hidden Tax on Fixed Income Investors

If you are an investor, you have been suffering from a lack of safe, moderate yield investments.

U.S. T-Bills have been yielding less than 1/2% since late December 2008. One year bank CDs are yielding from 1/2% to 1.5%. Money market funds are paying from 1% to 1.5%. Meanwhile, the inflation rate for the past five months has averaged close to 2.25%.

These low rates on fixed income investments are due to the Federal Reserve. The Fed has been keeping the discount rate charged to member banks below 1% since late 2008. While there is some concern that they will begin to raise this rate in 2010, there is a lot of pressure for them to keep rates low. If this base rate rises, the interest rate on government debt will rise and will add to the deficit.

The bottom line is that fixed income investors -- mostly retirees -- are subsidizing part of the federal deficit. They are paying in the form of lower yields on their savings in order to keep the deficit and the debt from increasing due to higher rates.

The effect of the Fed policy of keeping rates low is like a hidden tax on fixed income investors.

For more see "The Cruelest Tax of All".

Vern

Flat Tax vs. the Fair Tax

With the approach of April 15, there are a lot of commentators who are advocating the replacement of the income tax with a flat tax while others are promoting something called a "Fair Tax". What are the differences? Do either forms of taxation have any chance of replacing the income tax?

The flat tax is the easiest to explain. Instead of multiple, progressive tax rates that look like a stairway, there is only one tax rate. Instead of hundreds of diverse deductions, exclusions, exemptions and tax credits for different taxpayers, there is only one deduction for each taxpayer or family based on family size. But that deduction is substantial enough to eliminate the tax for lower income families. Various advocates of the flat tax disagree about what the single rate should be, but most of the proposals range from about 12% to as high as 33%. Most of the flat tax advocates seem to argue in favor of a revenue neutral rate that would produce the same amount of tax revenue as the combined revenue from the personal income tax, the corporate income tax, the social security tax, the estate and gift tax and an assortment of other taxes. But it would not require any major cuts in government spending as a pre-condition for switching to a flat tax.

Critics of the flat tax point to the 28% top income tax rate introduced by the 1986 Tax Reform Act that was pushed through by President Reagan. It was only a couple of years later that the rate was raised and has gradually gone up to 35% for individuals. Many deductions and tax incentives were removed by that law, but others have been introduced to take their place. Currently, the politically popular types of tax incentives are tax credits for various kinds of energy conservation. Critics also point to the fact that the flat tax is still a tax based on income and that it would require the continued intrusion of the IRS to verify that income had been reported truthfully.

For more on the flat tax see the CF&P video at http://www.youtube.com/watch?v=nhUOpNve1bY

and the Heritage Foundation Guide to the Flat Tax.

The fair tax is a national sales tax that would ostensibly replace the income tax. The government would send a check to each citizen that would represent the equivalent of an exemption from the tax at lower income levels, which is referred to as a "prebate" by the designers of the fair tax.

Advocates of the fair tax argue that a tax on consumption would have a stimulative effect on investment and would even draw investment from other parts of the world. The tax would be collected by businesses and could be managed by the state governments that already have a sales tax in place. In those states, the tax rate would include the amount already being charged in each state. States that do not impose a sales tax would either adopt one or the federal government would impose and enforce a sales tax in those states. One of the arguments in favor of the sales tax is that it is far more difficult for people to evade the tax.

Critics point to the fact that while the FAIR tax proposal calls for a repeal of the 16th Amendment to eliminate the income tax, that would require approval by 3/4of the state legislatures and would take a long time. Meanwhile, there is nothing to require that the proposal to amend the Constitution be submitted to the states. And there is nothing to prevent the politicians from simply adopting a national sales tax (or value added tax) in addition to the income tax. This is precisely what has happened in many European countries. Also, the politicians would be free to tinker with the amount of the prebate, and the various goods and services that would be granted an exemption from the tax. In addition, a high sales tax rate in border states with Mexico or Canada would lead to extensive smuggling of higher priced goods.

For more on the FAIR tax see the FAIRtax.org web site. and Wikipedia.

Is there a better choice?

While I favor the Fair Tax over the Flat tax, my main concern is that I see no mechanism to tie the introduction of the fair tax to the elimination of the 16th Amendment. I would favor a plan that would propose a repeal of the 16th Amendment with the stipulation that IF the income tax is repealed, then the federal government would replace it with a national sales tax. I would even favor making the repeal of the income tax (and other taxes like the Social Security tax, corporate income taxes, estate taxes, etc.) and the adoption of a sales tax part of the same Amendment. And while I have a problem with the idea of revenue neutrality, I do believe that once people are having to pay a sales tax of 15% to 30% of everything they buy, it will put a lot of heat on the politicians to reduce the rate and to not introduce a lot of exemptions. In addition, competition with other countries would help to keep the rate at a reasonable level.

Of course, there is also the "little" problem of getting a very left wing president and congress to go along either idea.

But that's just my two cents. And a lot of my professional colleagues think I'm a crackpot.

Vern

Estimated Tax Tips

Taxpayers who have income that is not subject to withholding not only have to deal with paying income taxes (and possibly self employment taxes) on their 2009 income; we also have to pay in advance for taxes on our 2010 income.

This can be a huge shock to people who first enter the murky tax world of the self-employed -- which has happened to a lot of employees who were laid off in 2009. But it also affects people who have income from foreign investments, controlled foreign corporations or foreign trusts. First there is the discovery that they won't be getting a refund anymore. Instead, they have to pay all their 2009 income and self-employment tax by April 15th of 2010. (The alternative is some substantial penalties and interest.)

But, to add insult to injury, they also have to decide whether to make advance payments of their 2010 taxes and they have to find a way to estimate what their tax will be for 2010. The tax law provides a safe harbor from penalties and interest on an underpayment of estimated taxes that is based on the previous year's total tax bill. Basically, if a taxpayer bases his 2010 tax estimate on his 2009 total taxes, s/he can avoid the penalties for an underpayment of estimated taxes. (For high income taxpayers, the estimate has to be 110% of the previous year in order to avoid penalties.)

Many newly self-employed taxpayers have not yet computed their 2009 taxes. But they are required to prepare an estimate in order to request an extension with Form 4868. That extension is only valid if the estimate is considered "reasonable" by the IRS, but they tend to allow quite a bit of latitude in that regard. So the first step is to estimate federal and state income taxes and self-employment taxes for 2009 and to pay whatever amount is due no later than 4/15/2010. (Penalties of up to 25% of the tax plus interest can be imposed for a late payment of the tax, in addition to any possible penalties for an underpayment of quarterly taxes for 2009.)

The next step is to use that same estimate for 2010. That creates a situation where it is as if the taxpayer is having to pay twice as much tax, although the 2010 tax can be paid in four installments. (4/15, 6/15, 9/15 and 1/15/11)

What if the income for 2009 was a windfall and is not likely to occur again?

The law does not require taxpayers to base their current year tax estimate on the previous year's tax. That is only a safe harbor from interest and penalties. Another way to make estimates is to keep track of any income (less expenses) each quarter and to estimate the total itemized deductions and other items that affect the tax bill. Those assorted deductions can be allocated to each quarter. Then the tax can be computed on a year-to-date method, based on what has actually been received. This may not eliminate the possibility of some penalties (in the form of interest) but it will avoid having to make an estimate based on a one-time windfall from the previous year.

By the way. The IRS doesn't tell you this very clearly, but the penalty for an underpayment of quarterly estimated taxes is in the nature of interest that is computed from the due date of each quarterly tax payment until April 15 of the following year. When money is really tight, it may be cheaper to underpay the quarterly taxes instead of borrowing on a credit card or from some other high interest lender. But if the taxes are not paid in full by next April 15th, the penalties and interest can be very painful.

These comments are a very non-technical summary and generalization of the specific rules. For more precise information about estimated taxes see IRS Publication 505. (http://www.irs.gov/pub/irs-pdf/p505.pdf)

Vern

Three Reasons Why Banks Aren't Lending

The government wants the banks to loan money to help businesses expand. But the banks aren't cooperating. Why? One reason is because there is more profit and less risk in using nearly interest free money from the Fed to invest in government notes and bonds.

According to Richard Suttmeier,

Banks are making a basic mistake of borrowing short and lending long, as this strategy seems to be the only risk of profitability they are willing to make. This House of Cards was a factor in the late 1980s/early 1990s, as the curve shifted to inversion, causing mismatched losses on top of bad loans.

The Federal Reserve has been keeping the federal funds rate near zero for an extended time.

The banks can therefore borrow from the Fed at a near zero interest rate and use that money to invest in longer term U.S. treasury obligations that pay interest. Borrowing short means borrowing money that is due to be repaid in a short time -- such as overnight or in a month. Investing long means putting money into fixed interest debt obligations that have a long-term maturity -- like three years or more. Except for the risk alluded to by Suttmeier, the banks see this as a nearly interest free and risk free way to use funds from the Fed to invest in government obligations for which the Fed is the guarantor of last resort.

But there is a second reason why the banks aren't lending.

Some people call it the bureaucracy.

Unlike entrepreneurs, employees have little to no incentive to assume any risk that might result in criticism from a supervisor, or even the remotest possibility of being fired. So when there are written rules to follow, they tend to follow the rules, regardless of whether those rules make sense or whether those rules are out-of-date or are inconsistent with some high level policy decision. And when employees are criticized or threatened with the loss of their job for some previous infraction of the rules, they are motivated to avoid a repeat of those occasions.

Employees of the banks perceive that failing to comply with the rules imposed by the regulators is a threat to their job security even when it is obvious to all that the rules are contrary to a new policy or even to a new law.

A third reason why banks aren't lending could be called the pendulum syndrome. When we do something that causes pain, we tend to over-react by shifting to an opposite extreme. Before the real estate bubble broke, many banks were lending money to nearly every every warm body that asked for a loan, Now they are over-reacting in the opposite direction. Lending standards have increased to such a degree that few borrowers can meet the requirements.

Meanwhile, there is a steady flow of news stories about high levels of bankruptcies, loan foreclosures and other indicators that the economy has a long way to go before there is a recovery to a relatively normal level of activity.

Just my two cents.

Vern Jacobs