Tax Time

Many Canadians and Americans are wondering if taxes will go up, when they'll go up, and how they will will go up. The answer to the first (if) is quite easy, the second (when) a little more difficult and the third (how) is still on the drawing board. Nonetheless, the scribbles are happening...



If?
With unsustainable debt and deficits in Canada and the U.S., every political insider knows that taxes are going up. They just won't talk about it because it's unpopular. Furthermore, they'll try and use clever names to try and avoid the word 'tax', which has always had negative connotations. A quick look at the projected numbers (table below) makes it pretty obvious that without an unfathomable decrease in government spending, taxes are going up. An additional problem is the large projected increases in entitlement costs (pensions and health care) over the next several decades.

Fiscal Year	US Deficit*	Canada Deficit**
2008/2009	$459 billion	$9.1 billion
2009/2010	$1.7 trillion	>$50 billion (up from $33.7 billion)
2010/2011	$1.1 trillion	$13 billion (not revised)
2011/2012	$693 billion	$7.3 billion (not revised)

*Congressional Budget Office
**Canada's Economic Action Plan

When?
The economy is showing signs of reflation with commodity prices increasing. Rising Treasury yields are a clear sign that cost of borrowing cannot be held artificially low for much longer. The foreign apetite for holding U.S. debt is falling. It is "time to sell" treasuries, said Kim Heeseok. Heeseok is the head of South Korea's National Pension Service, the country's largest investor in U.S. treasuries. All of this is an indication that the answer to the question of 'when', is likely sooner rather than later.

How?
There are three general classes of options for increasing taxes:

1. Sales Taxes (Value-Added-Tax, Sales Tax, Point-of-Purchase Tax, etc.)
   This class of tax is added whenever a 'taxable' good or service is purchased. Everyone in Canada is familiar with the GST. It was the Mulroney version of a "tax shift". The next government (Chretien) promised to eliminate it and failed to deliver. Ultimately, the GST was reduced by two percentage points. While it was a popular political move, the annual government revenues were reduced by an estimated $10 billion, nearly the same amount as the current account deficit. A federal sales tax is now the leading candidate for a universal tax increase in the United States, according to sources.


2. Income Taxes
   Income taxes are levied on all legitimate forms of compensation for services rendered. The structure of these taxes is often complicated as they are often 'marginal' to allow for higher tax rates for higher income earners. Capital gains and dividends are also typically taxed, albeit at different rates than 'standard' income. There is usually little room to maneuver upwards on income tax because these rates need to be competitive in order to keep people and businesses from migrating to other regions with more favorable income tax rates. They can also be evaded in instances where stringent records of income is not kept--as is the case with many small businesses.


3. Duties, Royalties, Excises and Levies
   These are miscellaneous taxes charged towards specific items. Politicians like this type of tax because they don't necessarily have the word 'tax' in it and the amount of the tax can usually be hidden inside the cost of the item itself. For example, most people have no idea how much excise taxes are on alcohol and cigarettes. California is now considering monetizing its underground marijuana industry by legalizing and taxing the substance. The resulting potential revenues for California would be massive in this case, but this example is the exception, not the rule for this class of taxes.


4. Savings and Property Taxes
   This type of tax is the most controversial as it is a direct raid on the savings of the citizens. One common example is an estate tax--when some of the savings of a deceased person are transfered to the government instead of to their designated beneficiaries. Properties are often subject to annual taxation indefinitely despite the perceived ownership by the landowner.


5. Phantom Taxes
   This is an indirect tax that tends to be the easiest for politicians to implement without creating public backlash. That's because citizens don't even realize that their savings are being raided. It occurs when the government decides that instead of borrowing money to finance deficits, they will print it to make up the shortfall. This leads to inflation and devaluation of the currency. The effective reserves (savings accounts) of the currency holders will fall. Many people attempt to use gold and other precious metals as an inflation hedge to hold value during this decline in the purchasing power of the dollar. The only trouble with using this inflation hedge strategy is that any 'appreciation' is subject to another type of tax--a capital gains tax.

No matter what you word it, the tax man is coming. Politicians will try and evade the question because any hint of an increase is unpopular; but the question still stands.

Getting Back To Prosperity

The pace of job losses in is slowing. This is apparent looking at the 16-month payroll chart for the United States, which shows that although the economy lost jobs for the fifteenth straight month, the pace of those losses is up off it's lows. The picture in Canada is similar, although the data is reported slightly differently. There will probably be at least another 3-4 months of negative job growth but there are other signs of "green shoots". That being said much of the appreciation in equity values that we have seen this past month is due to inflation as I mentioned in the previous post. The same is true for commodity prices, which are also up sharply off their lows earlier in the year. This trend is likely to continue, and without cheap oil, the extent to which the United States economy can recover is really quite dim. While the emerging economies still have a long way to go in terms of manufacturing quality, the productive capacity and thus growth potential of these regions far exceeds that of the 'developed' nations and at a much lower labour cost.

One of the biggest delusions I've heard is that the health services sector (drug research, health care, stem cell research, and so on) will lead us out of recession. While it's true that everyone is willing to pay more for their health, the reality is that they can still only pay what they can afford. The aforementioned speculation seems to be largely based on the premise that people will pay anything for good medical treatment when practical realities dictate otherwise. Further to this, the government will need to spend less, not more, on health care costs. Even with the health care sector outperforming other sectors, it alone cannot single-handedly sustain any economy of scale.

"Well, first of all, it's our money. We paid the taxes. We're just asking for some of our money back." - Buzz Hargrove, former Canadian Auto Workers Union president on why the union should be bailed out (April 26, 2009)

The attitude of Buzz Hargrove and thousands others needs to change. Hargrove did not finish high school and yet he feels that compared to international workers, he is entitled to better pay for equal work, simply because he was born in Canada. This is an indication, unfortunately, that the 'correction' is not quite finished yet, and we'll need to see a subsidence of the corporate welfare state, reduction in entitlement expectations and a notable improvement in workforce value generation. This means better service and quality for globally competitive prices. This is where America has diverged so far away from it's founding principles in recent years. In a free economy, jobs can, and should be outsourced unless the domestic workforce provides greater competitive value. Not only is this a critical component of a free economy, but it is also critical in a free society and any protectionist government measures to artificially maintain jobs domestically will only hurt the economy in the long term. There are no shortcuts on the road back to prosperity.

The Inflation Tease

The principle of inflation in economics is actually not much different than the principle of inflation in physics. When a balloon is inflated with hot air, for example, we see a very large increase in volume without any appreciable increase in mass. Similarly, in economics, inflation represents an increase in monetary supply without the corresponding increase in the value of that money. It looks like growth at first, but like a Ponzi scheme, it’s only a matter of time before the bubble pops and a correction occurs and everyone sees what’s really there; thin air.


There is no perfect way to measure inflation, but many different indicators exist. The most commonly accepted indicator is the Consumer Price Index (CPI); a sampling of the prices of the most commonly is purchased consumable goods. Using this indicator of inflation, the CPI chart indicates a step change in slope around 1971, the year the gold-based Bretton Woods system was officially abandoned because it was preventing government from running large deficits. The average annual increase in CPI jumped to a 4.6% average annual rate of increase from a more stable 2.5%.


The cause of inflation is a significant increase in money supply. Imagine playing a game of Monopoly where the bank decides to add a zero to the end of every new note it issues. Pretty soon, the old money becomes useless and each player would be forced to raise the selling price of his or her properties to reflect this new reality. It wouldn’t be so bad if we just added a zero to the end of every note, but the way it happens usually benefits some people quite a bit more than others. The first person to pass ‘Go’, for example, would find themselves flush with cash, and would likely go out on a spending spree. By the time the player in ‘Jail’ realizes what’s going on, he will probably have sold off all of this properties for what he thought was a great price, when in fact he got ripped off. This is exactly what happens in the real world, the first people to get the increase in money supply—the large financial institutions, hedge funds, very wealthy and so on, get to spend the new money at old prices. By the time this money gets into the pockets of the middle class and the poor, prices have already increased and they simply find that their savings have been rendered worthless. This is exactly what we are seeing today—wage depreciation occurring at the same time that consumer prices are either increasing or staying flat.

It’s no surprise that central banks such as the United States Federal Reserve, a pseudo-private, pseudo-public entity which is essentially run by banks and backed by government, makes their policy that creates the biggest benefit to their friends at large financial institutions. Government, which essentially owns (but does not directly operate) the central bank, is usually complacent to this policy because inflated economies look good—at least until the bubble bursts. And yet no president including Regan has been able to successfully balance recessionary and inflationary forces since the idea of having a naturally stable currency was abandoned in 1971. This is the main argument for why central banks should be abandoned—government has proven itself incapable of maintaining a stable currency in nearly four decades since it decided it could do a better job of this than free markets could.

"I'll bet you a lot more than a penny" - Peter Schiff predicting the credit crisis and collapse of the purchasing power of the USD (2006).

This reality is often underreported by the mainstream American media. Some claim this is because the media, including many so-called experts and economists, are mislead by the way the government reports on it's monetary policy. For example, the U.S. Federal Reserve decided to stop reporting M3, the total money supply in March of 2006, claiming the data was too difficult to accurately compile. It still reports M2, which is part of the money supply, but the M3 wedge has grown from less than 5% in 1971 to over 30% of the total in February 2006 when this figure was last reported (see chart). Not everyone is fooled though. The video below shows economist Peter Schiff on major U.S. television networks predicting the subprime and credit crises in 2006 and 2007 despite being ridiculed by his naive counterparts at the time. It is also worth noting that these counterparts recommended buying equity stake in firms like Bear Sterns, Merrill Lynch and Washington Mutual, all of which became insolvent and were forced into distressed mergers with more solvent financial institutions. Each of these transactions was facilitated by either the Federal Reserve or the Treasury with some kind of taxpayer-backed debt guarantee or subsidy. Hopefully these guys stay low-key for awhile until people forget how bad their recommendations really were. Enjoy watching the video.

Swineophobia

Let me first assert that infection from the active strain of the H1N1 virus does indeed cause serious illness which does have the potential to cause death--this is indisputable. However, it is important that any and all responses by the public, health officals and government remain both appropriate and contextual rather than hasty and irrational. This particular strain is not necessarily any more virulent than that of the 'human' influenza virus. For example, with the swine flu 'epidemic' of 1976, more people died from the recklessly synthesized vaccine than from the virus itself--one of the reasons many people still fear the influenza vaccine today. It is now reported that only 19 of the deaths in Mexico to date can actually be attributed to the virus rather than the hundreds they initially thought. Preliminary research suggests the current strain has a cleavage site that may reduce it's virulence. The 'mild' virus would need to mutate further in order to cause more serious danger to the general public.^[1]

Outbreak: A disease outbreak is the occurrence of cases of disease in excess of what would normally be expected. A single case of a communicable disease [may] constitute an outbreak.

Pandemic: The emergence of a disease new to a population involving infectious agents. The disease is spread across a large geographical region and can be transmitted easily and sustainably among humans and cause serious illness.

While the Swine Flu or H1N1 virus may meet the technical World Health Organization definition for both an outbreak and a pandemic, this classification is misleading as the disease is far from widespread. Confirmed cases in Canada affect 0.00027% of the population. Mexico's confirmed infection rate is 0.00036%, while the United States has 176 confirmed cases out it's 300,000,000 people. The actual number of cases is undoubtedly greater, but even if it is one hundred times greater, the risk of infection to the general population remains insignificant at this point in time (less than one tenth of a percent). This begs the question of whether the additional $1.5 billion president Obama has asked congress for to fight this virus could be more effectively deployed for other public health issues. There's a good chance the money won't even provide any assistance to the cause before the pandemic subsides. We won't know the answer for a while yet, but few people, including government, will hesitate to ask for more money when an opportunity arises.

The 'cartoon' model of a molecular protein. The label H1N1 is derived from the two proteins found on the surface of the Swine flu virus: Hemagglutinin subtype 1 (H1) and Neuraminidase subtype 1 (N1).

This does not mean preventative measures by health authorities do not need to be taken. It can certainly make sense for large businesses, for example, to encourage employees to take paid sick leave if indeed there are reasonable grounds to suspect they are sick with any respiratory infectious agent that has a high rate of transmissibility. From a company-wide perspective, this is not just a matter of ensuring the health of it's employees, but it's also a matter of maximizing the productive capacity of the workforce. If a single employee takes two weeks off, this outcome is much less disabling to the company than if he or she returned to work and infected tens or hundreds of other employees.

The standard preventative measures to reduce the risk of infection should always be taken, whenever possible. These include handwashing and personal hygene, as well as measures to maximize your body's immune system such as adequate sleep and good nutrition. I wouldn't plan a vacation to Mexico for next week, but if you already have a trip booked and can't get a refund, deciding to proceed won't exactly mean you're facing "certain death".

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My next post will deal with Human Physiology--the impressive amount of knowledge we've accumulated on the subject and how much we still don't really know.