A Recipe For Failure... And America Doesn't Bat an Eye

As president-elect Obama has so diligently and strategically pointed out, America is due for a "significant recession." I suppose I could go on a tangent about how this recession came to be, but I'll save that epic novel for a later post. For this short blog I will expound on the methodology the next government plans on using to go about stimulating economic growth.

With the Fed again having interest rates nearing rock bottom and the economy still stuttering, it will no doubt be the federal government's fiscal hand that makes or breaks this recession. In two general terms, the government has two options of stimulating economic growth: temporary and permanent infusions. We are all-too familiar with Washington's beloved temporary infusions; most of us got one this past summer in the form of a $600-1200 check. These handouts did a little to increase consumer spending in the summer months. Congress and the president-elect have mentioned another temporary infusion much larger than the first. The goal of this infusion, again, is to stimulate aggregate demand and send the economy soaring into the 21st century. Some of the proponents of this use the first Bush stimulus package in 2002, which was very successful, to support their argument for another rebate check. What these politicians don't mention is that Bush's initial rebates were coupled with massive cuts in personal income and capital gains taxes, or permanent infusions.

Economic theory and graphs aside, let us just look at this from a common sense perspective. If you give an individual a one-time check, what are they going to do with it? Save it. Use it to pay bills. Maybe they'll spend some of it. However, if you sit the person down and tell them you are going to cut their taxes by 5% for at least the next 8 years, what are they going to do? The increased security and predictability of the permanent infusion will encourage the individual to invest that money into long-term assets like businesses, capital, employees, and best of all, financial institutions!

One of the problems in the economy right now is uncertainty amongst lenders over which prospective customers are worth the institution's investment. In the available-for-sale securities market between financial institutions, are these packaged securities really worth what they say they are? The government already took the wrong course of action in their $850 Billion & counting Bailout package in October, which did nothing to unfreeze inter-institutional trading and lending, because it did not remove the uncertainty of valuation from the securities that make up the balance sheets of these respective institutions.

Since we have failed to tackle this problem from the business-end, the government still has the opportunity to help fix the problem from the consumer end. A permanent infusion (tax cuts) will give consumers the extra cash flow to then infuse financial institutions with fresh loans for business expansion and new equipment. This form of infusion can work. Another huge temporary infusion may very well succeed in boosting consumer spending for one quarter and printing off even more money that we don't have, but it will not succeed in the ultimate goal of stimulating long-term economic growth. The president-elect saying this will be a "significant recession" is simply giving himself a cushion to fall back on when their next poor investment backfires.

The only problem with a tax cut is that it would require the government to cut spending and do with less, and the government shrinking in size and scope would most assuredly lead to a lapse in the space-time continuum and the implosion of the known universe.

My next post: The real problem with the Big Three

Obama's "Tax Cuts"

The big issue in the media nowadays regarding Obama's venerable tax plan is how the numbers behind his "tax cuts" don't add up. Right now almost one third of the American workforce pays no income taxes once they receive their standard deductions and refundable credits. Obama's tax plan will essentially expand refundable credits to the lower income earners and put about 40% of the workforce off the tax grid completely. I have my personal gripes with the public policy effect of having this much of the voting population with no equity in the federal budget (namely apathy in regards to where that money goes), but I'll limit this post to facts behind the numbers. Recently the McCain campaign has been abandoning the Bill Ayers story, which they should have been concentrating on months ago, and is now shifting to policy issues. They have been harping on Obama for his comments about "spreading the wealth" and his "tax cuts for 95% of America" statements.

When asked about how his administration does not have a socialist platform with a third of the workforce effectively receiving income tax refunds for income taxes they never paid, his campaign and The Tax Foundation responded by saying that the refundable credits would also help to offset the burden placed on them by "payroll taxes, corporate income tax, excise taxes, etc."

It's all very fancy verbiage that, to the uninformed voter, seems fair. But here's my take on the Obama campaign's burden-offsetting refundable credits:

Payroll Taxes: "Oh, but this is to also refund their payroll taxes!"

Ah, well in that case, it means their contributions to medicare and Social Security are also being refunded... this is 40% of the population with little to no basis in the system who will be drawing checks in the future based on a number they supposedly paid in in the present. Where's that money coming from in the future? They tax "the rich" for it, and deny "the rich" the privilege to withdraw it when their time comes. Problem solved.

Corporate income tax: I don't know what they're trying to get at here. These lower 40% of wage earners aren't "corporations," they're people, so I am assuming these guys are talking about the lower 40% who have equity stakes in S-corps, partnerships, etc. Now that I think I know what they're talking about, it still makes no sense considering S-corps and partnerships are flow-through entities anyway, and what that means is the income of the "corporation" or partnership is distributed to the "corporation's" shareholders, and taxed at the shareholders' marginal rate on the 1040 - which makes the "corporate tax" argument null and void, and not even worthy of being mentioned in the explanation because it has no effect on their income taxes. Any "corporate" income will have already determined whether they are in the marginal bracket to receive an "Obama tax cut" or not - but it does jazz it up a bit to make the future welfare recipients seem as if they are contributing to the system rather than parasitically sucking from it.

Excise taxes: Ah, so now they are getting their gas taxes refunded, which means 40% of the people aren't contributing to the funds to rebuild and maintain our roads and highways. They're getting their cigarette taxes refunded so now they aren't paying for their fair share of SCHIP (how much do you want to bet some of those lower 40% of earners have kids subsidized by SCHIP?) Plus, I thought excise taxes were meant to discourage despicable things such as smoking, shooting, and drinking... why do these people deserve to get that money refunded to them? After all, the DC liberals are the ones who enacted those taxes in the first place. Seems kind've counter-productive to me, but then again I'm not a fan of the federal government partaking in social engineering via taxes either, the DC liberals are; thus they have more 'splainin' to do for this kind of thing than me.

So these taxes listed by the Tax Foundation that are supposed to put us at ease with the fact that we are becoming a nation of redistributionist socialists are null and void in regards to determining the Obama "tax cuts."

The Windfall Profit Dilemma

The media and certain politicians have been clamoring about this taboo word in American business – windfall profits. Each of the two major presidential candidates have made their positions publicly known regarding their stance on oil company profits in relation to the rising price of fuel. While they both have grievous fallacies in their logic that defy common sense economic principles, in this essay I would like to evaluate the particular stance of the presidential candidate Barack Obama. He has pledged to tax the “windfall profits” of the oil companies, citing the oil industry’s $132,000,000,000 profit last year. The intent of this article is not to open a salvo on Senator Obama as an individual or to lambast the seemingly universal platform of the Democratic Party regarding the oil industry, rather the purpose of this article is to shed some light on what I believe to be the most overused and misunderstood term of this election season.

What is a windfall profit? It is a term whose definition has been changed over the course of politics to benefit the populist motives of the particular group in power. Throughout history up through the latter part of the 20^th century, a windfall profit was defined as: a profit, or capital gain, derived from an investment in which the receiving entity did not contribute to the creation thereof. This may seem complicated, but in actuality the concept is very simple. As an example, let us take two striving entrepreneurs, Jack and Sally. Jack believes he has invented a new shampoo bottle that can revolutionize the shampoo bottle industry. Jack approaches Sally to convince her to contribute capital towards his shampoo bottle venture. Sally, believing that the idea would not be profitable, declined any financial backing to Jack. Thus, Jack pursued his shampoo bottle venture exclusively. Ten years go by, and Jack’s shampoo bottle idea finally takes off, and Jack becomes an overnight millionaire. Just to show Sally that his idea was in fact marketable, he sends his old friend Sally a check for $10,000 of his shampoo bottle earnings. Sally graciously accepts the gift. Which of these two individuals would be pegged with a windfall profits tax? Using the historically accepted definition of a windfall profit, it would seem that Jack’s millions of dollars would be recognized as ordinary operating income, seeing as though he had a risk, or financial investment, associated with every step of his shampoo bottle venture, from the conception of the idea to the manufacturing of the bottles. He had everything to lose in his investment, so any capital gain derived from it is legitimate. Sally, on the other hand, had no part to play in Jack’s shampoo bottle business, yet she received a large sum of money from Jack’s company, effectively reaping the benefits of the company’s success without having any basis or risk in the company itself. Poor old Sally is going to have to pay a windfall profit tax on her check from Jack.

Now that the definition of windfall profit is out of the way, how do Senator Obama and his party feel this scenario can be applied to the oil companies with their $132 Billion profit? That number in and of itself is mind blowing, isn’t it? The rich tycoons at big oil are making $132 Billion profit in a time when gas prices are $4 per gallon, doing an injustice to the working man. It’s the government’s job to step in and stop these corporations from ripping off American citizens, right? And the best way for the government to intervene is, naturally, to step in and tax those “windfall profits,” reducing the company’s inclination to make those dirty profits again. While the simple number, $132 Billion, may invoke strong emotions that are beneficial for empowering a particular political party’s voting bloc, that number in and of itself is not the whole story. I will take this opportunity to break down profits of ExxonMobil to see exactly where that $132 Billion came from. According to ExxonMobil’s audited income statement, their profit margin for FY2007 was 9.72%. For simplicity’s sake in my examples, I will use 10% as their profit margin, which in reality will overstate their actual income by tens of millions of dollars given the sheer volume of sales ExxonMobil recorded, but it will also make the numbers easier to calculate and follow for the sake of this essay. Given a 10% profit margin, we can conclude that for every $1 XOM invested, they received $1.10 in return. That 10 cent return on investment, multiplied by the gargantuan volume of investments, or risks, the company made, those meager returns on investment eventually amount to a massive $132 Billion over the course of 12 months of business. Now let us delve into whether a 10% return on investment is suitable for the company. An individual can find a decent, low risk Certificate of Deposit with around a 5-6% interest rate. All that is entailed with a CD is that the individual deposit his capital for a pre-specified period of time, and in return the financial institution pays the individual a pre-set amount of interest for the individual giving the financial institution the privilege of utilizing the individual’s funds. Given the definition of a CD, we can conclude that CD’s are considered very low risk investments that yield anywhere up to a 6% return in given market conditions. Now let us transition into the investment risks of oil companies such as ExxonMobil. In the oil industry, sunk costs are very common. Before an oil company drills for crude, they must pay geologists to determine to the best of their abilities whether the company will find any crude in the hole. They must pay environmental firms to conclude that there will be no adverse environmental effects from drilling in that particular location, and they must pay the federal and state governments exploration fines and protection costs to have the ‘privilege’ of being able to drill for crude in this great country in which we live. Once it’s said and done, ExxonMobil can spend over $1 Billion on preparation for drilling a hole in the ground, and they may or may not get any crude out of that hole. The risks are very high, and once the exploration and preparation costs are sunk, there is no way for XOM to re-obtain that capital. Given the high regulation and risks entailed with the oil industry, some would say that a 10% return on investment is considerably low when taking into account the fact that you can just as easily invest your money in a low-risk CD and get a 6% return on it. If this example alone is not convincing, consider the mid-1990s when oil companies sustained just as many risks as they do today, yet their profit margins were only 5%. Given this situation, would a wise investor contribute capital to a high-risk industry that gives a 5% return such as the oil industry, or a low-risk investment that gives a 6% return, such as a CD? The everyday risk averse investor would stick with the CD.

Now that we know where the profits come from and why they are the way they are, I will attempt to grapple the ever-prevalent idea that oil companies are overcharging Americans, and making too much money off the back of the working man, that they are “price gouging.” It has been given that ExxonMobil’s profits were 10%, or 10 cents for every $1 of fuel sold. Some say this is too much. Rather than disagreeing with that argument, which by the way, I do, I will take another approach. The federal tax on a gallon of gasoline is 18 cents. The average state tax on a gallon of gasoline is 42 cents. Thus, on average, 60 cents of every gallon of gasoline you put in your tank goes to the government. Using the current average price of gasoline, $4, we can conclude that the government receives an exclusive 15 cents of every $1 of gasoline sold (60 cents / $4 per gallon). In other words, ExxonMobil, who is in the business of extracting crude and distributing gasoline, earns 10% on their core business, while the government, who shares none of the industry risks that ExxonMobil has, righteously receives 15% of the earnings. Am I wrong for seeing the inherent flaw in the status quo? For those out there who claim the oil industry is price gouging, I ask the question… who exactly is gouging whom?

Now that the groundwork has been completed, let us transition back to the term “windfall profit.” Once again, windfall profit is defined as: a profit, or capital gain, derived from an investment in which the receiving entity did not contribute to the creation thereof. Politicians like Senator Obama would have us believe that the profits earned by ExxonMobil are to be considered “windfall,” and therefore should be taxed accordingly, effectively placing a double tax on the company’s earnings – a tax on gross income, and then second tax on the resulting net income. Since this message is clearly clouded in political spunk, I believe the best way to approach this is to take the oil industry and break it down into something that I call “The Gas Cycle.” What are the steps involved in the process of an oil company to bring gasoline to bear in the consumer market? In my gas cycle, the six-step cycle includes: Exploration, Extraction, Transportation, Refinement, Distribution, and Collection. Taking each step of the gas cycle, we will decide whether the expenses incurred by oil companies are directly attributable to the terminal earnings, thus excluding those earnings from a windfall profit category. Do oil companies make a direct investment in the exploration and extraction of crude? They most definitely do, spending billions of dollars every year in search of fresh crude reserves. Do oil companies make a direct investment in the transportation, refinement, and distribution of gasoline? Once again, yes they do. They pay for the oil tankers to transport the crude halfway across the world, and they spend billions of dollars every year increasing refining capacity and streamlining refining and distribution operations throughout the world. Are the collections from the sale of the distributed goods therefore attributable to ordinary operating income or are they considered a windfall profit that should be double taxed? Using our historical definition of a windfall profit, a profit, or capital gain, derived from an investment in which the receiving entity did not contribute to the creation thereof, I would conjecture that the answer is No. Operating income of oil companies does not qualify as a windfall profit, and should not be treated or taxed as such. Not to mention, believing that increasing the tax on corporate profits is an effective method to go about lowering the price of the good that the corporation supplies is counter-intuitive at best, and it completely negates centuries of proven economic principles – but this is another argument for another article.

Given that it is incorrect to classify oil company profits as windfall profits, I have a longstanding question that I’d like to throw into the debate arena. Since it has been our very own government officials who have been shrieking about the windfall profits of oil companies, it made me contemplate the government’s role in the oil industry, and to what extent the government’s income from the sale of gasoline was considered legitimate. We know that oil companies have everything to gain and everything to lose in crude exploration – just a few bad drilling decisions could lead to a company the size of ExxonMobil going under in an industry as internationally competitive as theirs. What financial basis does the government have in the gas cycle? What investment does the government have to lose if the oil company drills a dry hole? What financial risk do they carry in the success of crude exploration? They carry no risk, yet they still receive more income from the sale of gasoline than the oil companies themselves do. So I ask this question, “between the oil companies and the government, whose ‘windfall profits’ should we really be concerned with?”

Tax Cuts For the Rich?

I was never able to figure out what these "tax cuts 'for the rich'" were that the politicians kept blabbing about. Perhaps y’all can help me out here. I know this talk is all in reference to the Tax Relief Act of 2004. What I can't seem to figure out is how anyone can think this was simply for the rich. It completely did away with the marriage penalty and made the standard deduction for Married Filing Joint twice the standard deduction of filing single, like it always should have been. This helps everyone, and since it is a flat deduction (e.g. a poor couple gets to deduct $10,000 just like a rich couple gets to deduct $10,000) it could really be argued that it is a regressive tax benefitting the poor more than the rich. It also upped the Child Relief credit from $600 to $1000 per child. It's a refundable credit so even once your taxes paid for the year reaches $0, you still get the money back (effectively giving you money from someone else's pocket)... and for every $1000 over $100,000 a family earned, the tax credit begins to drop off until it hits $0, also making it a regressive tax benefitting lower income families. The Act also implemented a 10% tax bracket for those making less than about $7150 per year (from the 15% bracket), benefitting the very poor. On top of that, it lowered all the other tax brackets (25% from 28%, 28 from 30, 33 from 35, and 35 from 38.6). In effect, some people got a 5% tax break, a vast, vast majority got a 2% break, and some got a 3.6% break. There are also a truckload of other tax credits for teachers and low income workers that I won't even begin to delve into.

The politicians, when they talk about these "tax cuts for the rich," I believe are referencing the 3.6% tax cut that those families making over $326,000 per year received. We have to keep in mind that this tax relief package was designed to stimulate a stagnant economy, and the best way to do that is to free money up with the big investors and small business owners (those making over $326,000), to encourage them to invest into new business ventures and hire more employees. Four years down the road we can see that the plan worked very well, almost too well... but I just don't see how anyone running for national office could stand up and with a straight face say Bush's tax cuts were "for the rich." Sure, the rich got more money back than the poor, but that's only because the rich paid in exponentially more than the poor. The top 25% paid 86% of the total income taxes collected by the government. In 2006, the top 1% paid 39% of the total income taxes. When Bush took office, the top 1% paid 37% of the income taxes. Thus, as a tax base, those in the highest tax bracket contributed 2% more to the federal coffers than they did before the tax cut. This is where it boils down to the science of tax cuts ("for the rich," if you will). The tax cuts given 'to the rich,' that increased investment and hiring succeeded in creating more "rich," who in turn also had to pay the evil reduced 3.6% tax rate - but the more rich people still produced from the 3.6% tax break increased the government's revenue on rich people that were created from the successful investments made from those tax cuts... summarily causing the rich to pay more of the federal income tax than they were before the tax cut...