ataxingmatter

S corporation tax reform proposal to fund extenders: more payroll taxes

As Congress considers possible "extender" bills that would extend for another year a number of the Bush tax cuts that will otherwise sunset, it is also considering ways to pay for providing those tax breaks.  One item up for consideration is reform of the way payroll taxation works in connection with  S corporations, which though corporate in form are treated as pass-throughs, with their income subject to tax only at the shareholder level.  Remember that John Edwards' income for his services was funneled through an S corp, so that he received a portion as his "compensation" (subject to payroll taxes) but then claimed the rest as a passthrough of corporate profits.  In reality, almost all of those profits were attributable to his services and in an ideal system would have been subject to payroll tax.

 Naturally, those S corp shareholders who are currently receiving profit passthrough without payroll taxation are objecting.  A coalition of various business groups (Air conditioning contractors of america, American council of engineering companies, Associated builders and contractors, Food marketing institute, Independent community bankers of America, International franchise association, National association for the self-employed, National federation of independent business, National funeral directors association, National restaurant association, S corporation association, Small business legislative council, U.S. chamber of commerce & Wine & spirits wholesalers of America) has written Sandy Levin urging him to chuck the proposal as a revenue raiser to offset extended tax cuts.  (The letter is available on BNA at this link for those with a subscription.)

Although there is no text for the proposed statutory change yet, the letter refers to a similar proposal in the past that would have applied payroll taxes to active shareholders of S corporations that are primarily engaged in the performance of services.  The coalition suggests that if a company's business is partly from services and partly from sales, the mechanism would require payroll taxes to be paid on the company's profits in proportion to the split of the revenues between services and sales--so if 80% of the company's profits are from the performance of services, 80% of the distributive share to the active shareholder would be subject to payroll taxes. 

Now, this strikes me as a workable, "rough justice" provision that would make it simple to make the determinations in a fair way and would ensure that service providers are really paying the appropriate payroll tax on their compensation.

But the coalition has a number of objections.

First, the coalition wants to treat returns as partly  attributable to greater investment in physical or human capital.  So if the firm invests in a new computer, the coalition wants to take the "return" from the improved capital out of the profits from the provision of services.   Similarly, if the company trains a worker so that the worker can perform better, the coalition wants to treat part of the profits as derived from the return to human capital.

This would be quite complicated and is not really supportable.  Certainly, part of my compensation income as a law professor is a return to  human capital (my education and experience), but I cannot therefore reduce my compensation income and payroll taxes. It seems reasonable to treat the profits as earned by the end-point revenue creators--the services or sales conducted by the business and exact payroll taxes accordingly.

The letter also raises scope issues, asking whether landscapers and similar businesses are primarily performing services or conducting sales.   Anyone who has hired a landscaper knows that the bill is divided into "labor" and "materials": shouldn't it be relatively easy to determine whether a particular business is one that depends primarily on sales or services?   

The letter suggests that Congress's exclusion of S corporations from the new health care tax on investment income would be "effectively reverse[d]" if this provision were enacted.  But can't the exemption be read  to mean that Congress considers most S corp income to be either inventory sales or services income and not "investment" income.  That is  harmonious with applying the payroll taxes to such income from S corps that are primarily engaged in the provision of services.

The objections include a worry about "increasing taxes on small business owners" and "adding to the tax code's complexity" and being "an unfair tax increase on small and family-owned businesses."  Yes, it would increase taxes on small business owners and on owners of "family owned" businesses (which may in fact be quite large businesses).  That is the point of the proposal.  Unlike their employees whose wages are reported and subject to immediate withholding to cover the payroll taxes, S corp owners have had the advantage of claiming only a small amount of the profits of their firm as their compensation, while treating the rest as non compensatory passthroughs not subject to payroll taxes.  This proposal would treat active shareholders of service firms more like their employees, and that seems a reasonable result.

The letter also objects to "blurring the line between labor income and income from capital."   One of the reasons the tax code is so complex is that the "line" is an arbitrary one with many places where the distinction is at best hard to make.   Accordingly, those with sufficient resources have frequently attempted to arbitrage the boundary.   The best way to simplify the tax code, by far, would be to eliminate the "capital" and "labor" income distinction altogether.  And that would also result in a Code that would raise more in taxes from those who have the greater ability to pay.  At the least, we should err on the side of including items of income on the labor side when the profits of a firm are predominantly due to the performance of services by the owners of the firm.  Sounds to me like this provision is on the right track.

Charitable contribution deduction--thought for the day

Here's the way Alan Olsen, the managing partner at Greenstein, Rogoff, Olsen & Co. in San Francisco describes the charitable contribution deduction for stock (received via email titled "Financial and Tax Trends Media Need to KNow About" from Olsen's PR firm Apr. 28, 2010).

  Make charitable contributions.  If you have appreciated stock that you’ve had for more than one year you may want to keep the cash in your pocket and donate the stock.  You’ll avoid paying the tax on the appreciation but will still be able to deduct the full value of the stock.  You win.  Your charity wins.  The only loser is Uncle Sam.

Now, those of you who have been following this blog know that this particular deduction is one of my pet peeves.  It provides a freebie that is per se available only to the 30% of taxpayers to itemize and, within that group, primarily of benefit to the wealthiest set who own most of the financial assets and generally get the bigger rate deduction because of their higher tax bracket.  They can hold greatly appreciated stock without paying tax on the appreciation, and use that as collateral for borrowings at low cost, so already the possession of appreciated stock accrues benefits not available to ordinary Americans who generally hold only small amounts of stock.  But then if these fat cats want to reduce their tax bill, they can donate stock to their favorite charity (maybe it's one that provides a service that they enjoy, such as the opera or symphony, get all kinds of status and name recognition goodies and enjoyable services from the "gift" AND get a tax deduction for the full value as a gift from the federal government. 

 Note the way this works:   Let's assume a banker who has lots of stock that he received as bonuses.  Let's say each share of stock is worth $200 but the banker/contributor has only a $2 cost basis.  The banker contributes to his local opera company (that puts a plaque up in its lobby in his name in recognition) and gets a tax deduction of $200,  $198 of which is an unjustified freebie from Uncle Sam to the banker/contributor, resulting in about $66 lower taxes (assuming a tax rate around 30%).  So 1000 shares and that's $66,000 less in taxes paid on other taxable income.  If the banker had sold the shares and contributed the money instead, he would have paid tax on the appreciation (regretably, only at a reduced preferential rate, but at least that would be fairer).  Since he gives them away instead, he isn't taxed on the appreciation but still gets the deduction.  No income tax on the full value.  Tax deduction for the full value.

A window on the Senate hearings with Goldman's Mr. Tourre

Dana Milbank of the Washington Post goes a little overboard in his description of the Goldman hearings (there's needless ad hominem attack in his criticism of Mr. Tourre's accent), but he does pick out some of the information that will likely not sit well with most Americans.  See Milbank, Wall Street's Mr. Fabu-less, Washington Post, Apr. 28, 2010 (video link to Tourre's opening statement provided).  The blurb ends with the following from the questioning, when Tourre complained that he had "been the target of unfounded attacks."

Unfounded? Did he tell the clients he sold the worthless mortgage securities to that the portfolio had been designed by somebody who was shorting those same securities?

"I don't specifically remember the words I used," Fabulous said.

How much of the worthless portfolio was selected by the man who was shorting it?

"I don't remember," he said.

What about his previous claim that the doomed portfolio had been "selected and mutually agreed" with the client that bought it?

"It's not very accurate," he admitted.

The SEC probably will not rate that a fabulous answer.

Financial reform--the GOP's "chicken game"; and is it hedging or casino betting when banks go short on products they have created/sold to customers?

Edited to add additional links 4/28/10 at 5:35pm

As the GOP blocked progress on the Senate finance bill for a third time (56-42) in their foolish game of "financial reform chicken", hearings yesterday with Goldman executives raised many important questions and got lots of rambling answers.  See C-SPAN.org, Senate Hearing on Goldman Sachs & the Financial Crisis.  Why rambling?--the ABA online journal today notes that one of the principal Goldman lawyers advises that those responding at Congressional hearings take long pauses before answering and give rambling responses to questions--to use up the time of the questioner without advancing the ball in terms of information provided. See Goldman Sachs Lawyer Advises Long Pauses, Rambling Answers, ABA Journal, Apr. 27, 2010.

Re the game of chicken:

The Dems will lose if they blink first in this chicken game.  In fact, the best response to the GOP chicken play is to toughen the financial reform rules:  legislate a fiduciary duty of broker-dealers to their clients (since they don't seem to believe they have even quasi duties at this point--see below and see Gerding, The Senate Goldman Hearing: Fiduciary Duties for broker-dealers? and Ribstein's response that duties just create litigation costs); add a permanent financial institution tax on leverage and assets that will essentially force banks to downsize while appropriately charging them for the cost-of-funds advantage that they enjoy because of their size and the implicit federal guarantee--see, e.g., Leonhardt, A Bank Tax As Insurance for Us All, NY Times, Apr. 27, 2010; add a tough proprietary trading ban that wil return banks to the boring business of being bankers rather than day-traders; remove the "mark-to-model" version of fair value accounting that lets banks invent their own valuations and force them to use market quotes/actual trades for all valuations even in "disrupted" markets--and surely do not allow the FDIC to determine valuations during crisis as the Dodd bill currently does, since that is an invitation to distorted values that are adopted to enhance balance sheets; eliminate tax-free reorganizations for financial institutions; create rules as proposed by Senators Kaufman and Brown that will shrink the banks to manageable size rather than "TBTF" size, through limits on share of deposits (10% of total at insured depository institutions) and nondeposit liabilities (2% of GDP for bank holding companies, 3% of GDP for shadow banks) (the Kaufman April 21, 2010 speech on the proposed legislation is available with summary of bill on wealth.net, here).   On the reasons that downsizing banks makes sense, see Alford, Why dismantling too big to fail financial firms makes economic sense, Naked Capitalism, Apr. 27, 2010; Zamarripa, Big Banks Can't Be Reformed With Small Ideas, Roll Call, Apr. 28, 2010.

Every day that the GOP votes no, add one more tough provision.

re the Goldman hearings and hedging/casino gambling:

The Senate questioners recognized the problem of a bank whose assets and liabilities are sufficiently large that its failure could derail world economies and that has (and uses) ability to create innovative financial products that amount to nothing more than casino bets in which the bank is likely the only party with all the information (e.g., synthetic CDOs, where one said thinks referenced mortgages will fail, so buys the synthetic cDO credit default swap "insurance" pay-out on the failure of the referenced mortgages; the other side thinks mortgages will continue to pay out, so "insures" the mortgages (or may not understand the product sufficiently to know that it is providing the swap insurance guaranteeing the referenced mortgages)).  The concern here is that these investment banks are performing quasi-public functions (serving as middlemen in the sales of stocks and bonds, helping deals between corporations take place, etc.) but are acting with purely private greed (treating sales as a search for suckers, creating products that are toxic from the start and pawning them off on unsuspecting buyers, using flash trading schemes that permit the bank to make money off its own clients' trade information).

The banks, of course, see themselves as merely profit-making businesses.  It's "caveat emptor" from day one.  And if their risk-taking leads the economy into chaos, they don't care as long as they come out with profits--they claim no fiduciary duties to customers, no obligations to the public (other than mandated by securities laws, and even there they have a bank-friendly reading of disclosure requirements), only the rationale of making the most bucks possible in whatever way possible.  According to the bankers, their shorts are just reasonable "hedges" against loss.

This issue is central to the financialization of our economy and the need for substantive financial reform even beyond what is currently being proposed in the Senate amid the Republicans' game of chicken. 

End users of wheat are legitimately hedging when they buy futures.  Issuers of corporate bonds that pay a floating rate of interest are legitimately hedging when they buy an interest rate swap under which the counterparty accepts a fixed rate of interest and pays the issuer a floating rate that it can then pay over to its bond holders.

But if we allow investment banks to create synthetic CDOS and other complex financial products that are purely casino bets (I would urge that we should just not, but it is not clear Congress has the guts to implement the kinds of severe changes that are needed here), should we allow them to claim that shorting their own products is merely a "hedge" like other end users purchase?  I don't think so.  One way to disincentivize the creation of complex financial products and the endless financialization of the economy that ultimately adds no jobs and does nothing for quality of life (except for the wealthy traders and quants that create the products) is to change the risk appetite of banks.  No bank should be permitted to be net short on any product it creates or any product that it sells to customers.  But not being short is not enough.  Banks need to be bear sufficient risk for the products they create .  So we might also require banks that create and sell financial products to 1) retain a sufficient share of the interests issued to provide a reasonable equity cushion below the products sold --around 15-20% and 2) not be permitted to "hedge" those products by shifting the risk of loss off to another bank or financial entity.  Odds are their appetites for creating risky would diminish significantly if they bore the risk they created and there was no prospect for bailout (another item that needs to be strengthened in the current bill and that the GOP "no" vote makes possible to do).

By the way, a letter to the editor in the Times Friedberg, Goldman Deal and the Financial Market, Apr. 27, 2010, suggests that such naked bets are "good" for the market because they help pricing.  Would you claim that a bunch of people laying down a bet on "red 21" helped one know whether red 21 was a good bet and accurately priced?  Certainly not.  The naked credit default swap is probably not much better at predicting real value--for years, the CDS prices on even the worst subprime deal were really really low (that's why John Paulson could make so much money off his short).  Irrational bets on the long or short don't do anything except increase volatility and increase the size of the bubble market.  Pricing information gained is either too insignificant in that mix or misinformation that adds to the problem.

Senate Republicans voted to block debate of financial reform

Quelle Surprise!  the Senate GOP is content on saying no to reform--and purported Democrat Nelson of Nebraska voted with them because he wants derivatives trading to go on without change.  Herszenhorn & Wyatt, GOP Blocks Debate on Financial OVersight Bill, NY Times, Apr. 26, 2010.  Judd Gregg stated his view that the Democrats were in danger of strangling the markets with overregulation--what irony, when we have an ongoing economic crisis caused by lax enforcement of existing regulations and lack of regulations of any kind of the most destructive casino bets--the derivatives created by banks.  Does the GOP really think Americans will buy this argument that the bill proposed is too stern?  The real criticism is exactly the opposite--that there are too many ways that banks can keep on getting too big and conducting proprietary trades that work against their customers.

 At this rate, we'll be stuck without systemic change to a failing financial system, and when the crisis hits again it will be even more formidable than this one has been. 

Folks, call your senators.  Tell them we need to break up the banks, end proprietary trading, tightly constrain derivatives (even perhaps prohibiting naked credit default swaps and other derivatives that are essentially "bets" in the financial institution casino games) and impose a financial institution tax on excess leverage for the biggest banks that will constrain risky behavior as well as contribute revenues to the federal government to pay for the cost-of-funds advantage these big banks have enjoyed.

credit rating agencies, tax, and the financial crisis

[edited to include Krugman op-ed and for typos]

Senator Levin's Senate Permanent Subcommittee on Investigations held hearings Friday on "Wall Street and the Financial Crisis: the role of credit rating agencies", third in the series of hearings on the "causes and consequences" of the financial crisis.  The website provides statements of Levin and Coburn as well as those of the various speakers at the hearing.

What shows through all of these hearings is the way financial institutions lost sight of any responsibility to the public interest in their effort to earn quick profits that would translate into big bonuses.  Risky lending strategies promised quicker short term gains, so why not?  selling complex securitization products offloaded the risky loans to clients, so why not?  trading for the bank's own benefit made more money (especially when you could short naive customers) than merely serving as a staid, prudent middleman in normal business deals, so why not?

That mentality carried over to bankers' relationship with the credit rating agencies and to the way the credit rating agency did their deals, especially as more complex products were structured that were less comprehensible to even sophisticated investors.  Pressure from bankers for the "right" rating approach made a difference to the rating agencies' bottom lines, and that pressure generally got what it wanted.  As a result, the securitization "gig" led to  huge profits from the too-ready flow of securitization dollars  for banks and rating agencies.  See, e.g., Levin Exhibit 1g showing doubling of the top three credit rating agencies' revenues from $3 billion to over $6 billion from 2002 to 2007, a period when about $2 trillion in mortgage-backed securities were issued (36% backed by subprime mortgages).

This has significant repercussions for the financial crisis, since the easy availability of triple-A credit ratings meant the continuing flow of easy credit through the hyped-up securitization markets.  But it is also meaningful for tax analysis.

Back when I worked on mortgage securitizations (in the somewhat less heady pre-2001 days), we tax analysts also relied on credit rating agencies in making our analysis of whether a particular security would be treated as debt for federal income tax purposes.  A high credit rating signifies, we thought, that the credit rating agency has done its internal modeling on the underlying assets and concluded that there is unlikely to be a default and that the cash flows on the underlying assets in the securitization are sufficient to service the debt, so that interest and principal payments can be treated as relatively certain to be paid.  Lawyers giving tax advice, in other words, were also relying a great deal on credit rating agency "opinions" to give their own opinions that a security should be treated as debt rather than an equity investment.  That in turn opened the security for investment by pension funds or others who would only invest in relatively "safe" debt and insured the issuer that there would be an interest deduction, rather than a nondeductible dividend or other payment on equity. 

As a result, pressure from investment bankers who set up and sell securities to get the "right" credit rating may not only lead to deception of investors in terms of the riskiness of the loan but also to mistreatment of the security as debt for tax purposes.

And if investment bankers sometimes bullied junior associates to get the "right" tax opinion (which I personally experienced), one cannot doubt that they sometimes (perhaps even more frequently) bullied credit rating agency personnel to get the "right" credit rating. 

But the credit rating agency problems did not just stem from this inherent conflict of interest (that investment bankers who were putting together deals were paying them to come up with a rating that would help sell the deals). They also were hoist on their own "proprietary modeling" petard. Models are only as good as historical information can make them--they cannot easily deal well with the rapid pace of financial innovations, and human judgment is especially important for new products.  But the ratings agencies tended to go in the other direction--worries about market share tended to support delays in revamping models to deal with financial innovations or to enable "massaging" numbers that would otherwise lead to lower ratings and declining market share.

Here are just a few of the important statements made at the hearing:

Raiter, 1995-2005 S&P head of residential mortgage rating group:

The rating agencies were granted preferred status by the SEC and then other regulators incorporated ratings into their investment and capital rules, but nobody provided regulatory oversight or standards to ensure the quality of ratings.

Senior management ...was focused on revenue, profit and ultimately share price. Management wanted increased revenues and profit while analysts wanted more staff, data and IT support which increased expenses and obviously reduced profit.

Michelek, structured derivative products group at Moody's 1999-2007, describes how a culture that started as somewhat staid, relaxed and intellectual transformed to a please-the-clients (investment bankers" culture with Sumo wrestling in fat suits at retreats under the new head, Brian Carlson.

Structured finance...raised the profile and magnified the importance of the rating agencies.  Almost by definition, structured finance products beget new structured finance products, with ever increasing degrees of complexity....

The incentives for the 'fee-based' structuring investment bank were clear; get the deal closed, and if there's a problem later on, it was just another case of "IBGYBG"-"I'll be gone, you'll be gone." ...

[The derivatives group in New York started out with a practice of using two analysts for each deal--a "quant" who would check the modeling and a lawyer who would review the documentation.  But as the decade wore on, this shifted.] This shift away from two analysts per deal was, in my opinion, reflective of both the desperately under-resourced status of the Group, and the predominance of the concern for cost control (despite internally reported profit margins that were nothing short of extraordinary).  ... (later comment on this issue at page 12) Nevertheless, it was hardly reassuring that soon after the initiation of rating CDOs in the London and Paris offices, complex structured finance transactions (including cash and synthetic CDOs) were being rated by only one analyst, referring all legal questions to a single (thinly stretched) lawyer based in London.

We did not 're-underwrite' any of the assets proposed for inclusion in the issuer's portfolio.  Errors in the ratings assigned to the underlying assets ... by definition compound into magnified errors in the derivative product. ... "Systematic" errors--where whole cohorts or classes of assets would be found to represent more risk than was identified by the original underwriting and the rating ...understandably created very significant problems for the rating of derivative products. ...

Goldman Sachs ..were the only bank I knew of that employed someone whose primary job was--to put it politely--arbitrage the rating agencies.  It was not difficult to know where Moody's stood in terms of the relative conservatism of our modeling assumptions and drafting requests; Goldman was very prompt when informing us that "S&P doesn't require that." ...

With every increase in issuance there was a concordant increase to the number and size of the structuring departments at banks.  And with every such increase, there was automatic need for increasing deal flow to service that new investment in staff. ...

To be effective, [any new legislation] will do well to recognize that meaningful ratings represent a public good, and as such some part of the function of a publicly 'approved' Credit Rating Agency should acknowledge and accept the responsibility--and liability--for providing that public good.

Cifuentes, Industrial Engineering, University of Chile and former Moody's Senior Vice President

[T]he ratings agencies exacerbated the magnitude of this [financial] crisis by making three significant negative contributions: 1) They misjudged the quality of these loans..., 2) They misjudged the risk associated [with] the securitization (re-packaging) of such loans..., and 3) They misjudged the risk associated [with] the re-securitizations, that is, re-packaging of debt issued by previous securitizations...  All in all, the combined effect of these three unfortunate actions was that a colossal number of securities perviously known as 'investment grade' which, until recently, was a synonym of 'low probability of defaulting.' have either defaulted or been downgraded. ...

One can only guess what could have happened if the rating agencies had monitored the subprime market with the same level of care that they seemed to have employed to monitor their market share.

Susan Barnes, currently a managing director at S&P's, provides a discussion of securitization that essentially claims that S&P has always done appropriate review based on the information provided by issuers. She provides a chronology of S&P's public statements about the deterioration of the securitization market and downgrades to RMBS deals.

Consistent with our commitment to transparency we repeatedly informed the market of our view that the credit quality of subprime loans was deteriorating and putting negative pressure on RMBS backed by those loans.  And, consistent with our commitment to analytical rigor, we revised our models, took action when we believed action was appropriate, and continue to look for ways to make our analytics as strong as they can be. ...

[T]he years 2005 and 2006 were characterized by an inreasing flow of publications and information from S&P...regarding the deterioration of the subprime mortgage market and the ahistorical performance of rated securities.  Beginning in late 2006, these observations resulted in the earliest and most severe rating actions that S&P has taken in this area.

McDaniel, chair and CEO of Moody's, and Yoshizawa, senior Managing Director, Moody's Investors Service, similarly claim to have highlighted the trend of escalating housing prices and loosening mortgage underwriting processes, though Moody's "like many others, did not anticipate the unprecedented confluence of forces that drove the unusually poor performance of subprime mortgages."

[P]otential conflicts exist regardless  of who pays [for ratings--investors or issuers].  The key is how well the rating agencies manage the potential conflicts.  We believe that Moody's manages the potential conflicts in our business model to a global best practice standard, and we have implemented a series of changes over the past year to further strengthen these standards. ...

Moody's comes into the residential mortgage securitization process well after a mortgage loan has been made...and has been identified to be sold and pooled into a residential mortgage-backed security by an originator and/or an investment bank.  We do not participate in the origination of the loan; we do not receive or review individual loan files; we do not conduct due diligence; we do not structure the security....  Rather we provide a public opinion (based on both qualitative and quantitative information) that speaks to one aspect of the securitization, specifically the credit risk associated with the securities that are issued by securitization structures. ...

*****

Beale here: What is perhaps most striking about these statements is the way the current rating agency personnel absolve themselves of responsibility by asserting that due diligence is not a part of their duties, and by avoiding discussion of the drive for market share and profits as a rating determinant.  Is it really possible for an analyst to do a decent job of forecasting ability of a securitization to make payments without actually looking at the underlying assets, rather than some spreadsheet of information drawn up by the issuer?  Can a rating agency determination that is provided to a customer to help that customer achieve the sales objectives it has set for the deal possibly be "independent" when the customer determines whether or not to use the rating agency and the fee paid is negotiated at the same time that discussions about the rating determination are ongoing?

Krugman concludes that the Subcommittee's "work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation."  See Krugman, Berating the Raters, NY Times, Apr. 25, 2010.  But Krugman's key point is that the "deeply corrupt system" revealed by emails by rating agency employees is "a system that financial reform, as currently proposed, wouldn't fix."  Instead, "the ratings agencies skewed their assessments to please their clients [and that] helped the financial system take on far more risk than it could safely handle."

What possible refinements to the rating process for securitizations should be made--to the extent we think that securitizations are reasonable parts of the financial system of providing credit (an assumption that should itself be questioned in considering how to restructure the financial system)?   Krugman notes that the current bill before the Senate mainly makes it easier to sue for "knowing or reckless failure to do the right thing" whereas what is needed is "a fundamental change in the raters' incentives." 

What kinds of things might be considered?

• More transparency is needed--should all conversations and correspondence between issuer and rating agency be summarized as an exhibit that is part of the deal documents?  should rating agencies be required to provide a document summarizing the investigations they have conducted and their reasons for the rating provided as part of the deal documents?
• More analysis is needed--should every rating assignment require at least two analyst-participants whose final opinions must be included in the deal documents? 
• Less attention to market share is needed--should there be some kind of random assignment of rating agency reviewer to securitization deals, to remove the drive for market share from the equation (and if so, should there be a standard fee for ratings of complex structured products based on time spent by analysts rather than on type of deal)?
• More concern for the public interest is needed--should rating agencies be liable to investors when their "opinions" reflect a much more optimistic flavor than their internal documents and other analyses of relevant information show?   should their opinions be regulated like tax opinions by practitioners before the IRS under Circular 230--e.g., with specified requirements for disclosures and certifications of amount of certainty depending on the category of opinion (AAA requires a certification of more due diligence than BBB, etc.)?

Campaign finance and tax law

Ezra Klein, Congress's Bipartisan Regard for Wall Street Money, Apr. 21, 2010, provides an eloquent statement about the problems of our current campaign finance laws:  the rich are especially privileged, in that they can 1) donate to a candidate whose views they share in a way that can make a difference  in that candidate's chances for election but also 2) donate to all candidates indiscriminately in a way that hedges their rights to access no matter which candidate wins.  Poor constituents lose out doubly--they can afford only a pittance to help the candidates whose positions they believe most closely reflect their own, and they cannot begin to play on the "money for access" field.

So what if the access the rich are interested in is to talk about the tax laws?  For an amount of up-front money, access may provide a long-term monetary benefit in the nature of a tax expenditure that is tailored to provide significant benefits to upper-bracket taxpayers.  It may even be sold as a tax expenditure in the public interest--like the mortgage interest deduction, which is touted as a way to help ordinary Americans buy their own homes but which is especially beneficial for those with million-dollar home mortgages and high income tax brackets. 

The rich thus have money, in part, because they have had extraordinary access and through that access have succeeded in getting Congress (and regulators) to pass wealth-friendly laws.  Deregulation of swaps, for example, meant Paulson could short the toxic CDO specially created for it by Goldman and earn great wealth on a deal that might not have been allowed --or certainly would have been less likely with full transparency-- in a regulated market.  The preferential rate for dividends meant that a wealthy person could earn twice the income from his stock that his secretary earned in wages yet pay not a penny more of income tax. 

The power of money to buy access seems worrisome whenever it occurs, but perhaps particularly troubling if the access influences tax laws because of the underlying principle of sharing the burdens of the cost of government that is also corrupted.

So what can we do about this conundrum of the power of money to buy access?  I suppose we can vote those who readily provide access to money out of office.  But campaign financing pays for the information (and misinformation) that we receive, so it appears we voters will be likely to be misinformed more as the need to be informed rises.  On a local level, perhaps public financing of campaigns is the answer.  But on the federal level?  It appears that only volunteer activism and the work of organizations intended to counter directly the influence of purchased access could have an effect.

Do readers agree that corruption of the process is especially worrisome for tax laws?  Do you see any better ways to counter the corruption?

Financial Reform: Agriculture approves derivatives regulation

Blanche Lincoln 's Senate Agriculture committee voted 13 to 8 (including lone Republican Grassley) to pass a bill that goes a good ways towards establishing real oversight of the derivatives (and other financial innovations) market.  See Dennis & Kane, Senate committee approves derivatives oversight bill, Washington Post, Apr. 21, 2010.

The bill, known as the Wall Street Transparency & Accountability Act of 2010 (available in the Senate Agricultural website) is generally tougher on derivatives than the current Dodd bill on financial regulatory reform, but leaves considerable loopholes that will need to be closed if real financial reform is to be achieved.  It seems fairly close to the Obama administration's proposal (with separate rules for "swaps" under the Commodities Exchange Act generally regulated by the Commodities Futures Trading Commission (CFTC) and for "security-based swaps" under the Securities Exchange and Investment Acts regulated by the SEC)--which caused much consternation among Wall Street banks, but had commentators worried about the exceptions and discretion.

As described in the WaPo article:

Lincoln's legislation calls for banning big Wall Street firms acting as brokers for commercial companies and financial speculators who want to trade derivatives. It also would require nearly all derivative contracts to be traded in public on exchanges and approved by a separate body called a clearinghouse.

Those dealing in derivatives would have to raise money to cover unexpected losses, in case one party to the contract defaults. Lincoln also said swap dealers will have a fiduciary duty, just like investment advisers, to act in the best interest of their clients. The draft of her bill provides a relatively wide exception for agricultural and other commercial companies but still requires them to raise money for derivative trades.

Some officials view the legislation as too friendly to the commercial firms who have sophisticated derivatives trading desks, while overly punishing financial firms. If allowed to stand, they have said, the market would simply shift its activities away from Wall Street to the commercial firms, critics argue, but become no less dangerous to the financial system.  Id.

The bill would also prevent the Fed or FDIC from using federal funds to bail out Wall Street firms who engage in derivatives--those swap desks must be spun off or the firms will not be able to receive any federal assistance.   According to Lincoln, the bill's refusal of Fed funding for risky derivatives trades will require that banks choose whether "they want to be banks or [whether]they want to engage in the risky trading that caused the collapse of firms such as AIG."   RTT News, Senate Agriculture Committee Passes Derivatives Reform Bill (Apr. 21, 2010).

The exception from mandatory clearing is intended to cover end-users who are actually hedging business risks, such as electric cooperatives.  The summary describes this exception this way:  "Commercial businesses and manufacturers who use these markets and customized contracts to manage risk will still be permitted to do so without imposing additional margin costs."  See  the Ag Committee's summary of the bill.   In my view, however, that is a gaping loophole that lets a agribusiness interests off the hook, especially if those "customized contracts" are not hedges of commodities but tax minimization transactions or regulatory avoidance transactions.

As the Wall Street Journal noted when Lincoln revealed her proposal last week, the proposal is "likely to draw the ire of the largest Wall Street banks."  See Crittenden & Favole, Lincoln: Derivatives Bill to Provide '100% Transparency', Wall St. J. (Apr. 16, 2010).  But the view seems to be that financial reform will pass, and this suggests that it will contain at least some form of derivatives regulation. See Dennis & Murray, Once critical of finanical regulation, Republicans change their tone, Washington Post, Apr. 21, 2010.

As I've said before, regulating derivatives is essential.  Regulation needs to be comprehensive, however, and disincentivising and perhaps banning specific types should also be in the package.  It is hard to find a good rationale for permitting naked credit default swaps, which amount to casino bets that compound any misinformation in the markets and multiply the volatility. 

Prefunded resolution authority or "bailout fund": McConnell spins financial reform

[edited to add links]

Financial reform has taken over the hot seat from health care.  See the Senate Banking Committee's summary of the Dodd bill;  S. 3217 as filed (1408 pages).

The closer we get to perhaps doing some of the things that must be done the more the "party of nope" is pushing back.  Take the idea of a prefunded liquidation authority through which banks can be assessed now for funds that would cover the winding down expenses of a liquidation when a bank fails later.  Some Republicans apparently supported the idea of such a fund, since it would eliminate taxpayer bailouts, which nobody wants.  That is, until McConnell stepped in as spinmeister and called the fund a "bailout fund".  See Bacon, McConnell's Wall Street meeting prompts criticism from Democrats, WaPo, Apr. 20, 2010.  Now, surely McConnell knows better.  Bailouts occur when taxpayers pony up to pay for keeping an underwater bank alive.  The resolution authority is to liquidate a bank, not keep it alive; the fund will be used to pay transition winding down expenses, not the banks' creditors or shareholders; and the money is from the big banks themselves, not from taxpayers. 

Obama responded, as one would expect, by calling the mislabeling  "cynical and deceptive", suggesting that the GOP is really interested in just obstructing the passage of financial reform. Id.  This seems especially likely, since McConnell's push against reform came after a big meeting of GOP leaders with Wall Street executives.  Id. 

But Obama is already signalling that maybe the fund isn't an essential part of the bill.  And of course, this is the worrisome part of this staging.  McConnell knows in the long run the GOP can't completely oppose financial reform.  So the goal is to reduce the impact of the provisions and allow the banks to go their merry profit-making and bonus-paying ways. 

But if "bipartisanship" means letting the already weak Senate bill be weakened further, that is bad news.  Why? because the Senate bill has a number of weaknesses:

• the consumer financial protection agency would be under the Fed, which historically has at most indifference and sometimes disdain for ordinary people, and sees its primary purpose as keeping banks in working order, which has a tendency to trend towards maintaining the financial system that we have now, rather than helping us move to a more sober and less risky system;
• the bill would permit banks to continue their "financial innovation", pushing products that they have devised as good ways for banks like Goldman to make money.  So Obama would permit synthetic CDOs so long as the banks have a peppercorn of skin in the game (pardon the mixed metaphors).  But synthetic CDOs are a good illustrator of the reason that financial innovation should be stifled, not encouraged.  They serve no purpose whatsoever in the productive economy and are merely casino bets on positions that neither "short" or "long" side holds--neither has actually put money into the productive economy, but the banks get fed with big fees from both.  Synthetic CDOs were the instrument of choice that Goldman built to order for Paulson to short the mortgage loan market (and sucker the other side of the CDO).  These synthetic CDOs amplify existing risks, since they are built off loans by merely "referencing" them.  See, e.g., Dittmer & Smith, Magnetar, Goldman Press Flurry Still Misses the Biggest Point of All, Naked Capitalism, Apr. 20, 2010; Adams, The Myth of 'Insatiable' Investor Demand for CDOs, Apr. 20, 2010.
• regulation and disclosure with respect to credit default swaps would be insufficient--customization is a huge loophole.  Agriculture Committee chair Lincoln may push through much more stringent legislation on derivatives trading, which would be a step forward.
• the bills don't eliminate proprietary trading.  Banks are supposed to be the sober, boring glue of the real world's productive networks, connecting lenders and borrowers.
• the bills don't break up the big banks.  Systemic risk awareness, some kind of consumer protection, leverage and capital constraints--those are all good steps.  But we shouldn't allow banks of the megasize that the big 5 have become.  It is too dangerous when they fail, and we won't see every risk that we should see soon enough to prevent their failure.

Uncertain Tax Positions

The IRS released today its draft schedule and instructions for the new initiative (announced late in January by Commissioner Shulman and set forth in Ann. 2010-9) for disclosure on new Schedule UTP on uncertain tax positions for taxpayers with assets of $10 million or more.    The release, Ann. 2010-30 [Download Ann.2010-30. uncertain tax positions], invites comments and indicates that these draft forms and instruvtions will not be finalized until after the comment deadling of June 1, 2010, and after the IRS has had time to review all of the comments on the proposal and the documents.  REITs, RICs, partnerships and tax exempt organizations are not required yet to file Schedule UTP.

 One of the issues the IRS is considering is the extent to which the new form for uncertain tax positions (Schedule UTP [Download Schedule UTP form]) duplicates information required through other disclosure initiatives (such as the reportable transaction rules and Schedule M-3, the revised form for reconciling financial statement (book) and tax differences). 

(Of course, the recent financial accounting changes set forth in "Fin 48" have also led to revelations through financial accounting that are relevant for tax consideration.  See, e.g., "expedited resolution of uncertain tax positions-LMSB intiative to address certain implications of Fin 48.")

The rules generally require taxpayers to report positions if they made a decision to record a reserve 60 days or more before the filing of the return (or a decision not to record a reserved because of an expectation of litigation or in reliance on an IRS administrative practice).  Although the reporting requirement is supposed to apply to current and prior year tax positions, the IRS instituted a particularly taxpayer friendly transition rule by providing that prior years' tax positions need not be reported in the first year of the new reporting requirement.  In other words, prior year's uncertainties are essentially "grandfathered".  See Schedule UTP draft instructions released today [Download Schedule UTP Draft Instructions].

Why would practitioners and corporations object to a new disclosure requirement?  Primarily because it will further eliminate the uneven playing field in which insiders have the scoop on the taxpayer's positions and how aggressive the taxpayer has been in filing the return, while the IRS has to try to figure everything out from afar.  For the IRS, it's like trying to pinpoint the burrow of a mole from outerspace--without sufficient disaggregated information about the taxpayer's transactions and positions taken in respect of those transactions, the chance of finding items on audit is significantly reduced.  Corporate taxpayers with aggressive positions like it that way, of course, since it gives even frequently audited companies a version of the audit lottery--not whether there will be an audit, but whether the audit will be able to uncover the most aggressive tax positions taken and understand what it has discovered if it does.  I have argued that the pre-return tax advice should be considered business advice--accountants engage in those advising services as much as lawyers so it should not be eligible for attorney-client privilege.  Workproduct protection shouldn't be available, because anything prepared at this stage is prepared for inclusion on the return (directly, or as background information for what is included directly) and that business and regulatory use precludes the litigation focus that underlies work product protection.  The reporting of uncertain tax positions makes sense in this context.