Marotta on Money
Government-Provided Economic Security Is an Illusion
MAROTTA ON MONEY by David John Marotta
The various congressional bailouts have been touted as essential to the nation's economic security. So long as the notion of economic security remains vague and abstract, it has wide support. But anyone who examines the details should realize this so-called security threatens our freedom and stability.
Security can be understood in two different ways. The first is having enough to eat, a place to live and clothes to wear. We all can agree that in our affluent society we can afford to provide every citizen some minimum standard of living so those falling on hard times may be given a hand back up.
The second way to understand security is the assurance that whatever salary or assets you have earned, including your current position and rank in society relative to others, are yours to keep. Often this second type of security is overlaid with a moral judgment that the people benefiting from this support are more deserving than the rest of society.
With today's level of productivity we can provide the first type of security without endangering freedom or promoting corruption and preferential treatment. Even so there is still serious debate about this support. We should question if government is the best vehicle to deliver it or if private charities do a better job. With increasing globalization, we should also ask the moral question if our safety net should provide a level of support well above 95% of the world's population.
Nevertheless, security of this first type generally protects people against calamities they would naturally want to avoid under any circumstances. It helps them preserve their health, ability to work and the possibility of regaining a foothold if needed. In other words, it gives them a safety net, not a hammock.
The second type of economic security is much more of a threat to freedom and certainly more prone to corruption. Under this type of security, society tries to protect certain sectors of society from the natural and regular fluctuations of economic activity by subsidizing some or all of their losses from failed ventures. Some automakers get money, and others do not. Some banks are subsidized, and others are allowed to fail.
This form of economic security is ultimately designed to protect certain classes from loss of either their annual income or their accumulated wealth. In a free-market economy, people spend their money on those goods and services they believe are the most valuable. They are free not to spend money on things they deem less valuable. The behavior of consumers is an objective way to measure the value placed on particular goods and services.
Any supplement of the value that people are actually willing to pay for goods and services can only be based on subjective bias away from the fair market value. It may correspond to some perception of effort and intentions, but it will still be subjective bias, trumping an objective willingness to pay freely.
To understand these two kinds of economic security, consider that people are more willing for the government to bail out the consequences ensuing from a large disaster than a personal tragedy. The more people who are killed or inconvenienced, the easier it is to garner public support, even though a family is no less devastated by a single fatality in a car accident or a lightning strike. Helping people in need is always a kind and gracious act when freely given. But making it an entitlement of public policy is not.
Again, I'm not talking about efforts to help rescue families subject to the misfortunes of market forces by providing basic needs. I'm questioning the wisdom of bailing out the industries themselves so those who are employed keep their middle- and upper-class lifestyles. Ensuring security in some sectors of the economy comes at the expense of other sectors. Securing one sector against market fluctuations destabilizes all the other sectors, causing the latter to bear the brunt or needlessly fail themselves.
When a few receive the largess of a specifically targeted bailout, the rest of society is left to pay the consequences. The cost of the resources bestowed on the privileged drives up the cost for everyone else. The tax revenues directed toward the enfranchised are often taken from those of lesser means. And the trillions spent devalue the accumulated savings of those who received no government boon.
This problem is not simply that the free market gives people an incentive to do their best. Rather, the bailout removes any yardstick by which they can even judge what is best. The bailout changes a private mistake into a public crime. When private businesses fail, it need not be a public matter. The business goes under because of poor management, and the assets are sold or distributed as part of the company's liquidation. If there are fewer banks in town, I am not hurt. If one car company stops production there will still be competition to sell me a new car. But if the government guarantees the enterprise, then it becomes a crime against society for the company to fail. Failure now becomes a political scandal.
There must be charges of mismanagement. There must be an inquiry. Those responsible must be held accountable. Those innocently injured must be made whole. And all of this must be accomplished by government.
It doesn't matter that other companies, perhaps even in the same industry, were well managed. They will not receive support. And worse, they will experience an unfair disadvantage in the marketplace when their direct competitors are subsidized. To every grant of security bestowed on one group, every other group grows more unstable and finds its freedom compromised.
Government spending is often taken to have a wholly positive effect on the economy. It is assumed that as the money is spent, jobs are created, companies become profitable and the money received in taxes is spent again, creating a higher gross domestic product and a higher tax base. Such thinking is obviously false. No family can spend their way out of debt or financial troubles. Neither can society as a whole.
If the government had allowed the money to remain in the hands of the taxpayers, they too would have been able to spend the money, creating jobs and empowering the economy. Although you can argue that governmental choices are superior to the choices that individuals might make, you can't argue with the fact that individuals, free to make their own choice, would have chosen to spend their money differently.
In free markets, transactions are voluntary. They do not continue unless both parties believe they are better off making them rather than not. But government policies are not voluntary. They can continue indefinitely even if they impoverish society as a whole. Government doesn't have any productivity of its own. It can simply take money from some and give to others. And because government's pie is fixed, if it guarantees a set portion to one group of constituents, it inevitably diminishes the share apportioned to everyone else.
As a result, security becomes a political privilege and more difficult to achieve. We can only look to politicians to provide it. As a scarce and thus more valuable commodity, security soon overshadows other measures of success. Controlled areas of the economy cause other sectors to fail in an increasing spiral. And when they do not succeed, it is perceived as a failure of the free markets. Unregulated parts of the economy won't be able to take risks. And both the risk of failure and the potential windfall profits are then viewed as moral failings.
Put another way, the very engine of entrepreneurial capitalism is increasingly implicated as the problem. Lack of regulation is blamed until security is imposed on more parts of the economy. It doesn't matter that government intervention in the free markets provoked the failure. Government causes the problem in the first place and then gains sweeping powers as society relies on it to solve the crisis.
Unquestionably, both the Bush administration and the Congress dominated by Democrats are to blame for poor bailout legislation packages. We need a new political paradigm, one humble enough to acknowledge that regulation caused many of the crises we are currently facing. Intervention is prone to all that is worst in Washington special-interest lobbying. And intervention disrupts much of the equilibrium in the markets and makes security less likely. We must recognize that attempts to impose security are apt to destabilize rather than ensure people's security.
It's Time for a Tea Party
MAROTTA ON MONEY by David John Marotta
Some people try to defend the practice of earmarks with three arguments. First that earmarks only account for 1.9% of the budget. Second that earmarks stimulate the economy. And third that earmarks support many worthy causes. But in each case, the harm done by earmarks is much worse than the average citizen believes.
If you think earmark spending represents such a small and identifiable portion of the federal budget, you must believe it would be easy to eliminate. So let's do away with all wasteful spending as an act of responsibility, consensus building and bipartisanship. The impossibility of doing just that shows clearly how earmarks are tied significantly to the way money corrupts. The truth is that all of government spending would change if earmarks were eliminated.
Earmarks represent the graft and bribery that grease the passage of a pork barrel budget. Congress just approved a $410 billion spending bill, 1.9% of which was required in personal kickbacks (called earmarks) to buy votes. That so-called small percentage amounts to 2,484 times the compensation of the AIG executives. Bonuses at AIG were given to 400 employees with only seven receiving more than $3 million. In contrast, the average member of the House received about $18 million in earmarks.
Increasingly, in an attempt to show their transparency and responsiveness, representatives are inviting committees to review and prioritize projects based on efficient-sounding criteria. My own district representative invited the input from local bureaucrats who have the largest stake in feeding at the government trough. This tactic provides enough of an appearance of involvement for political cover without actually taking into account any of the small business owners who really pay the bills.
Earmarks themselves aren't the government waste. They are the price of the graft to corrupt politicians into supporting the real waste. For you who believe $18 million can't corrupt a politician, bear in mind that every congressional district is making off with more money annually than the $11 million perpetrator of our local Ponzi scheme scandal did over several years. Not content with the average $18 million, my representative attached his name to $159,630,155 worth of earmark requests.
This is not partisan criticism. The best we can say about members of one party is they can be bought for less pork or they cover their graft with more worthy-sounding causes. But these comparisons shouldn't lessen our outrage. Nothing can justify what Bernie Madoff did, even if he donated liberally to charity.
The second defense of earmarks claims they stimulate the economy. They do not. Economic resources are clearly limited. Money confiscated and spent by government has alternative uses that in most cases would have better stimulated the economy. Private enterprise can only spend money where their return would be positive, creating new jobs and causing economic growth. No economic growth means it is unsustainable in the private sector.
Not so with government spending. Unlike private enterprise, the government can deficit-spend indefinitely on programs with no redeeming value in the economy. I've looked over the 51 earmarks requested in my district. None of them relates in any way to susainable business ventures.
My first column for the Charlottesville Business Journal was coauthored with my father, George Marotta, in 2002: "Will the U.S. Go the Way of Japan?" The fall of Enron was fresh in everyone's mind, and our answer to this question was no because "In the US we allow companies to go bankrupt when they cannot succeed in business. In Japan, both banks and corporations that are bankrupt are allowed to continue and drag down the economy. The ruthless culture that allows large companies to go bankrupt in the US hurts less in the long run than the Japanese style of business subsidies. In the US, the government keeps hands off business; in Japan the government interferes with the operations of business and commerce."
But times change. Our government's intervention in the financial markets, its dictation of contractual bonuses and the firing of company CEOs is unprecedented statism and deserves to be described as socialism or even fascism.
Senator Charles Grassley of Iowa suggested that AIG executives should "resign or commit suicide." He advocated an attitude in corporate America that would emulate the Japanese model, saying, "People that run a corporation into a ground have violated their trust with the stockholders and maybe even the taxpayers."
The bailouts transform a private mistake into a public crime. A business goes under because of poor management, and the assets are sold or distributed as part of the company's liquidation. But if the government guarantees the enterprise, it becomes a crime against society for the company to fail. Failure now becomes a political scandal.
There must be charges of mismanagement. There must be an inquiry. Those responsible must be held accountable. Those innocently injured must be made whole. And all of this supposedly must be accomplished by government.
As a result, the so-called bailouts will prolong the economic malaise. The government should not have intervened. We would be better off if those over leveraged financial institutions had filed for bankruptcy. No company is too huge to fail. And those that claim to be are too big to subsidize at the expense of hundreds of small companies.
Make no mistake: there will still be a recovery, but it will be in spite of government's actions not because of them. The very livelihoods of scores of employees of publicly traded companies depend on them making a profit. The recovery will be on the backs of millions of workers, but congressional leaders will claim the credit, as always, if and when private enterprise can overcome government disincentives.
And finally, the third defense of earmarks claims they support many worthy causes. I expected this argument to be difficult to refute because discerning "worthy" is very subjective.
Interestingly enough, this claim isn't hard to refute because all the criteria selected are economic. In my district, appropriation requests were prioritized based on criteria that would give representatives economic political cover: (1) the potential to transform our economy, (2) the greatest impact on economic development, and (3) the ability to create or attract jobs.
First, all of the earmark projects were solicited by governmental agencies in and around the district. They are all justified by their descriptions as "This project is a valuable use of taxpayer funds because [fill in blank]." But in each case, simply allowing citizens to keep that money would have been a more valuable strategy. As government spending consumes an ever-larger portion of our economic output, less remains for real investment and economic transformation.
Efforts to attract jobs through subsidies or protectionism that can be done more efficiently elsewhere always lose money. If every district spends $1 million competing to attract new industries from other districts, it is a complete waste of $425 million. Even if the jobs we are trying to steal are outside of the United States, it's still a bad idea. Spending that money to force Americans to take jobs away from developing countries that aren't profitable enough for our citizens by putting incentives in place to make those jobs more attractive is a losing proposition. Why not simply allow our citizens to fulfill the roles in the global economy where we are more competitive?
Small businesses create all the new jobs and profitable industries in the United States. But no incentives are being offered for current entrepreneurs to expand or start new ventures. Two thirds of small business profits are earned in households making more than $250,000, yet every spending program has been justified with promises that it will be paid by those earning over $250,000. The marginal tax rate of these small business owners is expected to rise from 44.6% to 62.4%. At those rates, small business owners will change their behavior.
Business owners will not choose to maintain their level of productivity with a 62.4% marginal tax rate. They will simply work less. This is not a new idea in the history of fredom.
The most productive wage earners are among the hardest workers. According to Steven Landsburg, leisure used to be evenly divided among the classes, but it isn't any longer. Although Americans as a whole have an extra four to eight hours of leisure per week, it is those in the lowest tax bracket who enjoy this extra leisure. Today, more than ever, it is the working rich and the idle poor.
I've been studying the life of John Adams and continue to be impressed by his political insights. He feared our democracy would ultimately vote itself bread and circuses at the expense of individual rights and freedoms. "Property," he wrote, "is surely a right of mankind as real as liberty."
Just because a majority of citizens think it is a good idea doesn't make it so. Half of the country doesn't even pay taxes. Among the remaining half, even a small number in favor of a project tips the scales. Compare it to two foxes and a hen voting on what to have for dinner.
For those of you who would like to vent some of that righteous indignation, Tax Day rallies are held April 15 in nearly every major city. Charlottesville's Tea Party takes place on the east end of the Downtown Mall at 3 p.m. on Wednesday. For information on the Tea Party movement, visit www.taxdayteaparty.com. More details on the Charlottesville event are available at vateaparty.wordpress.com.
The organizers are asking people who would like to speak at the rally to keep their speech nonpartisan, supporting fiscal integrity and not a particular party. That makes sense to me because those who truly favor fiscal integrity probably couldn't support either party.
Roth Segregation Accounts
MAROTTA ON MONEY by David John Marotta
The world of retirement accounts is a confusing tangle of IRS codes. The average family does not take full advantage of the tax laws. They can find financial tax planning equally bewildering.
A complex technique called "Roth segregation accounts" could earn your investments an extra 30% over the next two years, so you'll have to study this column carefully to understand how it works. But trust me. Learning about this strategy will be well worth the time.
There are two types of individual retirement accounts (IRAs): traditional and Roth. With a traditional IRA, contributions are tax deductible for middle- and lower-income families and the values grow tax deferred. But as you withdraw the money, you have to pay ordinary income tax rates on it. If your tax rate is lower in retirement when you take the money out than it was when you originally received the tax deduction, a traditional IRA account can offer great benefits.
Upper-income families don't get a tax deduction if they are an active participant in an employer plan. However they can still contribute to a traditional IRA. Money they put in that didn't qualify for the tax deduction still grows tax deferred. But when they withdraw the money their tax liability is lower. Imagine they contributed $10,000 that was tax deductible and $5,000 that was not because their income had risen above the limit. After many years their $15,000 contribution has grown to $100,000. When they withdraw the money in retirement, 5% of it is not taxed because of that $5,000 after-tax contribution.
Traditional IRAs are also subject to required minimum distributions (RMDs). Starting at age 70 1/2, owners of traditional IRAs must take a certain percentage out of the account and pay ordinary income tax. The government requires the withdrawals because it wants to start collecting tax on the money. But because account values have dropped so much lately, Congress has waived the RMD in 2009. (The government evidently wants account values to recover to maximize the taxes collected.)
With the second type of retirement account, the Roth IRA, there is no tax deduction when you deposit the money. You must pay the tax on the income first and then contribute to the Roth. And only middle- and lower-income families are permitted to contribute. The investments grow tax free rather than tax deferred. Qualified distributions from Roth IRAs are not subject to any income taxes. Roth IRA accounts are to your advantage if your tax rate is higher in retirement when you withdraw the money than it was when you contributed.
With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket only to find themselves in a much higher bracket during their retirement. In fact, so much money has accrued in retirement accounts that if it were all withdrawn today, it could pay off a significant percentage of the federal deficit.
In fact, you can do just that. In a "Roth conversion," you take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. Currently only middle- and lower-income families can do this. But the law will change in 2010, allowing families with any level of income to convert to a Roth.
If you execute a Roth conversion in January of year 1, you may not have to pay the tax on that conversion until April 15 of year 2. You also may change your mind. If you decide the conversion wasn't worth it or you were over the income limits allowed for a conversion in 2009, you can move the money from the Roth account back to a traditional IRA account. This is called a "Roth recharacterization."
Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So you can change your mind any time before October 15 of year 2. And you can decide to recharacterize part or all of what you converted.
In the midst of all these changing tax laws, the tax rates are also in flux. At the end of 2010, the Bush tax cuts will expire. The Obama administration is not expected to alter the rates significantly before then. They don't want to be blamed for raising taxes before the midterm elections. They would rather implicate the previous administration for a crazy expiring tax law.
Until then, tax rates are at a historic low. After 2010, counting all the tax changes, top marginal tax rates will probably rise from 44.6% to 62.4%. Thus you will only have to pay a maximum of 44.6% on income you can take before 2011, but after that you may have to pay 17.8% more in tax.
The upside is that you can use all these laws and changes to gain an extra 30% on your investments. During the next few years, tax planning and management will be a significant part of wealth management. But it needs to be put together as part of a larger plan.
Here's the timeline of how to use a Roth conversion to maximize your investments. Early in year 1, do five Roth conversions of equal amounts into five separate accounts. You aren't going to keep them all, so you can convert five times as much as you want to end up keeping and actually paying tax on. Invest each Roth account in a different asset class (e.g., large-cap U.S. stock, small-cap U.S. stock, foreign stock, emerging markets and hard asset stocks).
The five accounts will appreciate differently, but the entire portfolio will be fairly well balanced. Before April 15 of year 2, decide if you will be keeping only one account or more than one. If more than one has appreciated significantly, you may want to keep more than one account's conversion. Compute your tax liability for the year and pay the tax, but instead of filing your return, file an extension.
Before the October 15 extension deadline, decide which of the five accounts you are going to keep. By now, nearly a year and three quarters has elapsed. You can easily determine which account has appreciated the most. Keep that one and recharacterize the other four. Because you only have to pay taxes on the amount you originally converted, it's like betting on the horse race after the winner has already been determined. After recharacterizing the accounts, file your tax return before the October 15 extension.
If all of the accounts decrease in value, recharacterize them all and pay no tax. Financially you are none the worse for having filled out a folder of paperwork. If only one account appreciates significantly, you only keep one conversion. But you have increased the odds of your Roth account going up by five times.
The average return of the S&P 500 is about 11%, but the standard deviation is about 19%. All of the other asset classes have an even higher standard deviation. It is likely, for example, that emerging markets will be either the best or the worst performing asset class over any two-year period. Using this technique you can guarantee that the Roth conversion you keep will have been invested in the best asset class during that year and three quarters.
Segregating each of the five conversions into a separate account allows you to decide to recharacterize or let each account stand separately. The difference in returns between the average and the best account is liable to be 20% or more over the year and a half before you have to choose which accounts to keep. Coupling the 17.8% tax savings and this Roth segregation technique could boost your returns by 30% or more.
In the quite likely event that all five accounts have appreciated significantly, you may decide to keep them all. Once you have reached the maximum tax rate, the top marginal rate does not increase from there. Those most fearful of expectations of higher tax rates soaking the rich after 2010 would be those most likely to benefit from converting everything.
If you are under the threshold for Roth conversions for 2009, you can start this year. This is especially appropriate for people older than 70 who are forgoing their RMD withdrawals. At least convert the same amount as you would have been required to withdraw anyway. Better yet, convert five times that amount in five separate accounts and keep the one which performs the best.
If you are over the income limits for Roth conversions this year, those limits go away next year. You can convert in January 2010 and you'll have until October 15 of 2011 to decide which accounts to keep and which accounts to recharacterize. If you do not qualify to make either Roth or deductible IRA contributions, you can still contribute $5,000 to a traditional IRA for 2009 even though you are ineligible for any deduction. Contribute another $5,000 in the beginning of 2010. Then immediately convert the entire $10,000 to a Roth IRA in 2010. If you do not have any other traditional IRA accounts, you will only have to pay tax on any growth over the $10,000 you contributed but for which you received no deduction.
As if tax matters couldn't get any more complex, Roth conversions during 2010 are taxable 50% in 2011 and the other half in 2012 unless the taxpayer elects to have them taxed completely in 2011. Generally, with rising tax rates, paying the tax in 2011 could be best, but individual situations may warrant spreading the tax over two years.
Even thought this technique could boost your after-tax returns by as much as 30%, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA), who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.