Managing Director of DLG Wealth Management Discusses Tax Fairness 101

We are in the midst of tax season, but we are also in the midst of an election year very much focused on our country's current tax structure. With Obama’s proposed 2013 budget plan to increase tax rates for those who make $250,000 per year or more, it is important to know how the tax system works and what this will mean in sense of fairness and future of the economy. Important answers to questions we need to know when deciding on candidates to vote for include; Who’s paying what and what is the percentage? Who’s left to deal with the bulk? Is increasing taxes just?

As voters, we need to have the numbers broken down so it’s easy to understand our system. In our economy, everyone has a different situation. Some people make a very low income and can’t afford to pay taxes and then there are those who can afford it because of their higher income. In this article we discuss tax fairness 101 and put it into terms we can understand as consumers. Say we are in debt for $100,000 and we have 100 people to raise money to pay off the debt. Based on individual circumstances, it cannot be divided equally where each person pays $1,000 to the debt. So if we use the system our Government uses to collect taxes:

• The richest 10 percent in America pays 2/3 of the taxes. So for sake of this example, 10 of the 100 people will pay $67,000 or $6,700 per person on average.
• Forty percent of Americans don’t pay taxes, so in this example the 40 out of 100 people pay $0 to decrease the debt.
• The remaining 50 percent have to pay the rest, which totals $33,000 or $606 per person on average.

CHART #1 USING THE 10%/90% BREAKDOWN:
$67,000              10 PEOPLE              $6700/P AVG
$33,000              50 PEOPLE              $660/P AVG
$0                       40 PEOPLE              $0/P AVG 

We can also breakdown our example using the Occupy Wall Street 99%/1% method. The breakdown looks like this.
• The richest 1% in America pay 40% of the federal income taxes. In our example that means 1 person would pay $40,000
• The same 40% of Americans will pay $0
• The remaining 59% of Americans will pay $60,000 or $1,017 each on average

CHART #2 USING THE FAMOUS OCCUPY WALL STREET  99%/1% BREAKDOWN:
$40,000                  1 PERSON           $40,000
$60,000                59 PEOPLE            $1,017/P AVG
$0                         40 PEOPLE            $0/P AVG

In this election year, voters are going to have to decide if they believe that our tax system is unfair and the wealthy must pay more or our system is fair. The numbers above paint the picture, all voters have to make their decisions. The unfair/fair rhetoric is going to be the main theme of our Presidents election campaign. It doesn’t matter how many times the terms fair or unfair are used to describe our tax system, the numbers are the numbers. These numbers should help voters be more informed and hopefully make the right decision.

I have been watching the talking heads crucifying Bank of America (BAC) for a $5 per month fee on debit cards. Bank of America and other large banks have been hit by a new law that puts a limit on the amount they can charge a merchant to swipe their card. Congress has told the free enterprise system how much they can charge for their services. Why, is this matter of national security? Not likely. But it is a “sound bite” for illinois senator, dick durbin and his colleagues to show they are behind the consumer and against big business making money.

But in the end the consumer suffers. The banks have a shortfall of billions of dollars and like any company, need to make up the difference somehow. Thus the consumer is hit with this $5 extra fee. I have heard no one ask how this swipe fee limit has helped the consumer at stores like Wal-mart and Walgreens. Have prices come down to reflect the windfall profits that were given to these large companies by limiting the bank swipe fees?

Again we see unintended consequences from decisions made by politicos in Washington.

Another political decision made in Washington to “protect the consumer” has had and will continue to have detrimental unintended consequences. A few years ago the powers  to be in Washington  decided that by changing the pricing structure of our stock exchanges from 1/16th’s & 1/8th’s to pennies, the consumer would get better pricing and the evil wall street would not be able to make money on the spreads. Again the politicos trumpeted their fighting for the consumer (great sound bite), the small investor.

But, again, in the end the small investor has and will suffer. What has emerged with this change in pricing structure? The takeover of our equity markets by HFT's (high frequency trading). This type of trading by computers now accounts for an estimated 60% of the volume on our exchanges. It could not be done without penny pricing. We now have 60% of our trades being done by computers that do not care about long term investing. Computers couldn’t care less about a company’s balance sheet. The only things that matter are the algorithms they are programmed with.

What we now have is a market with extreme volitility that has scared the small investor out of the markets. This is a disaster waiting to happen. Computers trade at lightning speed and just like what happened on May 6th, we are headed for another major “flash crash” because these computers cannot be stopped once they hit their sell points.

The small investor is looking to participate in our economy, to save for retirement and put their kids through college. In this market, they are stymied by the unintended consequences of increased volitility and potential danger of an hft trading disaster.

The answers are simple. Stop making decisions in Washington based on how they will sound to voters. It almost feels like the politicos are trying for a 360 degree slam dunk so they can be on espn highlights. They are not interested in winning the game by making decisions that are well thought out and have no unintended consequences. It is unthinkable that Congress would tell American businesses how much they can charge for a product or a service. If they are actually interested in creating jobs, put back the old pricing structures in our equity exchanges and bring back the 5000 or more folks who worked at our exchanges. We might have slower trading, but we will have trading based on what our systems were set up for, not algorithms.

For more information on how to manage and protect your finances, check out DLG Wealth Management's News page or reach out to one of our financial advisors.

DLG Wealth Management on Venture Capital

AS ADVISORS WE ARE SPENDING MORE TIME TALKING TO CLIENTS ABOUT PROTECTING ASSETS RATHER THAN GROWING ASSETS. WE HAVE TO BE PREPARED TO OFFER OUR CLIENTS THE ABILITY TO HANDLE THE POSSIBILITY OF ANOTHER 2007-2008. CLIENTS CAN’T HANDLE ANOTHER 45% MELT DOWN. THEY NEVER HEARD ABOUT “TAIL RISK” OR “BLACK SWAN”. NOW IT IS A PART OF MOST EVERY INVESTOR’S VOCABULARY.

WHAT IS ‘TAIL RISK”, ESPECIALLY   “LEFT TAIL RISK”. IF YOU LOOK AT THE STATISTICAL BELL SHAPED CURVE BELOW WE ALL KNOW FROM OUR STATISTIC CLASSES THAT STATISTICALLY 95% OF ALL RESULTS FALL IN THE CURVE. MONEY MANAGERS , HEDGE FUNDS BASE MOST OF THEIR DECISIONS ON THE CURVE. THEY ARE PREPARED TO HANDLE ANY EVENT WHERE RESULTS ARE INSIDE THE CURVE. WHAT HAPPENS IF RESULTS ARE IN THOSE LITTLE TAILS AT EACH END? IF IT IS ON THE RIGHT SIDE THAT WOULD BE POSITIVE, BUT THE LEFT SIDE TAIL RISK CREATES A NEGATIVE PROBLEM. WHEN THESE EVENTS HAPPEN THE CONTAGIOUS EFFECTS TAKE OVER CAUSING MASSIVE LOSSES IN DIFFERENT AREAS. WHEN THESE OCCURRENCES HAPPEN THEY ARE USUALLY CALLED “BLACK SWAN” EVENTS. EVERYONE THOUGHT ALL SWANS WERE WHITE AND NEVER EXPECTED TO SEE A “BLACK SWAN”.

WHAT ARE SOME SOLUTIONS:

1.    VARIABLE ANNUITIES can be used to protect investors in a number of ways. Two specific ways (there are apprx 1600 versions)that variable annuities can help protect the downside are:
a.    In a deferred variable annuity, negative returns are possible, but the industry has created various options to put investors at ease, such as riders that guarantee certain levels of income upon retirement. This guarantee of a certain income level has become a very key feature, especially for the retired or close to retirement baby boomers. Thus even if there is a “black swan event” you retirement income is guaranteed. In this era of companies getting away from defined benefit plans this guarantee allows an investor to set up their own “defined benefit plan”
b.    Guaranteed minimum death benefits can also protect the downside. Most deferred variable annuities sold include the basic kind: a guarantee that, if the account value has lost value when the investor dies, heirs will get the full amount initially invested. There are many variations of the minimum death benefit, such as “stepups” which are guarantees that heirs get the highest value the account hit on one of its anniversaries. Between 2001 and 2003, variable annuity beneficiaries received $2.8 billion more than the account value when policy holders died earlier than expected, according to the Insured Retirement Institute.

2.    MANAGED FUTURES can be used to protect the downside. Investors who want to be ready for a “Black Swan” event must have something in their portfolio that can make money not only on the upside but when values are falling. The values may be falling in equities, bonds or commodities and a managed futures program can make money in those falling markets, thus protecting some or all of your portfolio. The futures(commodity) markets have been built to hedge, although many investors try to speculate in these markets. The futures market is very complicated that is why we do not recommend a “do it yourself” futures  portfolio. Let the professional with proven track records do it.

3.    DIVERSIFICATION/ASSET ALLOCATION can be used to lessen downside risk. However in the events we are discussing especially in the last melt down nothing was safe. However diversification will protect you from being in one asset class that gets hammered.

4.    FDIC CD’S/ MONEY MARKETS can be used to protect the downside, however with interest rates at record lows the returns may not even keep up with inflation. Having said that, we have all learned that cash is an asset class. Many investors forgot that fact and portfolios did not factor in cash while building diversified portfolios. Nothing wrong with having a portion of your investment assets in cash.

 

MANY ADVISORS HAVE SPECIFIC PROGRAMS THAT CAN HELP WITH PROTECTING THE DOWNSIDE…….COVERED CALL WRITING, MARRIED PUTS, STOP LOSS STRATEGIES TO NAME A FEW. EACH  INVESTOR HAS TO DETERMINE THEIR FINANCIAL GOALS & THEIR RISK TOLERENCE AND THEN WORK WITH AN ADVISOR TO COME UP WITH A PROGRAM TO ‘HELP PROTECT THE DOWNSIDE “.