ataxingmatter

Bush Administration touts tax cuts with typical misleading propaganda

On May 28, the Bush administration released several items celebrating the 2001-2003 tax cuts. 

• Press release;
• Topics Related to the President's Tax Relief. May 2008
• Tax Relief in 2001-2011
• White House Fact Sheet

The Fact Sheet asserts that the "largest tax increase in history is looming."  As OMB Watch notes, at this link, this is "an ironic canard", since the President's budget merely assumes away the problem of paying for any extension of the temporary tax cuts.  The 2001-2003 legislation enacted huge but temporary tax cuts because legislators knew that the economy couldn't manage the cost--$400 billion less just by 2012--of making the legislation permanent.  Now Bush wants to pretend that wasn't so, and simply disregard the cost. 

And Bush also wants Americans to think that the tax cuts were progressive merely because "a small group of high-income taxpayers pay most of the individual income taxes each year."   Of course, informed readers will recognize that the fact that one group pays most of the income taxes doesn't establish the progressivity of the tax cuts:  you have to know something about trends in income and trends in tax payments. 

The fact is, the wealthiest Americans have been getting a larger and larger share of the income, and they are paying a relatively SMALLER share of income taxes under the Bush tax cuts.   Ordinary Americans are getting a smaller share of the income pie, and paying relatively MORE of the tax burden.  OMB Watch has some great graphs illustrating this point, in a May 29 analysis of the Bush materials.

Revised 6/5/08 to incorporate OMB Watch's corrected graphs (axes were mislabeled).

Farm Bill, Adjusted Gross Income, and Congressional Competence

The House and Senate reached agreement last week on a farm bill.  Regrettably, they continued the ridiculous U.S. subsidies for huge agribusiness enterprises and wealthy "gentlemen" (and ladies) farmers.  Each person and entity (like business trusts) that is actively involved in farming is entitled to huge payments (e.g., $40,000 for certain crops; $65,000 when payments are "counter-cyclical") from the federal government for not growing crops--even when their farmland is used for growing certain other money-making crops and even in some cases if they get duplicate payments (e.g., for not growing crop one and for not growing crop 2 on what would have been double-cropped acreage if they had grown the supported crops).  Each person is eligible for a taxpayer-funded commodity support payment as long as they have non-farm adjusted gross income of half a million or less and farm adjusted gross income of three-quarters of a million or less.  Remember--that's a per-person determination.  So a husband and wife could each qualify to receive payments, based on their own AGI amounts.  (If a couple files a joint return, income is allocated between them for this purpose.)   This is NOT a bill to help small family farmers stay on the farm!

Here are some links of interest:

• conference report
• managers' statement
• House Committee on Agriculture Farm  Bill Homepage
• Senate Agriculture Committee May 15, 2008 release on approval of Farm Bill conference report

I have two comments to make on this.  First, I express my chagrin that Congress provides farm payments to the wealthiest people in the country.  Second, I express my chagrin that some members of Congress apparently don't know what they are doing when they pass such bills--case in point, Ken Salazar of Colorado.

I. The absurdity of commodity payments under the farm bill

These farm payments should be used only for those family farmers who live on the farm and would otherwise be forced off the farm land.  As it is, in many cases we are paying people who are salaried workers (as long as each person doesn't have more then $500,000 income in such salaries, for example) support for not growing crops on their often-inherited farmland on which they don't intend to grow crops anyway.

Let me share an anecdote from my own personal experience with farm support payment recipients. I met a woman in her late sixties who was living with her husband in a very nice senior living facility in Kansas (built mostly with taxpayer dollars, by the way) a couple of years ago.  She bragged to me about being able to get an apartment in the facility, and then she went on to brag about the enormous wealth that she and her siblings had from non-farmed farmland, due entirely to government support payments.  And in the same breath, she complained about migrant laborers getting "welfare" from the government.  This woman had no capacity to understand that she herself was a much larger welfare recipient than the migrant workers she thought were "ripping off" good citizens like herself, or that the rationale for providing support to migrant workers was much stronger than the flimsy excuses used to justify continued corporate welfare to agribusiness and non-farm families like her own.

I find such hypocrisy intolerable.  It's people who apply this kind of double-standard to welfare ("good" corporate welfare and entitlements for the rich versus "bad" welfare entitlements for the poor) who also support the Bush tax cuts that primarily benefit the wealthy while rejecting foreclosure assistance for middle class and poor families who are losing their homes at record rates.

II.  The absurdity of members of Congress who either don't understand AGI or misuse it to justify their votes.

  As noted above, the farm bill includes  high AGI limitations that permit payments to go to persons (remember this is a person-by-person limitation, not a "farm" limitation) that are in the very top of the income distribution in the United States.  The caps beyond which persons or specific entities are not eligible for farm payments are more than $500,000 in nonfarm AGI or more than $750,000 in farm AGI.  (Farm AGI, by the way, is not really just farm income--it includes not only income from crop or livestock production, but also rental of farms for farming, ranching or even for hunting or water rights, gains from dealer sales of farm or ranching equipment (the House unsuccessfully tried to limit it to non-dealer equipment sales) and gains from sales of farmland for development or other commercial or industrial purposes). 

Ken Salazar, a Colorado Democrat, made statements in support of the farm bill that have been the subject of considerable discussion on the TaxProf listserve and on the ABA tax list serve and has been a target of a few good postings in the blogosphere such as Wash Park Prophet (tip of the hat to all of the above). Salazar said that he thought the AGI limits were ok, because a farmer could have lots of farming expenses that would reduce their profits.

Sen. Ken Salazar, a Denver Democrat who supports the bill, disputed the idea that it pays rich farmers. The bill allows payments to farmers with adjusted gross incomes of $750,000 or less.  That number doesn't take into account deductions for the cost of running a farm, Salazar said.  "A farmer with an adjusted gross income of $750,000 might be losing his shirt" after paying for fuel, a new tractor and other expenses, Salazar said.   Anne Mulkern, Plowing Into the Farm Bill, Denver Post, May 14, 2008 (formatting changed). 

Problem is, of course, that AGI already represents PROFITS from farming, since adjusted gross income is defined as gross income MINUS the deduction for farming business expenses --i.e., farming expenses are deductible "above the line" under section 62(a)(1).  So no farmer who has adjusted AGI from "farming" (as defined in the farm bill) who be "losing his shirt".  In fact, any farmer with an AGI of $750,000 from farming would be at least 10 times better off than the vast majority of Americans in the middle (and lower) classes who earn less than $75,000 a year.

Another problem with the Salazar story is the fact that the Denver Post reporter didn't bother to get her facts straight.  Reporters are supposed to serve an important accountability function in a democracy--ask candidates and government officials probing questions, and follow up when those candidates and government officials provide nonsensical answers.  Salazar's justification for the high income limit in the farm bill was pure nonsense, and the Denver Post should correct their failure to provide the correct facts to their readers.

More on Private Equity and Hedge Funds

I've written often about the "two and twenty" arrangement for hedge fund managers who are able to treat most of their compensation as though it were a capital gain, paying much lower taxes than ordinary people pay on their salaries or wages. 

Adding fuel to the fire, much of the activity carried on by private equity funds is destructive rather than constructive.  A reader criticized my comments about the destructive nature of private equity funds, suggesting that if they were able to sell assets at a gain, then the activity must be positive and constructive rather than destructive.  That kind of comment misses the point--the capital markets often reward short-term activity that is destructive in the long term.

The private equity managers created a new coalition, the Private Equity Council, to present their story in Washington.  These lobbyists liken the private equity managers to entrepreneurs.  But we might do better comparing them to marauders, especially when the funds engage in leveraged buyouts.  Those are deals where they find a business that looks ripe for a takeover, buy it with considerable leveraging that will generate tax deductions (essentially getting the fisc to fund the takeover), lay off workers and outsource activities to cut costs (even when that outsourcing may destroy the community in which the business is located and may cause the business to cease a large part of its activities), sell off the best assets piecemeal and then sell off whatever is left, reaping significant management fees at every step and earning compensation as preferentially taxed capital gains.

Congress considered changing the rules that let these firms make such huge gains with preferential taxation but hasn't done anything yet.  These Wall Street moneymen wield unfortunate power and ordinary taxpayers' interests are easily disregarded when lobbyists like the Private Equity Council come to town.  The Council argues that endangering the moneymen's profits would ultimately hurt Wall Street and freeze up money needed by business.  I've commented that these appear to be rather empty threats--if you earn $400 million and have to pay twice as much in tax as before, you still have hundreds of millions.  These managers aren't going to pull out of the business if their free ride finally comes to an end.  The threat of pulling out if their free ride doesn't continue is the real class warfare that is going on every day in Washington as inequality mounts.  Here's the way Andrew Ross Sorkin described this last year in the New York Times.

Let’s be honest: it is a charade that private equity firms have claimed their 20 percent performance fees at the lower capital gains rate. To qualify, they invest a nominal amount of their own money to demonstrate that they have put something at risk, but it’s a ruse. They are paying capital gains rates for doing their job, which should be taxed at the regular income rate. Andrew Ross Sorkin, Of Private Equity, Politics and Income Taxes, Mar. 11, 2007, NY Times.

The lobbyists have done everything possible to paint a sympathetic picture of the managers who pocket millions for managing funds and pay only a pittance in tax because of the preferential capital gains rate they claim under unclear partnership rules.  David Ignatius of the Washington Post ran a good story on the pay issue, and noted the lobbyists' claims that the capital gains rate is a just reward for the "sweat equity" the managers invest. 

The giant private equity funds are nervous enough about the pressure building for tax changes that a few months ago they created their own Washington trade group, the Private Equity Council, which is already producing studies to justify the existing tax breaks. Its Web site explains that although fund managers may be putting up little of their capital, they deserve special tax breaks because they are contributing "sweat equity." Try telling that to the guy on the shop floor who's actually sweating -- and paying taxes at a far higher rate. David Ignatius, A Backlash Against Billionaires, Washington Post, July 19, 2007.

Ignatius' actually had a couple of quotes from private equity managers who admitted that it was absurd that they should be taxed at the preferential capital gains rate on their compensation.  One unidentified financier had the following to say:

"Amusing what is going on in the tax charades of the money managers. How in the world anyone can uphold those [making] egregious amounts of money paying low or no taxes is really becoming laughable. . . . The private equity guys I know admit they do not have an argument that holds water."   Id.

For more, you can read a book by the founder of the Economic Policy Institute (and a Distinguished Fellow there), Jeff Faux, The Global Class War, or an article by Nomi Prins, Barbarians at the Gate: Private Equity, Public Enemy, Nov-Dec 2007, Mother Jones.

Republicans Plan a Giveaway: for the Wealthy

Republican Wally Herger of California appears to think that what is wrong with the economy is that the wealthy aren't keeping enough of their capital gains.   He and seven other Republicans (Dreier of CA, Johnson of Tx, Brady of Tx, Cantor of VA, Linder of GA, Campbell of KY and Conaway of Tx) have put legislation forward in the House to eliminate any federal income tax whatsoever on the main source of income of the very rich--capital gains and dividends.  H.R. 5908, available here Download hr_5908.txt .

Not surprisingly, Herger's press release in support of the bill is an attempt to hoodwink ordinary Americans into thinking that the bill is going to do them good (in spite of the fact that the bill is another piece of welfare for the wealthy).

• Herger talks about the importance of avoiding the purported "double taxation" on investments.  Of course, That is simply bunk.  Most corporate investments are NOT double taxed. Empirical studies show that more than 200 of the largest corporations in the country pay absolutely no U.S. federal income tax.  So as things stand today, corporate shareholders of those corporations are paying only 15% on their dividends and capital gains from selling shares on corporate earnings that haven't paid a penny of tax most of the time.  That's while their workers are being made to work longer hours, for less benefits and lower pay, and paying income tax on their salaries at the ordinary income rate, as well as the "payroll" taxes (social security, medicare) that the wealthy don't every pay on their capital gains and dividend income.
• Herger talks about this being intended as a benefit for everyone since "over half" of Americans own stocks and bonds.  Again, this is simply a deceptive way to try to gain support from ordinary Americans for a program that is intended to provide a windfall to the wealthy.  About half of Americans do own some small amount of stocks and bonds, but for anyone below the top quintile (those making, e.g., less than about 90,000 a year), that's a very small amount of stocks and bonds and they have very little capital gains or dividends during a year.  This windfall is intended to benefit the wealthy upper class that holds 70% of the financial assets and makes much of the income taxfree already (tax exempt municipal bond income, for example).

Herger and his co-sponsors want ordinary  Americans to believe they are thinking about them, but this bill is intended to provide a windfall for the wealthy and nothing more.  It would be extraordinarily costly, and that cost would have to be paid back out of the taxes on the salarires of the working middle class.

Okamoto and Breenan: Measuring the advantage we give hedge fund managers through the Partnership tax break

I've argued here that it is entirely inappropriate to permit hedge and private equity fund managers to be taxed on their compensation for services at the capital gains rate when ordinary wage earners pay the higher ordinary income rate.  It's particularly unfair, since these managers are merely using other people's money to get rich, and then using Uncle Sam's welfare for the elite to get even richer.  They are not really entrepreneurs, as they argue, but more likely either risky speculators or highly paid destruction crews.  It is these private equity funds, for example, that are able to buy businesses, rip them into pieces, and then resell at a gain.  Often workers are lost along the way, or the jobs are exported overseas.  In this "greed is good" climate engendered by the "free marketarian" fallacy coupled with the MBA in charge who knows very little about fostering a healthy work environment, nobody seems to care about that anymore.  All in all, a situation crying out for change, if only the Senate can be strong enough to take action that will impact a very few people who are very, very wealthy.

Karl Okamoto and Thomas Brennan have put together some empirical research on these hedge fund managers:  Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation.  Here's an excerpt from their abstract.

[O]ur model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Is Big Business Getting Bigger By Cheating?

Over the past half year, I have commented on the congressional investigation into Blackwater's gambit for enriching its owner--treating hired security personnel in Iraq and elsewhere as though they were independent contractors.  See Blackwater Security Guards (Mar.12, 2008) (discussing Waxman letter to IRS, Small Business Administration and Labor Department pressing for inquiry into Blackwater classification of employees); Blackwater Security Guards (Oct. 20, 2007) ( discussing Waxman letter to Blackwater's Prince seeking information about classification of employees).  That gambit saves the company millions, enriches the company's owners (in Blackwater's case, on no-bid government crony contracts), and leaves the little guy--the company's employees--out in the cold because the company doesn't even pay Social Security on the wages. 

See this WorldWideWeb-Tax posting on the difference between employee and independent contractor.  The key factor in making the determination is how much the company controls the employee.  And what about the consequences of the determination?  It can make a big difference in how much the company pays in taxes and in what benefits the employee receives.  The following is a quick overview from PayrollTaxes.com.

What difference does it make to classify a worker as an independent contractor instead of as an employee? Here are some of the requirements of an employer/employee relationship:

• Employee Withholding. Employers are responsible for the withholding and timely remittance of federal income taxes, state and local income taxes, and FICA taxes from wages paid to their employees.
• Employer Payroll Taxes. Employers owe, and must remit, their own share of payroll taxes, such as FICA and federal and state unemployment insurance, on employee wages.
• Labor Laws. Worker's compensation, working condition, and minimum wage laws all impose on employers certain financial and other requirements for the benefit of employees.
• Employee Benefits. Employees generally enjoy employer funded benefit programs such as vacations, holidays with pay, health insurance, and pension and profit sharing plans; contractors generally do not receive these benefits.
• Reporting. Wages paid to employees (along with the amounts of the various taxes withheld) are reported on Form W-2; amounts paid to contractors are reported on Form 1099. Additionally, Forms 940 and 941 (and perhaps others) must be filed for wages paid to employees.

So the worker definitely loses out when the employer misclassifies the worker.  But that isn't the only loss.  In effect, when an employer misclassifies an employee, we all lose--the worker, the employer's competitors (who are trying to make a profit while treating their workers with respect, as they should), and the public fisc.  See this entry on the unbossed.com blog.

The IRS ruled in the case of one Blackwater employee that the employee was just that, and not an independent contractor.  Hopefully, it is auditing Blackwater diligently and will assess acequqate penalties for its failure to treat its employees as such. 

Blackwater isn't the only big company with saving millions by pretending that its employees aren't.  FedEx is another one, as revealed this week in a story in the New York Times looking at the miserable result for one woman truck driver for Fed Ex.  See Steven Greenhouse, Working Life (High and Low), New York Times, April 20, 2008.  You can also check out FedEx's online recruitment information for single and team ground haulers at this link.  (You'll probably note that it doesn't leave much up to "negotiation" with its "independent contractors"--there are set rates, performance bonuses, times for work for singles versus teams, and various "discount programs" for buying gas at FedEx,etc.--sounds a little like the company store and coal mine job that Tennessee Ernie Ford used to sing about.)  According to the story, Jean Capobianco drives a truck for Fed Ex.  She was required to buy a particular truck, on terms set by Fed Ex.  She is required to wear a FedEx uniform.  She reports to work at the time FedEx instructs her to.  She loads and delivers the packages that FedEx instructs her to deliver.  She appears to be, in all practical details, an employee.  Yet she bears most of the risk of her job, and FedEx gets most of the benefit.  Instead of making the $60,000 that FedEx advertises for its drivers, she makes slightly over $32,000 after all those costs foisted on her by FedEx are taken into account.  And the benefit for FedEx.  It avoided about $400 million (a year), giving it a huge advantage over UPS, its competitor that treats its employees as, surprise, employees.

In 30 lawsuits, FedEx Ground drivers have argued that they are employees, not independent contractors, and that the company should therefore pay for their trucks, insurance, repairs, gas and tires. In one lawsuit, a California judge ruled that FedEx Ground was engaged in an elaborate ruse in which FedEx “has close to absolute control” over the drivers. Last December, FedEx acknowledged another setback: the I.R.S. ordered it to pay $319 million in taxes and penalties for 2002 for misclassifying employees as independent contractors. FedEx could face similar I.R.S. penalties for subsequent years. FedEx said it would appeal.  Id.

How common is this?  In New York State, an article by Donahue, Lamare and Kotler suggests that there is a significant underground of companies--especially construction companies--that misclassify their workers--averaging around 10% or more.  See The Cost of Worker MisClassification in New York State.  Other studies suggest that as many as 30-40% of workers may be misclassified.  See this posting on the IRS Mind blog (reporting a 1984 IRS study showing about 15% and a review of about eleven thousand 1988-1994 audits, suggesting more than 40%).  The IRS finally issue, in December 2007, Form 8919, a form that facilitates a worker's claim that its employer failed to pay over payroll taxes appropriately. 

In that context, the fact that the IRS has cut back on its audits of big corporations is again problematic. (See TRAC data on the significant drop in corporate audits by the IRS.)   And the fact that Congress seems bent on providing more and more corporate welfare through the tax code is even more ludicrous.  (See the proposal for a 4-year carryback of operating losses for construction companies and others, letting companies that over-speculated in housing get paid for their risky behavior by the taxpayers.)  Perhaps instead Congress should enact a legal presumption that new hires are employees, unless an employer can demonstrate that the new hires are clearly independent contractors.

Get with it, IRS.  Audit these businesses and require them to treat their employees as employees.  It's time to do what's right, instead of creating a climate where anything goes for big business.

Citizens for Tax Justice: on Bush's impact on "Tax Day"

Citizens for Tax Justice (CTJ) has a new report out on the Bush tax cuts: President Bush Has Made Tax Day Easier for the Rich--at the Expense of Everyone Else (Apr. 14, 2008). 

The tax cuts have been an ongoing "good news" story for a few Americans-- the superrich who benefited from thousands of dollars of lowered tax liability.  Those superrich, by the way, are the ones reported in the New York Times to be spending as always--$35,000 bottles of champagne, private jet flights with buddies to vacation spots, $200,000 bonus on a more than $400,000 car they just can't not have, $100,000 on a car for a girlfriend at the same time as several more hundred thousand on another luxury car for themselves.   Christine Haughney & Eric Konigsberg, Despite Tough Times, the Rich Keep Spending, NY Times, Apr. 14, 2008.  As CTJ notes, once the tax cuts are fully phased in, the majority of benefits go to these  superrich in the very top 1% of America's income distribution.

What have middle income Americans  (say, people who make $90,000 or less) gotten out of the Bush shrinking tax regime?  Mostly long term U.S. debts that will be payable for the rest of current adults' lives (and their children's lives, and their grandchildren's lives, unless the tax cuts for the rich are reversed).

And what is the cost of the Bush tax cuts from 2011-2020, if made permanent?  $5 trillion.  That's slightly more than the most conservative Stiglitz-Bilmes $3 trillion estimate of the costs for Mr. Bush's other boondoggle, the preemptive war in Iraq.  It's about the same as the more likely cost of the war, which Stiglitz and Bilmes say may run in the range of $5 trillion to $6 trillion. 

Here's a telling bullet point from the release sent out by CTJ on this report.

• "The Bush tax cuts just going to the richest one percent in 2008 will be more than the funding received by the Department of Education, almost twice as much as the funds received by the Department of Homeland Security and over ten times as much as received by the Environmental Protection Agency."

Surely Congress will reverse this fiscally disastrous policy of Bush tax cuts that are terribly unfair to the vast majority of ordinary Americans. They'd better change the compensation taxes of the superrich hedge and equity fund managers while they are at it.  (One of the guys in the Times article runs a private fund--making his millions by paying half the tax on his compensation for services that his secretaries and other ordinary workers have to pay on their compensation for services.) If Congress doesn't, it will be because they are in the pockets of the superrich.    It will not be because their continuing acquiescence in this unfair charade in favor of wealthy shareholders and their businesses is the right thing for America or ordinary Americans

CEO Pay and Taxes: Top 200 for 2007

This blog has noted the continuing problem of increasing CEO pay, increased corporate risktaking, especially among financial institutions, that affects the entire economy, increased control of democratic processes by corporations and their super-wealthy shareholders (de-regulation under the Bush Administration being a prime example), and the ultimately destructive impact of these concentrations of wealth on sustainable democracy, when ordinary people--the "vast majority", in David Cay Johnston's terms in Free Lunch (review coming soon here)--are not in the few thousand at the very top 1% who have hugely benefitted from the last 8 years' economic growth.  Instead, most Americans have suffered stagnation in wages and inflation in living expenses and their dream of someday being rich themselves has taken a backseat to the reality of economic struggles and worries about the future burdened by the $9 trillion in US government debt that has funded an ill considered war and various welfare entitlements for the super-elite, from too low taxes on their passive investment income to outright giveaways.

Today's New York Times has a superb graphic on CEO compensation.  It has information about the pay of CEOs at the top 200 corporations, whether that pay was increased or decreased (and by what percentage), the overall wealth of each CEO, and the relative change in the economic wellbeing of the corporation the CEO ran during that same period (measured by stock price).  It's available at this link.  In many cases, corporations that did poorly for their shareholders either gave their CEOs significant raises anyway or cut their CEO pay by a smaller percentage than the value of the corporation was cut.  Ken Chenault at American Express, for example, got a 95% pay increase (total comp of more than $50 million last year) while the company's stock price fell 13%. 

That, folks, is the elite taking care of their own, as boards of directors (made up often of fellow CEOs) vote pay packages that they want for themselves, supported by compensation specialists that constantly move the average up by suggesting that every company should be in the top third of the country (like that famous town in Minnesota where the children are all above average).  The CEOs have joined the private hedge fund and equity fund managers (see this link on Blackstone Chief's $350 million 2007 pay) and the few families with huge corporate wealth as the new super-elite.  Not a few of them make more in half a day than many corporateworkers make in an entire year.  This super-elite walks the halls of Congress--in person or through their many hired lobbyists--writing the laws and the regulations to suit themselves. 

Should we look to these statistics as one of the factors in the current housing crisis?  It appears it adds another factor to the mix. Remember that just last week, the Republicans in the Senate (and a few right-wing Democrats and oddities like Joe Lieberman whose hawk views have overtaken whatever fiscal and compassionate sense he used to have) defeated (by 2  votes) the cloture vote that would have allowed the Senate to include a bankruptcy provision for home mortgage loans in its housing bill.  That provision is the most sensible, least moral-hazard-prone provision that the Congress could adopt to deal with the housing crisis.  It could only apply to those who are clearly in severe financial trouble.  And bankruptcy research by Elizabeth Warren at Harvard suggests that the kind of financial trouble that leads Americans into bankruptcy is a severe medical crisis or job crisis--or, rather, a combination of several severe crises that breaks the back of the person trying to manage it all. 

Instead, the most expensive provision the Senate adopted is more welfare entitlements for builders, at the behest of the influential construction lobby.  The entitlement is in the form of carrybacks of NOLs four years instead of 2, allowing builders to reap immediate tax refunds from taxes paid (already too low) on their stupendous profits prior to the housing meltdown.  Those tax refunds are likely to go right into the pockets of the home building company's owners and CEOs:  I predict they won't do a thing to help construction workers keep jobs or even much for the economy in general.  For example, even though the company has been hit hard in the housing slump, Toll Bros. voted its CEO an even larger bonus package .  See this NY Times story (Mar. 13, 2008) (noting the bonus can be as much as $25 million, and can be paid for overhead cost cuts, gross revenues, cash flows, even when there are no profits!).  Although the company was still managing to turn a profit in 2007 though hit hard with the housing slump, see this link about its 2007 slump, it could end up with losses in 2008 and be one of those firms eligible for the extra long carryback to get refunds of taxes paid on its huge profits four years ago. See this Feb. 27, 2008 story about Toll Bros. swinging to a first-quarter loss in 2008.

The bankrupcty provision isn't the only one that the Congress should adopt to deal with the widespread community impact of the housing crisis.  But it is certainly one that all of us should be able to support.  There is no moral hazard in the bankruptcy provision, as there is in providing a tax refund to home builders who over-speculated in building what they thought were going to be lucrative new housing units. 

So why didn't the Senate adopt it?  Because the financial institutions and mortgage brokers--that's the gang that got us into this mess with risky mortgage products, speculation with credit default swaps, and too-high-interest-rate loans that made great commissions for brokers even if it caused financial jeopardy for borrowers-- don't want them to. Both of the Senate's actions--the wasteful NOL carryback provisions for the big home builders and the failure of the mortgage loan bankruptcy modification provision--are examples of undue corporate power at work, created in part by these enormous and unreasonable pay packages to CEOs while ordinary workers lose ground.

The Senate's Cop out: no bankruptcy modification for struggling homeowners, but money from the Treasury for owners of construction firms

Yesterday, Senate Republicans (pushed by the banking and mortgage loan industries) refused to pass the most important measure to assist struggling homeowners who deserve assistance--a bankruptcy reform  that would permit bankruptcy judges to modify mortgage loans on primary residences.  See David Herszenhorn, Senate Rejects a Proposal to Allow Bankruptcy Judges to Alter Home Mortgages, NY Times (Apr. 4, 2008).   The bill they are working on is the Foreclosure Prevention Act of 2008, offered by Sen. Chris Dodd as an amendment (S.A. 4387) to H.R. 3221.  The CBO's estimates in connection with the bill are at this link.

Couples who try hard to make their mortgage payments are suffering.  See, e.g., this story in the Boston Globe (Feb. 18, 2008).  The banks have argued that it wouldn't be a good idea, because it would mean everybody's costs for mortgage loans would go up, but they haven't offered any real evidence to support this assertion. See this story by  Marcie Geffner, Fox Business.

I suspect that argument is not accurate but rather one of those lobbying positions that tries to win by dividing and conquering.  If even some of the public can be convinced that helping people in dire need of help will cost others later, they won't be as likely to be supportive of a reform that they themselves might need someday. Consumer protection groups arguing for permitting modification in bankruptcy have done studies that show very small rate increases related to this, at most.   Note that Geffner cites various academic studies that have shown that the Bank's stories of woe are woefully exaggerated, at best.  There's simply no reason to expect the grief they claim from the bankruptcy revision.  See also this 2007 report from the Center for Responsible Lending. 

After all, foreclosures are extraordinarily expensive--banks are generally better off avoiding them, just as homeowners are.  It's the law firms and other agencies that feed on foreclosure activity that make lots of money out of that tragic event.  The fact is, banks like to control the timing of when they have to recognize the loss--if it is up to them to decide when to foreclose, they have that control.  If a judge in a bankruptcy close can cause a mortgage loan to be written down, banks lose control.  One byproduct could be worse looking financial statements than the banks want to admit to at the moment.  Finally, loans on vacation homes, family farms, investment properties, yachts and even credit cards can be modified in bankruptcy; why shouldn't loans on primary residences be modifiable?

Let's remind ourselves that this mortgage loan industry is not a saintly enterprise out to help the ordinary person buy a home or out to help cities create more livable environments.  Mortgage brokers made all kinds of fast money out of shoving people into more expensive loans than they needed to be in.  I'm a fairly sophisticated homebuyer, yet I was astounded last year when I bought a home (not for the first time) at all the fees and service charges that the brokers and banks have added to mortgage loans and sales deals to squeeze the last penny out of buyers that they can.  They charge for services that they don't actually provide or that cost them pennies on the dollar of the fee the charge. (I asked about one such charge, and was told "It's a standard charge; it doesn't matter whether we actually have to do it or not.")  They do it because they can get away with it because the mortgage lending industry and broker industry is underregulated.  They have cozy relationships with appraisers and they sock the fee to the buyer (making money on it, too) to pay for an appraisal the result of which is set before the appraiser does a thing.  They expect from the beginning that they will sell the loan to a securitization vehicle and, maybe, still service it and make more fees off that but bear no risk of loss if the loan goes bad.  They charge "administrative fees" of several hundred dollars that cover no particular "service" but are just another way to make money on the loan.  And they tack several hundred basis points onto the interest rate of the  loan as their "commission" for "helping" the buyer get a mortgage loan.  It's a racket, and nothing less.  It's time for Congress to step in and regulate it and end the unconscionable fees being charged to ordinary people who are merely trying to use lending services.  Between the realtors who work together to increase the amount of an offer and the brokers who lie about prevailing mortgage interest rates, it is a major problem.  The fact that black homebuyers were steered into subprime loans when their credit was just as good as white homebuyers who were given regular (cheaper) loans demonstrates the perverse market incentives that have been allowed to hold sway.  See the Atlanta Journal last November: "Among black homebuyers making more than $100,000 a year, more than 41% got a subprime mortgage, compared to 7% of whites in the same income category."

Changing the law to permit modifications in bankruptcy would have a positive effect in many ways.  It would keep families in their homes and prevent more families from becoming casualties of the banks' risky lending practices.  It would reduce the problem of multiple foreclosure properties blighting neighborhoods.  It would have a positive impact on home housing markets.  It would protect urban areas, in particular, that are the most likely to suffer from the housing crisis.  It would force the lenders who made so much money off the housing boom to bear some of the cost of their reckless financing arrangements and their use of even riskier financial bets (credit default swaps) to make even more money.

Allowing modification of loans in bankruptcy doesn't raise moral hazard issues, because it is within the very framework that we have developed to deal with individuals who have gotten themselves on a financial deadend street and require the assistance of the bankruptcy laws to get out.   Hopefully, the House will have the gumption that the Senate didn't have to face down the powerful financial institution lobbies with a resounding "get out of the nation's business" and pass a bankrupcty reform that will treat home mortgage loans like every other debt --modifiable in bankruptcy, according to the discretion of bankruptcy judges.  Those judges are not fools, and they don't offer modifications of debt lightly.  The mortgage industry should not have more sway over Congress than the little guy that has been eaten alive by the same industry.

What did the Senate think worthy of passage, if not real protection for ordinary people who face financial ruin and just want to stay in their homes and pay off their mortgages at some more reasonable rate?  Regrettably, the Senate thought it would be more important to enact another big and costly tax break for businesses. This break will translate into more money in the pockets of construction business owners and their investors, but it won't do a thing to help the workers who have been laid off and are struggling to put food on the table.  There's a $15-20 billion giveaway to contruction companies (which supposedly will reverse in later years and so not cost quite so much over the long term), in the form of a new provision permitting them to carry back losses from this bad time to their rollicking good times up to four years ago and get a refund of the taxes that they paid on their huge incomes then.

The Finance Committee explained that by allowing corporations to apply excess net operating losses for 2008 and 2009 to tax returns from four prior profitable years--instead of the two currently allowed by law--will increase cash flow for businesses and allow them to write off losses over a longer period of time. BNA Daily Tax Report, Apr. 4, 2008, G-7.

I think this kind of special interest legislation is extraordinarily short-sighted.  It doesn't use the money to provide unemployment compensation to laid off workers.  It doesn't address the needs of ordinary people--those 80% of households that earn less than $100,000 a year.  It doesn't do much even to boost the general economy.  This will provide money in the pocket of the owners of the construction firms and, for the bigger firms, their investors.  It won't lead them to hire more workers or even avoid laying off their construction workers. It's doubtful that it will lead to new investment.  It may, perhaps, stave off some of the lower-priced sales of excess inventory (which the Finance Committee seemed to see as a problem).  But the builders have too much inventory because they overbuilt--the problem won't be over until there ceases to be excess inventory.  Helping the builders sustain higher prices for their excessive inventory does not appear to be a reasonable intervention by the government.  It's about as token a gesture as those checks coming out in May, to the extent they go to people with incomes above the median who will just use them to pay off the latest credit card splurge.

[This paragraph is corrected from its original statement.]   The Senate also included a $7000 tax credit for people who buy foreclosed homes. Apparently this will be only for purchases of foreclosed homes as principal residences, and the taxpayers who receive the credit will have to use the home as their principal residence for the two years over which the credit is taken.  See Section 603 of HR 3221, the Foreclosure Prevention Act of 2007 (available on BNA).  So my original concern that it would be a taxpayer-subsidized boon for real estate developers and real estate businesses that will swoop in like vultures to buy the best properties anyway was incorrect.  However, I still don't think it is a reasonable use of taxpayer money--the taxpayer who happens to need to buy now gets a $7000 break but others don't (and the tax break is probably susceptible to easy cheating, as well.) The break isn't based on the purchaser's need but merely on the type of property purchased (that it be in foreclosure).  Even million dollar homes can be foreclosed, and quite well-off purchasers could just happen to want to take advantage of the $7000 credit. (This isn't a deduction, remember, but a dollar for dollar reduction in tax liabilities due.)  This is basically unfair to all those taxpayers who have struggled to buy their homes without that federal subsidy, which is a one-year-only deal.  When the homeowner sells the house, say right after the end of the two-year period, there is no requirement that the homeowner repay the government, since gain on a principal residence is not taxed, under current law.  It would be much more reasonable to take the same revenue otherwise going to that tax break and provide it to cities to use to purchase foreclosed properties.  Let the cities then resell them at market prices.  That would help restore the housing markets, at below bubble prices, get people into foreclosed homes, AND provide revenues from the resales to help blighted areas in the city.   A much fairer proposition all around.

There's another very strange provision in the Senate bill--a property tax deduction ($1000) for taxpayers who do not itemize.  Since the standard deduction is the provision that is already intended to cover that issue (e.g., taxpayers who don't itemize do not do so because the standard deduction is already MORE than their actually deductible amounts, such as their property taxes), one has to wonder what the rationale is here.  Again, this is not really going to do anything about the foreclosure problem or the fact that many people have mortgage loans that exceed the value of their homes.  The Senate could address that issue, but chose not to.  It is instead applying a very ill-fitting bandaid to the problem. 

The property tax deduction for non-itemizers also carries an onerous restriction--property taxes won't be deductible if the municipality raises its taxes!  Now, folks, given the hard times currently hitting many cities and the fact that property taxes are the only means most cities have for paying for schools and police and fire departments, that seems like a Republican "starve the beast" strategy, since everyone knows cities already have trouble getting their residents to support increased taxes.  At the least, this draconian restriction should be eliminated--it makes no sense at all and it is simply unworkable, since it requires an individualized determination by the IRS to verify the legitimacy of the deduction (which there aren't enough IRS resources to support).  See the CBPP's analysis, here.  (I'd personally, though, prefer eliminating the entire idea of providing a special deduction for non-itemizers for a tax that is already included in their standard deduction.)

In the House, Barney Frank's proposal to create a fund to guarantee refinanced mortgages sounds like a much more workable idea.  Lenders and loan service companies would have to cut the principal of the loans and take a loss.  That's only fair, since their greedy high risk loans are one of the primary sources of the problem.  Homeowners would be enabled to stay in their houses, but they would still have to pay the full fair market value of the home.   

CORRECTED 4/5/08

The Free Marketarian Fallacy, the Shadow Banking System, and Bear Stearns

I've talked here about an approach to tax policy and distributive justice that I call democratic egalitarianism.  Anyone who has read much of what I have to say already knows that I find most economic theory useful in terms of providing insights from a particular perspective, but certainly not the guiding light for understanding either our economic system or ideal tax policy.  In legal scholarship these days, there is a predominant view based on "law and economics" that tends to coordinate well with liberatarian and neo-conservative think tank positions.  I call it the "free marketarian fallacy."  A colleague who embodies that perspective told me when Enron failed that it was not an example of market failure and the need to balance economic risktaking and competitiveness with governmental boundary-setting and regulation.  Instead, he said that he thought that Enron was an example of the market working.  After all, he said, Enron deserved to fail because its business model was built on quicksand, and it eventually did.  So the fact that the market failed, eventually (and with a huge explosion of hot air) is proof that the markets were working all along.

Now, my answer to that was simple.  If that's the way the markets are supposed to work, then something is wrong with the theory of the markets.  It took too long.  It fooled too many people along the way.  It rewarded the very people who created the problem and cost the little people dearly.  The big guys who flew high on Enron's glory days didn't suffer much.  Lay was found guilty, but appealed and died before it ever came to prison time for him.  Fastow went to prison and lost some money, and Arthur Andersen suffered, but many others involved in the big schemes didn't.  It took too long for the hot air balloon that was Enron to burst, and in the meantime California bore a huge cost from the fake energy swaps.  An awful lot of little people were terribly hurt by the Enron fiasco.  So we enacted the Sarbanes-Oxley Act, which has helped, to some extent, by forcing some greater transparency around financial statements.  It's not quite so easy to hide overleveraged business problems off balance sheet.  It's not quite so easy to fool investors.

But then look at the mortgage mess.  It's another example of the free marketarian fallacy at work.  Banks were regulated, but the creed of "free markets" clamored for unregulated financial institutions and innovative financial transactions.  A shadow banking system emerged, mostly outside the scope of federal regulation.  The private equity funds and hedge funds made enormous wealth for the few people running them, who also felt comfortable taking advantage of an ambiguity about treatment of profits interests in partnerships and getting taxed on their services compensation at rates lower than their secretaries paid.  They leveraged themselves at huge odds--debt at 30 times equity.  And then along came Long Term Capital Holding, a hedge fund run by the smart numbers people who figured out how to price options, but it bet itself into a risky corner and had to be rescued.  Still, the shadow system kept growing.  Banks issued subprime loans at very high interest rates to people who otherwise couldn't get credit (and sometimes color was the reason).  They made huge fees again, and then securitized the loans for even more profits.  All along, they repeated the free marketarian fallacy--no regulation, no risk; no risk, no gain; we're making the world grow for you too. 

But now their shadow banking edifice is crumbling.  And guess what.  They are all perfectly willing to step up to the Fed window for a big handout of taxpayer assistance. JP Morgan got the Fed to help it buy off its rival Bear Stearns at a fire-sale price of $2 a share.  The Fed stepped in and took the risk of 30 billion of Bear's bad assets, all to save the shadow financing system that said it didn't need regulation.   The Fed (and that's we, the taxpayers) gets to bear the loss.  JPMorgan gets to make the profits.  Folks, this is a bailout, big time. 

Of course, you've heard the latest chapter in the Bear Stearns story, I'm sure.  Shareholders who loved the company when it was flying high and taking huge risks in the shadow banking world were angry about losing money.  They were greedy.  $2 a share and the Fed taking the losses wasn't enough for them.  They want more.  So now JPMorgan is negotiating to pay them $10 a share.  If it was going bankrupt, then the investors don't deserve to get bailed out with more money--certainly not backed by the Fed.  If JPMorgan has enough to pay 5 times what it planned to pay, then it can do without the Fed's guarantee.   Else it looks like this has all been a racket to get the Fed to open its coffers for the investment banks, who intend to keep right on piling on the risk and the wealth.

The answer is to put an end to the free marketarian fallacy.  There is no such thing as a "free market."  Markets  exist in an intricate web of institutions, public and private.  Without the public--as we see in the case of the shadow banking system--things will go crash in the night. 

So stand by the big banks, now that we've let them get "too big to fail."  But make them stand by the federal fisc.  Two things need to happen: 

1) the investment banks and other financial institutions need to be made subject to full regulation just like regular banks and

2) the financial institutions need to lose the "active financing" exception that lets them defer US tax, possibly forever, on their overseas business income. 

It's time they paid their fair share of the tax burden.  They are surely feeding their fair share--or more--at the taxpayer trough.  Or, as Barney Frank put it in a speech to the Greater Boston Chamber of Commerce:  "The absence of sensible regulation has taken parts of our economy hostage."  Since the investment banks have been riding a "new wave of innovation" in their securitizations that have "outstripped" regulation, government needs to develop a new wave of regulation like the reforms that repaired the financial system under the New Deal.  (But Frank also told reporters after the speech that we're not likely to get it done right under Bush, so we should focus on "get[ting] the patient healthy" first.)  See Frank says Subprime Mortgage Crisis Demonstrates Need for More Regulation, 90 Banking Report (BNA) 535 (Mar. 24, 2008).  Even the Republicans are getting it, finally.  Vito Fossella of New York admitted the US financial regulation is "outdated" and needs "meaningful reform".  Reading the BNA descirption of Fossella's teleconference with reporters, however, I tend to agree with Frank--if we try to do it in this Congress, with these Congressional representatives and this President, we won't get it right.  Fossella seems to be trying to use the need for regulation as an excuse to de-regulate (including finding another reason to give corporations a big tax cut).

For more on the need for regulation and the Bear Stearns mess, read these:

March 24, 2008, theStar online, US$1 billion Offer for Bear Stearns

JP Morgan has now upped its offer 500%, with the Fed still taking on $29 Billion of Bear's losses--Does that make sense?  Now the shareholders--and 30% of them are Bear Stearns employees who ran one of the most risk-loving banks in the business--are getting more (a whole lot more), and the taxpayers are still on the hook for $29 billion...

March 24, 2008, Michael Grynbaum, New York Times, Wall St. Cheers Bear Deal and Housing Data

The Deal made Wall Streeters happy.  Dow went up 187 or so points. Housing sales broke a six-month losing streak.  (Housing sales were up, but not much, above the last two reports. It's spring, after all, and some people have to move this time of year.  Housing prices are still swooping downward, with their "worst year over year drop in four decades" in February.)   Will Wall Street's euphoria last? 

March 24, 2008, Mark Thoma, Economist's View, A Coordinated Way to Destroy Effective Regulation

August 8, 2007, Bear Stearns Fat Cats Cashed Out at the Top

July 18, 2007, Bear Stearns Tells Investors "No Value Left" in two hedge funds