Monday, November 10, 2008

Mackay Asks a Question...

I received this link from Mackay. Its a story about a bank "tax loophole" re-opened by the recently passed bailout bill. Here's a brief excerpt:

Section 382 of the tax code was created by Congress in 1986 to end what it considered an abuse of the tax system: companies sheltering their profits from taxation by acquiring shell companies whose only real value was the losses on their books. The firms would then use the acquired company's losses to offset their gains and avoid paying taxes.

Lawmakers decried the tax shelters as a scam and created a formula to strictly limit the use of those purchased losses for tax purposes.

I hope folks found the previous post to be at least slightly insightful. I know its not the most profound thought in the world that "all that is consumed must be produced," but the fact is that many of our economic policies of today absolutely spit in the face of this very simple truism and its consequences for our lives.

This is one of them. The reason I wrote the previous post is so that I could refer back to it in answer to questions like this one.

So what is to be the probable impact of such a rule change on the future of our economy? Let's ask ourselves: does the new rule do anything to promote the connection between production and consumption? Does it bring new resources to market? Does it put new tools in the hands of people? Expand their productive horizons or make markets more efficient?

Or does it erode them?

The modern income tax is about one thing and one thing alone: redistribution of wealth. The broadest view to take on the effect of this change of rules is that it is redistributive. Some entities now will owe less in taxes, but the government's bill will likely remain the same. I doubt the knowledge of this rule change will alter the behavior of our profligate politicians. The remainder will have to be made up in deficit spending, which is paid for by everyone in the form of inflation and higher interest rates.

Of course, if you don't have any savings, there's not a lot to inflate.

As far as the tax advantages for the individual companies are concerned, Ben would probably be a better guy to ask than me, as he is working as a CPA. But before I punt to him, I'll make just a brief comment because I think it points to an interesting developing situation.

Tax law generally says that losses can be carried forward for tax purposes for up to three years. I doubt the government is likely to change this rule at at time like this. The big banks will likely be taking losses for at least the next two years, giving about five years in which THEY WILL BE PAYING LITTLE OR NO INCOME TAX AT ALL. So it is likely: a) that this rule will have no effect for several years, as there is no income to tax, b) there will be massive losses of tax revenues during this time as these companies constitute a substantial fraction of the US economy.

At the end of the day, this is really an accounting question, not so much an economics question. It is a matter of pushing money around in circles and trying to pass the buck on to somebody else while collecting the most government largesse one can. It doesn't increase production, and has little to do with consumption. Except of course paying the salaries of the folks to do the money pushing, and the loss of productivity in employing them in this way. But that's small potatos at this juncture. The bigger idea is the effect that redistribution has on markets.

Redistribution flies in the face of what we know makes an economy work well. It begins to sever the link between consumption and production. When you hear brain-dead media wonks talk about "stimulating demand" through inflation or incentives or what-have-you, you should be thinking "theft," because that is what it is.

The "stimulation" and "economic activity" you see as a result is the burning of our precious capital, as our bank accounts are drawn down involuntarily by our government and the money/capital spent on immediate consumption. We are all poorer as a result, though busier for a time doing whatever it is that we do on our jobs. We hustle and bustle, staying busy, "working hard," buying big houses and fancy cars, drawing down our retirement accounts and growing poorer by the minute.

Doesn't seem right, does it? Its not.

The hardest part about getting through the present mess is going to be the realization that we are working twice as hard and consuming half as much as we had been, but that this is actually a fairer accounting between what we produce and what we consume. We have been burning the accumulated capital of several decades, receiving subsidies on our lifestyles from Asia, and pretending we were getting richer while pursuing our lavish lifestyles. All this is likely to end. We have a lot of bills to pay, and not nearly the real capital saved we thought we had. We also have a stifling bureacracy and inflexible regulatory scheme to slow us down in the transitions we will have to make.

And, of course, a bad attitude. And poor ethics for doing all this in the first place.

Redistribution in general is going to make getting on a sustainable path that much harder, as it obfuscates accurate pricing and creates the wrong economic incentives. It will result in a lot of wasted resources, time, and effort. Not something we can afford right now.

But I suppose that's the penalty for practicing bad ethics. Hopfully they won't get any worse, but they probably will as the pinch really begins to hit and people squeal for "releif." Which means "theft."

But what about this particular rule? I doubt it will have much real effect. The tax law is already so obtuse, how much worse could it get?

More interesting is the "shell game" aspect of it. This shell game activity is one of the practices that got Enron in trouble. What do you do if you make a lousy investment? Why, you make another company that you control, and buy the investment from yourself! That way, your "shell company" that you don't care about takes the loss, and the "mother company" is safe and even makes a profit! This particular rule seems to work in reverse, however, as the way you get your tax bill down is to take a loss. Or, I suppose, just break up your gains so you wind up in a lower bracket. We'll have to see if the banks get into trouble with it, too.

Again, Ben would probably be better able to field this question, as he followed the Enron events quite closely as I remember. Any thoughts, Ben?

------Update!-------

Sheeze I'm so stupid! This has HUGE ramifications! Maybe. I should delete the whole post because it makes me look like a fool. Anyhow, you get to see that I'm really quite the amateur. I should say that more often. "I am an amateur!" Don't take my word as the gospel...

In addition to being redistributive, this is a government incentive for merger and acquisition activity in the banking community. The rest of the tax community picks up the incentive's tab. That's how it works.

The government wants bad banks bought out rather than fail. Right now we are in the "pushing on a string" phase of the business cycle, which I really don't want to explain tonight as I've already put several hours into this. But basically, the banks aren't cooperating with the FED's agenda of expanding the money supply because it is not in their interest to do so. The FED lends them money, and they sit on their hoard like a bunch of mountain trolls, not lending it into circulation to "thaw the credit markets" like they're supposed to. If they don't, the weaker banks fail, and *poof* the competition disappears and the FED/FDIC is left picking up the pieces. The FED doesn't want to do this. The US taxpayer doesn't want to do this. So the FED is trying to sweeten the pot for the stronger banks to buy out the weaker ones.

However, as I said, I don't see a lot of profits to offset, at least in the near term, so I don't see how this changes much. The incentives just aren't going to be there, to my mind. Maybe the banks just want it going forward to take advantage of in the next boom (if there is one).

We should expect to see a LOT of consolidation, however this all turns out. In previous crises, literally thousands of banks failed. This will reduce competition in the banking industry.

Prepare for future consumers of banking services to get screwed through lack of competition. This means you.

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