Taxes, Individual Decisions and Investment Alternatives

1
Taxes, Individual Decisions andInvestment
Alternatives

• Presentation to the Presidents Advisory Panel on
• Federal Tax Reform
• March 16, 2005
• Brian S. Wesbury
• Chief Investment Strategist
• Claymore Securities, Inc.

2
People Pay Taxes, But The Tax System Really
Impacts Peoples 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 fathers family from taxes in
  Israel. I Samuel 1725

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
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.

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
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
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
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
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.

10
Lower Taxes and Investment
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.

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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.