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Taxes, Individual Decisions and Investment Alternatives Presentation to the President’s Advisory Panel on Federal Tax Reform March 16, 2005 Brian S. Wesbury.

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Presentation on theme: "Taxes, Individual Decisions and Investment Alternatives Presentation to the President’s Advisory Panel on Federal Tax Reform March 16, 2005 Brian S. Wesbury."— Presentation transcript:

1 Taxes, Individual Decisions and Investment Alternatives Presentation to the President’s Advisory Panel on Federal Tax Reform March 16, 2005 Brian S. Wesbury Chief Investment Strategist Claymore Securities, Inc.

2 2 People Pay Taxes, But The Tax System Really Impacts People’s Chosen Activities  From an economic perspective, it is the impact of taxes on incentives and behavior that matters.  Taxes influence decisions about how individuals allocate their scarce time, talent and resources.  Investors contrast potential after-tax rewards and risk.  Now the Israelites had been saying, “Do you see how this man [Goliath] keeps coming out? He comes out to defy Israel. The King [Saul] will give great wealth to the man who kills him. He will also give him his daughter in marriage and will exempt his father’s family from taxes in Israel.” – I Samuel 17:25

3 3 Different Investment, Different Taxes Bonds  Corporate Bonds – Corporations deduct interest from income. Interest payments, however, are taxed at individual or corporate marginal income tax rate.  Treasury Bonds – Interest income taxable at marginal tax rate.  Municipal Bonds – Most interest exempt from income tax for individuals. Banks, however, are limited to the type of tax-free bonds they can buy, and also face TEFRA haircuts and AMT.  Original Issue Discount (OID) Bonds – Can create a tax liability even if no interest is earned (example, zero-coupon bonds).  Treasury Inflation Protected Securities (TIPS) – Increase the principal of the bond by the rate of inflation. Tax is then due on this increase in principal as if it were actual interest income. Loans  Mortgage Interest – Deductible for borrower, taxable for lender.  Investment Interest – Interest paid on loans to fund investment, such as margin loans, is deductible to the individual.  Other Interest – Interest paid on car loans or credit card debt is not deductible.

4 4 Different Investment, Different Taxes  Corporate Dividends – Prior to 2003 tax cut, dividends were taxed at individual marginal income tax rate. Today, recipient is taxed at 15% on “qualified dividends.”  If corporation earns $100, and pays 35% tax rate, or $35 in corporate tax, then $65 remains to be paid as dividend. Recipient is then taxed at 15%, which leaves $ Tax rate = 44.75%.  Capital Gains on Stock – After holding stock for one year or more, taxed at 15%. Less than one year, taxed at individual marginal income tax rate. Stock option compensation plans are very complicated.  Capital Gains on Housing – Tax-free up to $500,000 for a couple who has used home as primary residence for at least two years. Gains over $500,000 taxed as income.

5 5 Further Complication: Tax-Deferred Vehicles  Different tax treatment for investments are further complicated by the existence of tax-preferenced vehicles such as IRAs, Roth IRAs, Keoghs, 401(k)s, 529s, life insurance policies, pension plans, deferred compensation plans, and others.  Alter after-tax returns on investments.  For example, no one should buy municipal bonds in an IRA.  The existence of these vehicles makes investment decisions even more complex.

6 6 Differential Tax Rates Change Behavior  Prior to 2003 tax cut, the long-term capital gains tax rate was 20%, but dividends were taxed at marginal income tax rates.  As a result, corporations issued debt, bought back stock and paid fewer dividends.  This reduced the combined corporate and shareholder tax liability.  2003 dividend tax cut to 15% encouraged dividend payments.  Homeowners can deduct mortgage interest from income and interest paid on home-equity lines.  As a result, many use home-equity lines to make large purchases of furniture, vehicles or home appliances.

7 7 Differential Tax Rates Change Behavior  Does the tax code boost the trade deficit?  This panel has already heard testimony about how the U.S. tax code is biased against saving (see 2/16/05 transcripts).  Future consumption is relatively more expensive because investment dollars are taxed more than once. As a result, current consumption is encouraged, which increases imports.  At the same time, foreign central banks and many other foreign investors do not pay taxes on interest earned from US bonds. As a result, interest earnings from owning US debt are higher for foreigners than for US citizens who must pay taxes on interest.  The tax code boosts domestic consumption and encourages foreign investment. The result could be a larger trade deficit than would otherwise exist.

8 8 Interest Rates are Higher, Investment Lower  Because interest income is taxable and interest payments are deductible, investors demand a higher interest rate.  This is why corporate and Treasury bond yields are higher than municipal bond yields. Most municipal bond interest is tax-free to investors. As a result, investors are willing to accept a lower rate.  If interest income were tax-free, interest rates would be lower across the board.

9 9 Tax Cuts and Investment  2001 recession was an investment depression.  Even with dramatic Fed rate cuts in 2001, business fixed investment fell for nine consecutive quarters, between Q and Q  Employment growth was slow and the economy struggled. During the first five quarters of recovery (which began in November 2001), real GDP growth averaged just 2.1%.  Investment grew after the May 2003 tax cuts, which cut capital gains and dividend tax rates and provided for accelerated depreciation.  Business investment has grown for 7 consecutive quarters, and real GDP has since grown at a 4.5% annualized rate.

10 10 Lower Taxes and Investment

11 11 The Housing Market  Housing is the least taxed investment in the US and it is clearly booming.  Tax cuts in 1997 exempted $500,000 of capital gains from sale of home for couples who live in home for 2 years.  Strong Growth.  Housing starts and sales grew through the recession.  Since 1997, residential construction jobs have increased by 36% and real estate jobs jumped 17.6%, while retail employment rose just 5.8%, and manufacturing jobs fell 17%.  Housing prices are up dramatically.

12 12 Summary: Leveling the Playing Field  Different tax treatment of different investment vehicles distorts the financial market playing field.  Interest rates are higher than they would otherwise be, corporations make decisions based on the tax code, individuals are encouraged to save less.  A consumption-based tax system would level the playing field for all types of investment.


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