Big-Ticket Government Purchases

According to the Office of Management and Budget (OMB), the federal government spent an estimated $3.7 trillion in 2013.  Keep in mind this $3.7 trillion budget only applies to the federal government.  Each state has its own tax regime, as do municipalities in the form of property taxes.

There are often misconceptions about what the government spends money on.  While the federal balance sheet is very complex due to on- vs. off-balance sheet accounting, here are some big-ticket items (2012 data):

Source:  http://usbudgetalert.com/spending.php

Here are estimated 2013 budget figures (gross data that excludes offsetting trust fund accounting):

Social Security	$818 billion
Defense	$660 billion
Income Security*	$564 billion
Medicare	$511 billion
Interest on National Debt	$421 billion
Health Care Services	$334 billion

*Federal pensions, unemployment, housing assistance, food and nutrition assistance, other income security

Source:  http://www.whitehouse.gov/sites/default/files/omb/budget/fy2014/assets/hist03z2.xls

These six items alone add up to $3.3 trillion, representing the vast majority of the budget.  International affairs, science, space, technology, energy, environment, agriculture, commerce, transportation, community development, education, veterans, justice, and general government are among other expenses.

This demonstrates what lawmakers need to prioritize if meaningful spending cuts will ever be made to close our gaping budget deficits.  The complication, of course, is that there is minimal political willpower to touch any of these items.

Elephants in the Room

As the pie chart above depicts, Social Security, Medicare, and Medicaid combine for about 45% of the federal budget.  The big problem is that these pieces are growing rapidly.  Between 2008 and 2013, the Consumer Price Index increased by 8.2%.  Here is how entitlement growth compared:

Expenditure	2008	2013	Spending Growth
Social Security	$617B	$818B	33%
Medicare	$391B	$511B	31%
Non-Medicare Health Care	$248B	$334B	35%
Total	$1,256B	$1,663B	32%

Source:  http://www.whitehouse.gov/sites/default/files/omb/budget/fy2014/assets/hist03z2.xls

Perhaps this growth rate will slow down, you would hope.  Unfortunately not.  Here are OMB estimates for 2013-2018 spending growth of these programs.  And if anything, the estimated growth for Medicare and Medicaid will likely be understated compared to what will actually occur over the next five years.

Expenditure	2013	2018	Spending Growth
Social Security	$818B	$1,086B	33%
Medicare	$511B	$615B	20%
Non-Medicare Health Care	$334B	$557B	67%
Total	$1,663B	$2,257B	36%

Entitlement programs are the third rail of American politics, and necessary reforms would likely need to be part of a grand compromise (e.g. Bowles-Simpson):

http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf

Regardless of your political persuasion, when the threats of government shutdowns and debt defaults cannot even reduce entitlement spending growth by $1, it does not bode well for this possibility.

Any legitimate attempt to make reforms and stave off much greater financial difficulties is met with extreme viciousness.  It takes a mobilized electorate to realize there is no free lunch, and that starts with being armed with facts to see through self-interested politicians who feebly resort to scare tactics at the mere mention of reform.

Source: http://www.cagle.com/news/socialsecuritymedicare/

18 in America

Before attending Williams College, Dylan Dethier embarked on a unique journey at age 18.  Dylan took a year off after high school to travel the country and golf in all 48 contiguous states.  What makes Dylan’s trip so compelling?

·         Golfing at Pebble Beach to hardscrabble municipal tracks, with many unique venues in between

·         His playing partners, ranging from hosts at private clubs to the unemployed in Flint, MI

·         How he managed a 35,000 mile trip on such a low budget

·         The evolution of his maturity and perspective during this life-changing experience

Source:  http://www.amazon.com/18-America-Golfers-Journey-Essence/dp/145169363X

Dylan’s story has been chronicled by the New York Times, USA Today, National Public Radio, and numerous other media outlets.  His book is an exemplary read.  Dylan’s writing talents are in full display, there is captivating storytelling, and parts of the book are remarkably introspective.

After reading Eighteen in America, my own perspective on golf was broadened.  Dylan thoughtfully identifies the ways in which the sport provides commonalities for a wide variety of players.  He certainly took the road less traveled after being accepted into college, which adds to the allure of his story.

Jason Dufner and Jim Nantz even conveyed their enjoyment of the book.  For an entertaining and fresh perspective on golf’s essence, consider Dylan’s book:

http://www.amazon.com/18-America-Golfers-Journey-Essence/dp/145169363X

http://dylandethier.com/

Growth Rates and New Baselines

As taxpayers, we should carefully look at spending programs that had very high growth rates over the past few years.  Many programs, particularly in social assistance, are designed to ramp up during bad times to help smooth out income shocks for people.  Unemployment benefits are a prime example.  Therefore, we should not be surprised to see increased inflation-adjusted spending levels from 2008-2013 in certain programs.

The reduction in the nominal unemployment rate is often cited as evidence the economy is improving.  However, if this is the case, government spending that is counter-cyclical to the economy should significantly decline over the next few years as the economy improves.

By 2018, these programs should have a budget that is 20-25% higher than 2008 levels due to inflation adjustments.  Between 2008 and 2013, the Consumer Price Index increased by 8.2%, and an estimated CPI increase of 11-15% between 2013 and 2018 will produce that overall 20-25% increase over ten years.

However, opening up this OMB spreadsheet (http://www.whitehouse.gov/sites/default/files/omb/budget/fy2014/assets/hist03z2.xls) reveals a different story for many agencies (not limited to counter-cyclical spending), vastly exceeding 20-25% inflation:

Expenditure	Est. 2008-18 Increase
Federal Employee Pensions	40%
Food Stamps	67%
General Government	82%
International Affairs (non-Defense)	80%
Medicaid	113%
Medicare	57%
Social Security	76%
Transportation	44%
Veterans Benefits and Services	102%

Displaying these line items is not an indictment of the programs; rather, it is a mathematics-based conversation starter.  Some liberals and conservatives alike would shun at the mere mention of reducing the growth rate of some of these entities.  “Cutting” is the operative buzzword used to scare away attempts to reduce growth rates.

From an economic perspective, however, this level of increase over ten years—far outpacing inflation—is problematic for many reasons.  Remember, this time series is between 2008 and 2018, which is when the economy should return to nearly full employment and yield an apples-to-apples comparison.

Practically speaking, it is very difficult in Washington to reduce the spending growth of many programs, even when it is clearly warranted.  Consequently, these elevated levels become new baselines that all future spending is based upon.  This feature is crucial, because it essentially guarantees higher spending levels in perpetuity that exceed the economy’s ability to pay for them.

Whether or not you pay much attention to politics, understanding these economic concepts will empower us to thoughtfully analyze the budget and immediately recognize the shallowness of what many politicians and pundits claim about “cuts.”

Roth IRA Accounts and 401(k) Conversions

If you have not received my guide to retirement accounts (6-page Word document) and would like to view it, send me an e-mail at krkreflections@gmail.com .  There is a new section that may be especially beneficial for current MBA and other graduate school students.

The Pension Time Bomb

In recent years, there have been intense political battles regarding pension systems, and these arguments will persist and only worsen.  Many readers of this website will have sharply divergent views from one another on this topic, so I will do my best to present this in a rational economic construct.

Governments on the federal, state, and municipal levels have completely and systematically overpromised pension benefits to current and retired employees.  The mid-to-late 1990s witnessed significant economic growth and stock market appreciation, which is unquestionably a good thing, but unfortunately this outperformance set unrealistically high expectations for future investment growth rates.  Many politicians, who receive significant campaign contributions and electoral support from public sector unions, were incentivized to make pension plans more and more generous.

Unfortunately, investment returns over the past 13 years have been quite paltry.  Crucially, for the past four years and going forward for at least the next couple, we have been in a protracted low interest rate environment.  This drives bond yields lower, thereby making it exceedingly difficult for pension funds to achieve investment targets without taking undue risks.

Source:  http://www.freeworldmaps.net/printable/us/us_political2.gif

Nearly every state now finds itself having promised way more in benefits than it can possibly deliver.  As we have witnessed in California and other high-tax states, trying to tax your way out of this problem ends up being largely counterproductive, as businesses and higher-income earners end up relocating to states like Texas and Florida which are relative tax havens.  In this still-depressed economic environment, states may be able to raise some revenue without suffering a significant exodus, but not nearly enough to make up for the pension shortfall.

This leaves us with an uncomfortable realization, but a realization nonetheless.  Pension reform isn’t a choice, it’s a necessity.  And the sooner states adopt pension reforms, mathematics proves that comparatively small short-term sacrifices will be far preferable than having a bankrupted system that cannot afford to make any payments to retirees.

The next article below provides the math to back up this statement.

Pension Math and Investment Returns

While the private sector primarily utilizes a defined contribution scheme, where employers will contribute funds to a 401(k) account that an employee is in charge of managing, the public sector predominantly has a defined benefit pension system where fixed dollar amounts are promised during retirement.

To illustrate these concepts, let us consider the case of a 40-year-old who opts to retire at age 65, and then receives a defined benefit amount for the rest of his/her life.  For simplicity, looking at a single payment illustrates how projected investment returns considerably influence how much money needs to be contributed now.

Money contributed in 2013  è  Compounds for 25 years  è  Money for retirement in 2038

Suppose that upon retirement in 2038, the worker is supposed to receive a payment for $100,000.  State and local governments must contribute money now, in 2013, to ensure the retiree will receive $100,000 in 25 years.  The compound interest rate (also called the discount rate) reflects the state’s estimate of annual investment returns over the next 10-20 years.  You can also think about the discount rate as the expected rate of return (which in theory should be achievable with the asset mix the pension fund uses).  For example, if you believe that investing in stocks and bonds will generate a 6% annual return over time, then 6% would be the appropriate discount rate.

A high discount rate allows for smaller contributions now in the hope that significant appreciation will grow the amount to $100,000.  A low discount rate means that larger contributions must be made now.

Given that states are struggling to balance their budgets, many are using more aggressive assumptions in order to save cash now.  However, if actual investment returns fall short of these targets, states will have to contribute substantially more money in the future to compensate for this shortfall.  Despite lower interest rates and investment returns, many public pension plans have never adjusted the discount rate, exposing these plans to grave risk.

Let’s look at the difference between compounded returns of 8.25% vs. 6.50%.  Many state governments are using figures around 8.25%, while corporations are (by law) using a much more conservative 6.50%.

? contributed in 2013  è  25 years @ 8.25%  è  $100,000 in 2038       vs.

? contributed in 2013  è  25 years @ 6.50%  è  $100,000 in 2038

Required contribution using 8.25% rate:  $100,000 / (1.0825) ^25 = $13,782                                                           vs.

Required contribution using 6.50% rate:  $100,000 / (1.0650) ^25 = $20,714

Reducing the discount rate by 1.75% (from 8.25% à 6.50%) necessitates contributing a staggering 50% more money now.  It’s no wonder that states have generally opted to use a significantly higher discount rate, but in this “new normal” rate environment, they are likely deluding themselves.  Yet even at the high discount rates, states have promised far more in benefits than they will be able to pay, resulting in massive projected shortfalls.

For instance, New Jersey, only the 11^th most populous state, has unfunded pension liabilities of $55,000 million at an aggressively high discount rate.  Applying a more conservative discount rate, this number increases to around $100 billion, fundamentally compromising the state’s capability to provide any other desired services (e.g., education, human services, transportation, etc.).

Source:  http://www.policyprospectus.com/2012/08/a-primer-on-pensions.html

In order to shore up the pension system, state governments will need to adopt a combination of these politically unpopular, yet economically necessary, approaches to stave off a true fiscal crisis where everybody will lose out (defaulting on debt, huge cuts to state budgets, and not having cash to pay retirees):

1)  Employees contributing more to their pension plan to ensure its sustainability

2)  Gradually migrating from a defined benefit to a defined contribution system

Unfortunately, politicians who care about their self-interest above all else have “kicked the can” on pensions and other issues for years, and it takes statesmen to address difficult fiscal issues now in order to stave off financial ruin later.  When offering constructive ideas, the debate is often poisoned by public sector unions claiming that teachers, police officers, firefighters, clerical workers, etc. are being attacked, when in fact pension reforms are necessary to ensure the solvency of the very system they are relying on for retirement.

For any helpful discourse, it is paramount that both sides separate the individual from the union they are required to join.  The default response from certain interest groups has been to demonize the messenger without offering any meaningful proposals, but it is critical for people to see through that shallowness.  Hopefully these mathematical concepts and their applications were illuminating.

Double Taxation of Capital Gains and Dividends

At 35%, the United States has the second highest corporate tax rate in the industrialized world.  Through their ownership, shareholders receive capital gains and dividends from these corporations.  Instead of the taxation ending at the corporate level, however, individuals also pay federal, state, and local taxes on these distributions.

Policymakers continually debate about what the optimal capital gains and dividend tax rates should be.  In fact, nearly every president since Gerald Ford has presided over a change to the long-term capital gains rate.  While interest income gets taxed as ordinary income, capital gains from investments held for over one year typically receive preferential tax treatment.

On January 1, 2013, capital gains and dividend rates increased for higher-income earners as depicted here:

Source:  http://www.forbes.com/sites/beltway/2012/01/24/capital-gains-taxes-are-going-up/

With this background, we can illustrate the effects of double taxation.  For simplicity, let’s assume:

·         100 people purchase all shares of a company for $1,000 each; the company is therefore worth $100,000

·         Over the next year, the company earns $20,000 pre-tax

·         35% corporate tax rate is applied à the company earns $13,000 after-tax

·         Each shareholder risked $1,000 of capital by investing in the company, and is entitled to fractional ownership of the company’s profits

·         An individual owns 1/100 of the firm, and would therefore receive (1/100) * $13,000 = $130 of profits through stock price appreciation or dividends

Because of double taxation, however, more deductions need to be calculated.  Most people need to add a 15% federal rate, plus state and local rate, to the tax burden.  This issue becomes even more acute for higher-income earners, where the effective federal tax is now about 25%.

If the (Federal + State + Local) tax rates on capital gains and dividends amounts to 30%, then the shareholder only receives $130 * 70% = $91.

Stocks are inherently risky to invest in because the firm’s creditors are entitled to cash before shareholders.  In this example, the company did well by earning $20,000 for its shareholders.  As a 1/100 owner of the company, you would be entitled to $200 pre-tax.

However, the corporate tax lowers this to $130, and then the capital gains and dividend taxes lower it further to $91.  The $91 represents merely 45.5% of what the company actually earned on a pre-tax basis, meaning that as an owner, you are subjected to an effective 54.5% tax rate.

Political discourse will continue about these issues, and hopefully this provides some helpful background material about corporate and individual tax rates. 

Source:  http://www.invigorlaw.com/choosing-a-business-entity-double-taxation-v-pass-through-taxation/