...Not so Common...

Today's title is part of a quote from Voltaire, where he opines that "Common sense isn't so common".   Unfortunately I agree, but it is essential to keep looking.  Let me also acknowledge that if ever there were a place where common sense remains elusive it's the Internal Revenue Code. Still, that doesn't excuse continuing to apply common political maneuvring in the guise of sensible solutions to help the economy. 

In particular I am struck by the notion of financing what are supposed to be tax cuts designed to stimulate the economy with tax hikes.  I’m not an economist, but it feels counter intuitive that switching who pays the taxes actually creates economic stimulus.  It turns out I’m not the only person who thinks this way.  Megan Mcardle, writing in the Atlantic, puts it nicely.  “Providing stimulus through payroll tax cuts that are financed with tax hikes on other people is like trying to boost your household income by making your wife pay you to mow the lawn.” 

Her follow up to this point cites the work of Christina Romer on the topic.  Romer, a former Chairperson of the President’s Council of Economic Advisors posits that “tax increases are highly contractionary". Her conclusion from research is that tax hikes have a disproportionate dampening impact on investments, and that makes them more specifically damaging to the economy than other types of tax changes. 

There is a sense of urgency here to take steps that will make a difference, not just trying to score political points.  As Bryan Caplan notes in his Econolib blog, “Free markets do lead to higher economic growth, but this is a very gradual process. “  Which brings us to the question what do we do in the meantime?  I don’t have a point to advocate here beyond common sense.  While it may be true that a payroll tax cut is too expensive, it’s also true that there’s evidence a step like that has positive economic impact.  Just as the IRS gets to test deductions based on the idea that they have to have economic substance, the legislation to fix the economy should be held to the same standard of being able to create substantive economic improvement.     

Location, Location, Taxation

As the talk about tax reform increases in Washington, the actions of businesses are moving that one step faster.  Even with the current real estate relocation challenges businesses are making the effort to locate in a way that mitigates their tax burden.  One big example appeared in this week’s Wall Street Journal  where they detailed how many US based companies that have the opportunity to incorporate offshore prior to an IPO (lots of restrictions on this, but it can be done) are making sure to do so.  Another area that’s getting plenty of attention now is state taxation.  Certainly the buzz I hear is that companies are doing the tax math in terms of both their initial location and how they grow the business.

The Small Business & Entrepreneurship Council just released their Business Tax Index of 2011 ranking the 50 states in terms of tax friendliness.   The top five friendly states are:  South Dakota, Texas, Nevada, Wyoming and Washington.  The five worst:  California, Maine, Iowa, New York, New Jersey, Minnesota and Washington DC.  (I don’t know if that last one is supported by data or emotion.)  Speaking from my own limited experience I would say that New York, California and New Jersey don’t make it easy for small business owners in terms of taxes.  In particular, they have a thicket of fees for corporations located outside of the state who do business in the state that make the airlines look like they have transparent pricing. 

Of course, the issue is more nuanced than just thinking about income taxes.   For example states that have no income tax like Texas and Florida have other “fees”  that impact the bottom line of a business the same way a tax does.  A recent Ernst & Young study on the topic noted that income taxes from businesses make up a relatively small portion of state budgets, but that in 2009 property taxes collected from businesses by states  went up.  In the midst a huge commercial real estate crisis, business property taxes collected are going up?!  The other direct tax issue to consider is personal vs. corporate tax rates.  Many small business owners pay taxes on their profits via their personal returns, so that’s an important factor to consider. 

Like everything else involving taxes it’s not straightforward, but doing the math during your tax planning time rather than at filing time is worth the effort.

Tax Simplification

As a mom, my view of Mother’s day is thinking about the future, and what it holds for my son.  He’s a strong student, so I’m optimistic he’ll be in a position to appreciate the benefits of tax planning when he’s older.  Of course, what kind of planning one will be doing 20 or so years from now is a big question.    

Some interesting thoughts about tax overhaul include the risk to “S” corporations from corporate tax reform.  Ernst & Young  sponsored a study looking at some scenarios around this issue. According to the E&Y article, it’s important to consider “S” corps because they represent more than half of all business activity.  If the plan is to reduce corporate tax rates and then make up the difference through individual taxation, the E & Y scenario gurus believe the tax bill of your average “S” officer / shareholder would increase on average, by 8 percent or $27 billion annually from 2010 through 2014.  Not sure how they got this nugget, but in their alternate tax reality the biggest changes in tax payments (as in paying more) would be to agriculture and mining, followed by construction and retail trade, and then manufacturing, finance and insurance.

While the piece I read was sketchy on the details, it’s worth thinking about.  As we’ve seen from the current recession, what’s best for the big companies isn’t necessarily best for the economy as a whole.  Small business remains the icon for what can bring back prosperity.  That will certainly mean S corps matter.

An Investment newsletter for financial planners  highlighted by the AICPA had similarly dire ideas around some proposed simplification tax reforms.  They predict nothing bad until 2013, but in particular anticipate capital gains related tax breaks are the most at risk.  Another area where the planners see issues is sheltering retirement income, if you’ve got plenty of it.  That doesn’t sound so off base, as with the aging of the baby boom, most of the savings in this country will be related to retirement. 

While simplifying the tax code is offered as an easier fix than cutting the budget, it’s discussions about the implications that make me think that’s going to be the hardest fix of all.

More Self-Employment

I am always on the lookout for happy news about the economy, mostly because it’s relative scarcity makes it interesting.  (Can’t wait for boredom to set in.)  It was in the LA Times that I first read about the 36% increase in the number of self-employed people in the US.  One sure way to eliminate your unemployment problem is to start employing yourself. The consensus appears to be that the jump in this area of the economy is just that.  People are tired of looking for jobs that aren’t there, so they’re applying their skills on their own.   While this has many benefits,  it also carries many responsibilities that never came up in your life as a wage-slave. 

Just last week I had to explain to a friend that her newly self-employed husband would have to pay self-employment tax.  For the uninitiated this is the part of your FICA withholding that your employer pays.  If you can’t find an employer to pay it, your Uncle Sam expects you to take care of it.  The “Cliffs Notes” version (While I did insert a real link, I’m using the term metaphorically.  Would that there were a Cliffs Notes version of the Internal Revenue Code!)  is that the payroll taxes  used to pay for Medicare and Social Security Benefits are typically 15.3% of wages.  In a typical year, the employee pays half that amount and the employer pays the other half.  If you are both the employer and employee you pay the whole amount.  When you file your tax return for those wages, if you’re self employed, you get to deduct that “employer” half, so in a way you get it back.  There are income caps that impact the collection of the tax, and for this year only the employee amount is lower, but you get the drift without me going into more detail.

Not only do self-employed people need to pay this, but they need to also follow the example set by their previous employers of paying these taxes in a timely fashion.  For most people (again a lot of exceptions and income related caveats go along with this) that means paying a quarterly estimate of how much tax you think you’ll owe.  This does have the benefit of placing the former April 15^th related headaches in context.  Think of it as the difference between a tension headache and a migraine.  Actually, it’s probably more like the difference between a passing and a persistent headache.  To get into migraine territory we’re talking about multi-state commerce and retail goods subject to sales tax.  If either of those applies take two aspirin and call your accountant.  We can follow up on those topics here another day. 

LIFO in the Oil Patch

The Wall Street Journal had a really nice piece about how it’s a well known “secret” that the oil industry uses LIFO accounting rules to reduce their tax bill.   (this strategy only works when oil prices are going up.) LIFO stands for “last-in first-out” which means you value the inventory based on the cost of the most recent oil purchase.  The Journal article explains,

“Oil inventories are typically valued each year using prices at the start of the year, said Les Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an expert on inventory taxation. If a refiner builds up one million barrels of oil inventories over the course of 2009, it could value that crude at the January 2009 price of roughly $40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the additional 500,000 barrels would be valued at around $80 a barrel, the January 2010 price.”

 The cost of that sold inventory reduces the company income, which in turn reduces the amount of income tax paid.  The article points out that this practice is so widespread that even as supply levels go down at the end of the year, prices don’t follow at the same rate.  Investors not in the know (like me) can be fooled into thinking there’s a price spike coming, when in fact inventories will make their way back at the start of the year because actual demand hasn’t changed.

Speaking of demand, the Journal had another tidbit on this topic in Heard on the Street this week.  Apparently the President’s deficit commission decided this earnings management tool is an area where the Treasury department might pick up some bucks.  Among their recommendations was a proposal to disallow LIFO for anyone.  The report focused on the oil companies’ current LIFO reserves, which are estimated to be worth about $10 billion in additional tax dollars if this accounting principle were to be eliminated. 

Of course oil companies aren’t the only people to use LIFO.  The article goes on to say the AICPA estimates about 36% of companies value their inventory that way.  Tax issues aside, LIFO is considered by many astute financial types to be the most accurate form of reporting inventory value.  The logic is that bias toward the current price of whatever the company sells is a more realistic snapshot of the company’s  current financial prospects. 

While there may be a tax advantage to LIFO in an inflationary period, or when the price of your inventory is rising, the opposite is also true.  Presumably whoever wrote the report must have heard that the big fear these days is actually deflation, so eliminating LIFO in that scenario won’t help the deficit at all.  What happened to all the talk about reducing the deficit by cutting complexity in the tax code?