New Year’s Resolution to Save More? Here’s Some Motivation…

Here is a thought exercise -- think about what you spend money on and if there is a way to cut back on individually small expenditures. Suppose that you routinely order an extra drink or two at a coffee shop or bar. And let's say you're able to pinpoint a few other items to save on, and can spend an average of $15 less per day.

Saving an extra $15 per day, and investing this amount at the end of each year, can boost your finances considerably more than you’d expect.  With inevitable fiscal pressures threatening the viability of Social Security, Medicare, and pension systems, you would be very wise to do this if at all possible.

If you’re 25 now, let’s consider the extra money you’ll have at age 65.  Assuming 6.5% investment returns and a 2.5% inflation rate, saving an extra $15 per day will generate extra pre-tax savings of… $1,433,208!

Note:  Your contributions will need to keep up with inflation, which should rise at a similar rate to your income.  In this scenario, you would save $15.38/day next year, $15.76/day in 2015, etc.

You may be wondering how $15/day could generate so much additional wealth for you.  Perhaps you’re in a position to save an extra $5, $10, or $25/day rather than $15.  If we modify the rates for inflation and investment returns, how would that impact the savings calculation?  What if you want to save money for a 5- or 10-year goal, rather than 40?

If you want the answers to any of these questions, e-mail me at krkreflections@gmail.com and I will send you a very user-friendly Excel spreadsheet where you can obtain these findings instantly.

Excise Tax on Medical Devices

The Patient Protection and Affordable Care Act, more commonly referred to as Obamacare, will have far-reaching consequences in the health care industry. (See the first paragraph of this previous post for my take on how congressional bills are named.)

Without getting into the political, moral, and religious implications of the legislation, it is important to consider the economic impact.  Let’s look at one single provision of the ~400,000 word statute.  To raise tax revenue, a 2.3% excise tax on the sales of medical devices went into effect on January 1, 2013.  At first glance, this figure may not seem especially high, but this tax is on sales, not profits.

Traditional corporate taxes are paid on profits, so if a company sells $10 million of furniture, and incurs $9 million of expenses, its pre-tax profit is $1 million.  The federal corporate tax rate of 35% is applied to this figure, so $350,000 goes to the federal government and $650,000 is kept by the company.  A start-up company is likely to lose money for years, and it pays no federal tax because it is unprofitable.

The Obamacare tax on medical device companies, which manufacture a wide array of products, behaves differently.  Start-up companies now have to pay taxes despite being unprofitable, which is devastating from a cash flow perspective and could threaten their viability.  The 2.3% tax on top-line revenues has a huge effect on the profitability of mature companies as well.  These calculations below illustrate comparing 2012 vs. 2013 for three hypothetical companies with pre-tax profit margins of 20%, 5%, and -10% (start-up):

Pre-Tax Profit Margin = Pre-Tax Profit / Gross Revenue
Net Income is based on 35% corporate tax rate

20% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$800		$800
Pre-Tax Profit	$200		$177
Net Income (Profit)	$130		$115
Net Income fell by 11.5%

5% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$950		$950
Pre-Tax Profit	$50		$27
Net Income (Profit)	$33		$18
Net Income fell by 46.0%

10% Pre-Tax Loss for Start-up Company
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$1,100		$1,100
Pre-Tax Profit	-$100		-$123
Net Income (Profit)	-$65		-$80

Net income fell by $15, but actual cash loss was $23 because losses for a start-up can only be offset by future gains

These results are staggering, because a 2.3% tax may not register as being huge, but it is extremely problematic for the industry.  Profitability falls by 11.5% for a firm with a pre-tax profit margin of 20%, and 46.0% for a firm with a pre-tax profit margin of 5%.  Start-up companies looking to create innovative products that could help save or improve our lives now face a huge additional financial burden that could threaten their existence and cause a slowdown in entrepreneurial capital flowing into the industry.

At a time where tens of millions of baby boomers are requiring more health care services, it is instructive that many medical device manufacturers have resorted to layoffs over the past two years to cut costs in response to this excise tax.  The companies will also have no choice but to pass on costs to hospitals, physicians, and consumers, thereby increasing, rather than decreasing, the cost of health care.  This illustrates yet another example of government policy producing unintended economic consequences.

Source:  http://mblb.com/wp-content/uploads/2012/04/Medical-Symbol2.jpg

General Motors and Chrysler

A contributing factor to Barack Obama's defeat of Mitt Romney on November 6, 2012 was a New York Times op-ed authored by Romney on November 18, 2008. General Motors and Chrysler were hemorrhaging money amidst the sharp economic downturn, attributable to both low demand for automobiles and an unsustainably high cost structure. If the automotive manufacturers closed down entirely, many suppliers (primarily located in the Midwest) would have suffered irreparably and be forced to shut down their own operations. Having read Romney's op-ed the morning of publication, his methodical outline of the situation was rooted in a unique perspective – his father actually ran a Detroit car company called American Motors.

http://www.nytimes.com/2008/11/19/opinion/19romney.html

The New York Times editorial staff’s headline associated with Romney’s op-ed, “Let Detroit Go Bankrupt,” ended up resonating very poorly among some of the 2012 electorate because of the negative connotations associated with bankruptcy.  In debates and on the campaign trail (particularly Ohio and Wisconsin), President Obama repeatedly accused Romney of wanting to let Detroit go bankrupt.  This charge was not effectively countered by the Romney campaign, and losing Ohio sealed his fate on Election Day.

In this context, it may be surprising that the actual content of Romney's fateful piece is in fact quite moderate and business oriented, rather than politically oriented. He addressed failures of management, GM and Chrysler's lack of product competitiveness amidst high gasoline prices, and how labor unions had extracted untenable wages, benefits, and pensions during the good industry years of the early 2000s.

Crucially, Romney became the first major public figure to propose a long-term solution other than just throwing money at the problem, and some of his proposals were indeed incorporated by the Obama Administration in early 2009. The government would oversee a pre-packaged bankruptcy process, where the companies could avoid liquidating all their assets, and customer warranty agreements would be protected.

A critical difference emerged, however, between Romney's proposal and what the Obama Administration implemented. The next article below discusses this difference, centered on the companies' creditors. While the bankruptcy process may not seem like an incredibly compelling topic, the consequences of these 2009 actions are far-reaching, and almost certainly affected you as taxpayers or your family members as investors and/or pensioners.

Source: http://kids.britannica.com/comptons/art-54773/Detroit-Michigan

Lending to a Company

In order to finance operations, companies need to obtain cash by either borrowing money (debt) or issuing equity (stock). When most people think of the financial markets, the stock market immediately comes to mind, yet the credit market is much larger. In the stock market, if you purchase five Apple shares at $500/share, you pay $2,500 to own 0.0000005% of the company's market value of $500 billion, hoping the market value will increase over time.

A company's equity represents what is left over after paying all other obligations, and is driven by earnings (profits). Earnings fluctuate, and a struggling company may experience a decline in its stock price. A firm can struggle to the point where its liabilities exceed its assets, such as GM and Chrysler, and the value of its stock becomes worthless ($0/share). Investors in the stock market demand a higher rate of return than investors in the bond market, because it is a riskier investment and they need to be compensated for taking that extra risk.

While this prioritization holds true between debt and equity, debt itself can be divided into different tranches that vary according to risk and return. This diagram depicts different investments that can be made in a given company, and ranks the investment types from lowest risk to highest risk.

Source:  https://www.fiig.com.au/learn/educational-articles/2009/07/10/capital-structure---a-detailed-assessment

Before the Equity investors can be paid $1 in dividends, the company is legally obligated to pay all other investors. The Senior Secured Debt investors may demand a 4% annual return, 5% for Senior (Unsecured) Debt investors, 8% for Subordinated Debt investors, and Equity investors receive whatever is left over. Debt investors receive their principal back with interest, but don't receive any upside – a lender to Apple ten years ago would receive the same amount of money whether Apple's stock was $10/share or $500/share.

Without going into great detail here, the GM and Chrysler bailouts deviated from what always happens when a company files for bankruptcy. The Senior Secured Debt investors consisted of banks, mutual funds, and pension funds. Many of you have investments in corporate debt through mutual funds (401k and brokerage accounts), and you have family members who receive private or public pensions. Many such funds lent money to GM and Chrysler, either directly or in the secondary market, knowing that by law, they would receive top priority on any money that could be recovered from the companies in the event of bankruptcy.

In the 2009 bailout, this fundamental principle was completely revamped. Politically favored groups (i.e., United Auto Workers union) had claims in the Senior Unsecured Debt tranche, which was below the Senior Secured Debt group consisting of the banks and investment funds. Despite having legal priority, the Senior Secured group was substantially pressured and felt, shall we say, obligated to accept far worse terms than what the Senior Unsecured group received. Tens of billions of U.S. taxpayer dollars were also used to indirectly prop up the Senior Unsecured group, and you will be financing the principal and interest on that loss for decades to come.

The managed bankruptcy process provided an opportunity to make Detroit sustainably competitive with other automakers (many of whom have significant operations in the U.S.). Instead, very little was done about its burdensome cost structure. Moreover, arbitrarily overhauling bankruptcy law increases the risk premium required by lenders, so automakers and other industries with similar issues will incur more interest expense in the years ahead. Increased expenses leads to fewer profits, which leads to lower stock prices, which leads to less money for investors and pensioners, and results in fewer jobs in those industries. Time will tell if these issues will (yet again) cause financial hardship for GM and Chrysler.

Leverage and Banking

Leverage is a financial term typically used to express the borrowings an individual or business takes on, in the hope of magnifying investment returns.  For instance, if someone is absolutely convinced that investing in Company X stock will generate great returns, he or she could buy shares on margin.  Purchasing $2,000 of Company X stock could be financed with $1,000 in cash and borrowing $1,000 from a broker.  If the stock magically doubles after a year, you could sell the overall position for $4,000.  After paying the broker the $1,000 you borrowed (plus interest), approximately $3,000 would remain.  In effect, you’ll have turned the initial $1,000 cash outlay into $3,000 by applying 2:1 leverage, which turns a 100% return into 200% (before subtracting borrowing costs).

While this example is rosy, the clear downside of leverage is that losses can be magnified as well.  If Company X performs poorly and its stock drops by 50%, the $2,000 position would fall to $1,000, and your entire equity investment of $1,000 would be wiped out (since the lender would collect the remaining $1,000).  Despite the stock falling 50%, your investment would decline by 100%, which is where 2:1 leverage would be regrettable.

Banks need to use leverage in order to generate enough profitability to be sustainable.  A bank’s assets consist of loans it makes to businesses and individual borrowers.  A traditional bank’s liabilities mostly consist of borrowings that are federally-insured deposits made by individuals and businesses.

For individuals, assets would equate to money deposited at a bank, and liabilities would equate to debt we have incurred.  But for lenders, this gets flipped, and a bank’s fundamental business model is to charge more in interest for loans it provides (e.g., construction, commercial real estate, agricultural, multifamily, individual mortgages, consumer) than the interest it pays to borrowers on deposit accounts (e.g., CDs, money market, savings, checking).

When banks use deposits from you and me to fund loans, they are applying leverage.  For simplicity, let’s say you decide to start a bank tomorrow and have $100 million of capital.  Without using leverage, you could lend at most $100 million (actually less because the government requires banks to keep reserves).  Let’s say those loans would pay an average interest rate of 6%.  The bank would receive about $6 million per year in interest income, and its ability to lend more money would be very limited until many loans reach maturity where the entire principal is paid back.  In this scenario, your bank would not be profitable because of all its expenses such as maintaining branches, personnel, computer systems, and ATMs.  Not to mention the fact that some loans could go bad, reducing the collected interest and wiping out a substantial portion of the initial loan.

Source:  http://money.howstuffworks.com/personal-finance/banking/bank4.htm

Therefore, banks must apply leverage to make more loans, and this can be accomplished by using low-cost deposits.  In this interest rate environment, your bank could borrow $900 million of deposits at 2%, and lend that money to borrowers at 6%.  Now instead of having $100 million of capital fund $100 million in loans, the capital can be used to run the company and serve as a cushion in case some borrowers are unable to fully pay back their loans.  In this scenario, $900 million of loans would generate $54 million in interest income, and the $900 million of deposits would cost your bank $18 million in interest expense, resulting in a $36 million differential.

In this example, having 10:1 leverage allowed for net interest income of $36 million, compared with only $6 million when no leverage was employed.  Of course in the real world, there are plenty of other considerations that dictate a bank’s profitability, such as:

·         Losses from nonperforming loans

·         Alternate sources of borrowing

·         Fee income

Hopefully this simplified model provides a solid background of how banks work and why they use leverage.  The next article will address important considerations involving leverage that will impact our economy for years to come.

How Much Leverage is Optimal?

If the financial crisis taught us anything, it conveyed how crucial the credit markets are to sustain a functioning economy.  In the darkest days of September – November 2008, the nation and world came perilously close to a complete and utter economic meltdown, which could have plausibly led to a widespread destruction of wealth and even massive food shortages.

To be sure, many factors contributed to the financial crisis and the subsequent economic downturn that continues to persist.  The formation and collapse of the U.S. housing bubble was the catalyst that broke Bear Stearns, Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Washington Mutual, and AIG, among others.  Government mandates on subprime mortgage origination, loose underwriting standards, shoddy diligence, excessive leverage, credit default swaps, and vast trading losses all played important roles to doom these institutions and the broader economy.

Source:  http://architecture.about.com/od/periodsstyles/ig/House-Styles/Ranch-Style.htm

Bear Stearns, Lehman Brothers, and more recently MF Global, were each leveraged to the hilt before their collapses.  In the years prior to 2008, Bear and Lehman raked in serious money as lines of business were profitable and asset values on their balance sheets appreciated.  The substantial leverage enhanced profitability during the good years.  Bear and Lehman held major positions in financial instruments linked to the housing market, and once the bubble started bursting, those assets lost value.  If an institution with 40:1 leverage experiences a mere 2.5% write-down of its assets, the equity is wiped out – resulting in insolvency.  While the business model for broker-dealers like Bear and Lehman differed from traditional banks, their fate highlights the delicate balance that companies need to strike when weighing shareholder profitability with proper risk management.

Banks

In the case of traditional banks, domestic and international regulators have taken a more conservative approach following the financial crisis.  Institutions are now required to have higher capital ratios, thereby reducing leverage.

If these banks have solid business models without taking excessive risk, the more stringent capital requirements will curtail their profitability.  The expectation and realization of a permanent reduction in profits serve to adversely affect bank stock prices.  As a result, individual and institutional owners of bank stocks (including mutual funds and pension funds) are worse off because of reduced capital appreciation and dividends received.  The companies themselves, experiencing reduced profitability and growth potential, will not seek to expand their business and hire employees to the extent they would have otherwise.  In fact, many banks are contracting, with loan reduction and widespread layoffs occurring as a result.  This scenario which is playing out today hardly seems like an optimal outcome.

Financial stability is paramount in a functioning economy, and some contend that the additional capital requirements are necessary to prevent another financial meltdown from occurring.  In this construct, the tangible downsides of reduced profitability are outweighed by the potential increased stability that a reduction in leverage would provide.  In accordance with, and separate from, the major financial reform legislation passed in 2010, banking regulators have taken a position to encourage significant deleveraging.  Depending on how the economic and political climate evolves, there will be a continuing debate on what the “right” capital ratios are for banking institutions.  This is certainly an important issue because either a) another financial meltdown, or b) a weakened economy and job loss caused by tepid loan growth could result from ill-advised policy.

Housing

Consumers leveraging to take on a mortgage is fundamentally different from traditional banks leveraging to underwrite loans and facilitate economic growth.  Banks use leverage to increase lending and borrowing capacity, and its absence would make the business model untenable.  On the other hand, consumers typically use leverage because they cannot afford to pay the full price for a house, and taking on mortgage debt allows for long-term financing.

If you purchase a home for $250k, you can finance it by placing 20% down and borrowing the remaining 80% from a mortgage lender.  So you would invest $50k out-of-pocket (equity) and take on a $200k mortgage (debt), typically at a fixed interest rate for a 15- or 30-year time horizon.  In this example, you would be leveraged 5-to-1 on the underlying asset.

If the home price appreciates by $25k, from $250k to $275k, that 10% increase translates to a 50% increase of your $50k equity stake.  However, the same 5-to-1 leverage works the opposite way in cases of price decline.  Depreciation by $50k, from $250k to $200k, equates to a 20% reduction in the home value.  This translates to a 100% decline of your equity stake, resulting in the home value being equal to the mortgage debt.

Borrowers are “underwater” on a mortgage when there is negative equity; that is, when the principal balance exceeds the value of the home.  Considering the fact that millions of borrowers contributed negligible down payments (< 5%), and that national home prices have fallen over 30% since 2006, it is rather obvious that more stringent down payments and less leverage will generate safer mortgages where borrowers can a) actually afford mortgage payments, b) have “skin in the game” to align incentives, and c) have more of a cushion to protect against price declines.

Keeping this thought in mind, this article highlights minimum down payment requirements for mortgages that are backed by the Federal Housing Administration (FHA) [a.k.a. taxpayers]:

http://blogs.wsj.com/developments/2010/03/11/fha-says-higher-down-payments-risks-double-dip-price-decline/

While the article is from 2010, it is just as relevant today.  Here is an excerpt:

An increase in down payments to 5%, from the current minimum 3.5%, would limit new FHA-backed loans by 40%, equivalent to 300,000 fewer home sales, according to testimony that FHA Commissioner David Stevens is set to deliver on Thursday.

“We share the goal of increasing equity in home purchase transactions, but determined after extensive evaluation that such a proposal would adversely impact the housing market recovery,” Mr. Stevens says in his testimony.

To protect taxpayer money, some experts have proposed the radical idea of requiring homebuyers to purchase a volatile asset using only 20-to-1 leverage (5%), rather than 29-to-1 leverage (3.5%).  If the FHA is serious that 95% financing is too stringent a requirement, the housing market is in a far more perilous situation than many people realize.  Ironically, many of the same people who decry excessive leverage in other financial sectors are big proponents of excessive leverage in mortgages, despite everything the housing bubble and subsequent crash has taught us.

Political Strategies and Election Outcomes

Many facets of the Republican presidential primary can be analyzed using game theory.  Each participant seeks victory through a combination of skill, luck, and money.  A great of strategy is involved, as becoming too dominant may result in all opponents ganging up on the front-runner, instead of distributing attacks equally, thereby weakening the strongest competitor.  Conversely, a candidate who is not perceived as a threat may be left alone for a while, thus enhancing his or her relative position.

Throughout this campaign cycle, Mitt Romney has consistently been at the top of national polls.  While being subject to attacks, until this week Romney has not faced the unanimous scrutiny that is likely required to undermine his position as the overwhelming favorite.

Romney is viewed by many as an establishment candidate who appeals to moderates and is most likely to defeat President Barack Obama in the general election.  The individual strategies of Michele Bachmann, Herman Cain, Newt Gingrich, Rick Perry, and Rick Santorum have involved emerging as the strongest conservative alternative and coalescing support among much of the party’s base.  For the most part, each ascended to poll numbers comparable to Romney’s, but then retreated once that elevated status invited further negative scrutiny and attacks.

Candidates seeking conservative support have been unable to separate themselves, which is the best case scenario for Romney.  Possessing an aura of invincibility may convince undecided primary voters to support a candidate who they see as the inevitable nominee.  However, the GOP challengers are now converging on Romney, in an effort to dilute his support and prolong the primary.

Even if Romney manages to survive these attacks and win the nomination, he may emerge as a weakened candidate heading into the November election.  This electoral phenomenon may help explain why historically, the vast majority of incumbent presidents seeking re-election ultimately prevailed.

Source:  http://blog.su-spectator.com/wp-content/uploads/2010/11/donkey-vs-elephant1.jpg

How Can We Improve Living Standards?

Amidst the continuing economic malaise, politics and economics are now inextricably linked, which has profound social implications.  Nowadays, many proponents of income and wealth redistribution constantly demonize the upper echelon to induce class warfare.  While opponents point out that high-income earners statistically possess more collegiate and advanced degrees, and work longer hours than the general population, these facts alone do not alleviate the genuine plight of the middle class.

It is important to note that income inequality is not inherently bad.  If every strata of the income distribution experiences real income growth, with the top decile growing faster, income inequality would increase but the entire population would experience a higher standard of living than before.

However, the situation we currently face is different, and involves the middle class getting squeezed and hollowed out.  Globalization has challenged American industry to improve and innovate, but a great deal of low- to moderate-skilled labor has been outsourced.  The United States still offers tremendous opportunities for highly skilled workers, and those employees can command premium salaries.  Because of increased global competition for other jobs, however, wage growth has flatlined in many sectors.

With most workers experiencing stagnant wages, living standards are determinant on expenditures.  Unfortunately, living costs have increased relative to income for most workers, thereby making most people feel poorer.  This effect is increased exponentially, of course, for the tens of millions of unemployed and underemployed.

Globalization is not going away, and American society needs to adjust to this reality.  To preserve and enhance living standards, we must take a multifaceted approach to boost income and reduce expenditures.  Robust economic growth is also the country’s only chance in tackling the ungodly amount of debt that has incurred and will incur in the future.

With these considerations in mind, it is imperative to rethink certain educational priorities.  The modern economy revolves around a workforce that is adaptable to new systems and technologies, and places a premium on critical thinking skills.  These traits, rather than rote memorization, should be emphasized as much as possible in many disciplines.  Moreover, students who would be unlikely to pursue a college education should gain more exposure at an early age to mechanical trades and vocational skills that are not outsourceable.  By age 22, many of these individuals could have 4-5 years of tangible, marketable work experience under their belts, and not incur the suffocating student loan debt that college may entail.

As part of a holistic solution, immigration policy also must be examined more closely.  While the labor market within different industries varies, generally speaking, illegal immigration has helped undercut wages and reduce employment for a significant portion of the U.S. citizens.  Conversely, there is a shortage of visas for highly skilled foreign workers whose contributions would greatly benefit the American economy.  The United States is a land of opportunity that attracts people from all over the world, and better harnessing this quality would yield benefits for all of us.

Living standards can also be enhanced by gradually, but steadfastly, reducing the scope of government in our economy.  This is not an ad hominem attack on regulation; instead, it is an acknowledgment that through intended and unintended consequences, the government has aggrandized its own power by fostering a culture of dependency from businesses and individuals.  Every pay stub reminds you of the taxes withheld from your paycheck by the federal, state, and perhaps local government.  Recognize also that owning a home, driving to work, watching television, dining out, calling a friend, heating your home, and shopping for groceries are all activities where the government depletes your wealth through taxation, surcharges, and fees.  In light of the staggering $3,819 billion the federal government alone spent last year, extricating it from certain areas of the economy would lead to more efficiency and self-reliance, and less confusion, dependency, and crony capitalism.

As just one example, the fact that gasoline costs well over $3 per gallon during the winter amidst a struggling economy is an absurdity.  Through government policies, the United States is handicapping itself by not tapping more domestic oil and natural gas resources.  Developing economical energy alternatives can remain a priority, but utilizing more of our own resources would help buy time for the discovery and implementation of any energy breakthroughs.  We could be less dependent on foreign oil and thereby funnel less money to countries who are hardly our allies.

Overall, increasing domestic energy production would not only reduce energy costs but also spur economic and job growth.  With more disposable income, consumers would pare down debt and increase discretionary spending.  In addition, because energy prices are fundamentally tied to costs associated with production and transportation, a more sensible energy policy would boost living standards as goods and services would become less expensive.

The United States will surely face very demanding socioeconomic challenges in the years and decades ahead, but the country will emerge stronger if it transcends partisanship and embarks on a reasonable and intelligent course of action to confront them.

Source:  http://www.ayearfromoakcottage.org/2009/08/kitchen-table.html

Will You Receive a Tax Refund Soon?

Millions of Americans will file income tax returns over the next several months, and the term “refund” is often misunderstood.

Federal, state, and local governments employ a wide range of levies to raise revenue.  They come in the form of sales taxes, property taxes, payroll taxes, excise taxes, surcharges on businesses that get passed to consumers, and income taxes, among others.  Assuming the best in politicians’ motives and the need to boost government coffers, each type of tax can easily be justified.  Sales taxes discourage profligate consumption, property taxes fund education, “sin taxes” discourage vices that have adverse social and health consequences, etc.

While most taxes are applied uniformly – any two Milwaukee residents would pay the same sales tax for identical television sets and the same excise tax on a pack of cigarettes – income taxes greatly diverge from this notion.

Most income taxes are applied using a progressive scale.  Someone making $20,000 a year may experience a federal marginal tax rate of 15%, whereas the rates for $50,000 and $200,000 of income are 25% and 33%, respectively.  Much of the current political discourse revolves around different conceptions of “fairness,” with lawmakers balancing marginal utility with the distortion of incentives and resulting economic inefficiencies.

In recent years, however, progressivity has taken on new meaning with some people incurring zero or even negative income tax liability.  Traditionally, individuals and families sought to maximize tax deductions to help reduce the amount of income subject to taxation.  Recently, tax credits have become more prevalent, where taxes themselves (not just income subject to taxes) get reduced directly.

As a simple example, let’s say someone makes $5,000 and has a 10% federal income tax rate.  Here is how a $500 deduction vs. a $500 credit would impact him or her:

Deduction

Taxes = (Income - Deduction) * Tax Rate

Taxes = ($5,000 - $500) * 10%

Taxes = $4,500 * 10%

Taxes = $450

$450 is 9% of Income

Credit

Taxes = (Income * Tax Rate) - Credit

Taxes = ($5,000 * 10%) - $500

Taxes = $500 - $500

Taxes = $0

$0 is 0% of Income

As you can see, credits affect income tax liability more than deductions affect it.

This brings us to the notion of refundable vs. non-refundable tax credits. Non-refundable credits cannot reduce overall tax liability to less than $0, whereas refundable credits can.  Using the above example, let’s look at how a $1,000 tax credit would affect the taxpayer:

Non-Refundable Tax Credit

Taxes = (Income * Tax Rate) - Eligible Credit

Taxes = ($5,000 * 10%) - Eligible Credit

Taxes = $500 - Eligible Credit

Eligible Credit à Tax liability cannot be negative

Eligible Credit = $500

Taxes = $0

Refundable Tax Credit

Taxes = (Income * Tax Rate) - Entire Credit

Taxes = ($5,000 * 10%) - $1,000

Taxes = $500 - $1,000

Taxes = –$500

In the latter example, the refundable tax credit not only nullifies any tax liability, but the government will actually make a transfer payment to this individual.  Keep in mind, of course, that the government is a behemoth middleman taking money from someone else and distributing it to this person.  In effect, this example is nothing more than glorified welfare, where Washington uses the tax code to engage in direct wealth redistribution. Therefore, transferring money to someone who contributes $0 in income taxes and calling it an “income tax credit” or “income tax refund” is a complete and purposeful misnomer.

A tax refund is simply the money that was over-withheld from your paychecks that the government has been able to borrow at a 0% interest rate. In contrast, the assertion that someone who pays no income taxes and receives additional payments from taxpayers has received a “tax refund” is a logical fallacy.  Try going to a store and demanding a refund for something you didn’t pay for in the first place.

Keep these terms in mind when filing your own tax return, and hopefully this post cleared up any misconceptions.

Source:  http://media.lansingcurrent.com/img/photos/2011/07/08/IRS_Logo_t640.jpg