# Presentation: 370594

## 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.

## 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*

## 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.

## 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 $55.25. 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.

## 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.

## 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.

## 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.

## 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.

## 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 Q1-2001 and Q1-2003.
- 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.

## Lower Taxes and Investment

## 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.

## 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.