With Europe in disarray after Brexit, US lawmakers should fix the nation’s broken system for taxing foreign profits of US corporations.

In theory, foreign profits of US corporations are subject to a US tax of 35 percent. But in practice, these profits are not taxed at all by the United States — unless they are brought back to the states. Because of this rule, US multinationals have kept abroad over $2.5 trillion of their foreign profits.

This huge sum could be a growth engine for the American economy. The money could be used to build factories, modernize infrastructure, or pay dividends in the United States. Instead, it is deposited in bank accounts or invested in foreign countries.

We clearly need to reform this system, but responses in the past have not had much success.

Most Republicans argue for a territorial tax system in which foreign profits would be taxed only where they are earned. But this unfortunately won’t work. US multinationals have become very adept at shifting their earnings to tax havens, such as Bermuda, and other low-tax jurisdictions, such as Singapore.

Thus, if Congress adopted a true territorial system for taxing foreign profits of US multinationals, these companies could easily move more facilities and jobs out of the United States to low tax jurisdictions. Then they could use their foreign profits to distribute higher dividends without paying any US corporate taxes on these profits. In short, the adoption of a territorial tax system would be disastrous for our economy.

On the other hand, Congress should not simply keep the 35 percent rate on foreign profits of US corporations, while stopping them from deferring US taxes on these profits. That combination would prevent US multinationals from competing on a level playing field with their foreign counterparts. When the average corporate tax rate is 24 percent for the association of industrialized countries, the United States is left scrambling.

So what should be done?

In the short term, US corporations should be encouraged to repatriate past foreign profits by taxing them at a relatively low rate, such as 10 percent — if and only if a substantial portion was invested in federal or state infrastructure bonds. This condition would help implement a proposal put forth by Democratic presidential candidate Hillary Clinton. It would boost government spending on US infrastructure in order to promote economic growth and increase American employment.

US firms cannot compete with companies in other countries unless we reduce our corporate tax rate. With a more competitive rate, somewhere around 25 percent, we could eliminate the ability of US corporations to defer US taxes on their foreign profits.

However, we cannot afford to reduce the corporate tax rate without raising tax revenues from other sources. Without revenue neutrality, we would be just increasing our national debt.

There are several sensible proposals to limit existing preferences in the US tax code and generate substantial revenue. For example, to reduce the code’s bias for debt and against equity, Congress could allow large companies to deduct only 65 percent of the interest they pay on their bonds and loans. More broadly, Clinton’s proposal would cap various deductions that are utilized extensively by high income taxpayers. Such proposals could help achieve revenue neutrality while creating a more level playing field for the average family and small business.

Although politics may inevitably get in the way of comprehensive reform, both parties should agree that corporate tax reform is long overdue. They should find a way to reduce the US corporate tax rate and bring back foreign profits to the United States, while helping rebuild our infrastructure and create jobs — all without ballooning our national debt.

Editor's note: This piece originally appeared in the Boston Globe.

      

 

 

Last year, China's stock market took a tumble, which sent shock waves through the global securities markets. Now, money market funds are booming in China and could present the next systemic risk. While Chinese regulators have taken steps to reduce that risk, the question is whether they have gone far enough.

Assets of Chinese money market funds have doubled in the last year - from approximately $350 billion at the end of 2014 to over $700 billion at the end of 2015. These funds are primarily sold online to individual investors by Internet giants like Alibaba and Baidu.

Money market funds have become so popular in China because they offer higher interest rates than retail bank deposits. But these funds achieve higher rates by investing in a much riskier array of debt securities than U.S. money market funds - and the average Chinese investor may not be aware of the level of risk involved. If there were significant defaults in the debt securities held by Chinese money market funds, investors would likely run for the exits, just as they did last summer in the Chinese stock market.

To prevent these potential problems, the Chinese Securities Regulatory Commission has adopted rules, which became effective in February of this year. These rules are designed to decrease the riskiness and increase the liquidity of Chinese money market funds, although the rules are still looser than the regulations for U.S. money market funds.

Since Chinese money market funds are not backed by the government, they can approach bank-like levels of risk only by holding high-quality debt securities with very short maturities. Such maturities reduce the fund's exposure to defaults and other adverse events that can happen between the purchase date and the payment date.

The new regulations move in this direction by shortening the holding period until payment of a Chinese money market fund (the weighted average maturity of its debt securities) from 180 to 120 days. But this time limit is still twice as high as the time limit in the U.S., where the weighted average maturity is 60 days for a money market fund.

U.S. money market funds are also not allowed to use any leverage -- borrowing monies and investing these monies in additional securities. Leverage is dangerous because it exposes the fund to significant risks -- it would have to pay back the borrowed monies even if those additional securities defaulted.

Again, the Chinese regulations move in the right direction, though not as far as the safer U.S. standard. They reduce the maximum leverage of a Chinese money market fund from 40 to 20 percent of its assets.

Money market funds must generally stand ready to meet all shareholder redemptions on a daily basis. Given the volatile Chinese securities markets, it is critical that Chinese money market funds hold a significant portion of their assets in readily traded instruments to meet redemption requests.

Under the new regulations, a Chinese money market fund must hold a minimum of 5 percent of its assets in specified instruments with very high liquidity -- cash, government bonds, bonds of government policy banks, and central bank bills. Moreover, the fund must hold a minimum of 10 percent of its assets in the above specified instruments or others due within 5 trading days.

Liquidity is especially important for wholesale bank deposits - a large holding for most Chinese money market funds. Under the new regulations, a money market fund may not hold more than 30 percent of its assets in fixed-term bank deposits, unless there is an agreement on early withdrawal. The new regulations also permit a money market fund for the first time to invest in negotiable certificates of deposits, which are traded in a secondary market.

Nevertheless, the new liquidity requirements are not as strict as those for U.S. money market funds: 10 percent of their assets must have overnight liquidity and 25 percent must have weekly maturities.

To cope with turbulent markets, the new regulations give Chinese money market funds, like their American counterparts, more tools to meet heavy redemptions. When the liquidity of a Chinese money market fund is thin, it must impose a 1 percent redemption fee on anyone redeeming more than 1 percent of the fund. And if someone tries to redeem more than 10 percent of any Chinese money market fund, it may delay the transaction or postpone payment of the proceeds.

More broadly, the regulations mandate an array of disclosures designed to educate investors about the risks of Chinese money market funds. For instance, a fund must display prominently in all sales literature that it is not a bank and offers no guaranteed returns. All sales literature must be approved by the fund manager or authorized sales institution. And any fund sold online must develop effective methods of communicating to investors its basic features, services offered, and financial risks.

Yet, the new regulations make one potentially significant change in the credit rating of fund investments, which may not be readily apparent to retail investors. Specifically, the regulations lower the minimum rating for fund investments in non-financial bonds from AAA to AA+. These are ratings from Chinese rating agencies, which some experts already view as using less rigorous standards than international rating agencies.

On the other hand, under the new regulations, fund managers are not supposed to automatically accept the bond ratings of external agencies. Instead, managers of money market funds are instructed to compare these external ratings to their own internal risk ratings before purchasing corporate bonds.

In short, the recent regulations have generally reduced the risks associated with Chinese money market funds, although they do not yet meet international best practice standards. Over the next few years, we will see whether the new restrictions will be adequately enforced by the Chinese securities regulators, and even if so, if they are enough to make this booming investment safe for individual Chinese investors.

Editor's note: This piece originally appeared in Real Clear Markets.

      

 

 

It’s true for everyone: despite our best intentions, we often fail to accomplish what we set out to do. When it comes to retirement investing, millions of Americans do not meet their own declared saving goals for retirement.

As a result, almost one-third of the U.S. population has no retirement savings at all, while many others will fall well short of what they will need for their Golden Years.

A solution can be found in the field of behavioral economics, which suggests ways to help Americans start saving. It seems that saving is a lot like dieting — small changes can help you reach your goal.

For example, many studies have shown that being automatically placed in a savings plan dramatically boosts participation by employees — even if they can opt out.

These studies show that when an automatic savings plan is introduced with an opt-out, 60% to 70% of employees remain in the plan. This may seem like a technical nuance, but there is a big difference between opting in by completing an application versus choosing not to opt out.

A plan designed to take advantage of this behavior is called an automatic IRA. In the same way that many people fail to start saving, those placed in an automatic IRA simply fail to stop saving by withdrawing from the plan. Automatic IRAs help people build their savings using the power of inertia.

Here’s how: Workers in firms above a certain size without company-sponsored retirement plans are required to contribute to an IRA plan — unless they chose to opt out. These plans are relatively easy to administer for employers who simply “connect” their employees to a retirement plan run by a qualified financial institutions. The plans save small businesses from the hefty paperwork and sometime onerous regulations associated with traditional retirement plans.

Around 60 million U.S. workers currently do not have a retirement plan offered by their employers and many of these people work in firms with fewer than 100 employees. Automatic IRAs are particularly valuable to these people. Nevertheless, while Congress has considered the automatic IRA for years, it has not come close to passing this legislation.

The federal government should make this kind of plan available nationwide — creating uniform standards and solid investment outcomes for all plan participants. But given the current political vacuum, several states have taken the lead, adopting their own versions of an automatic IRA. These states include California, Illinois, and Oregon — each with a modestly different approach.

Accordingly, it’s up to the federal government to minimize conflicts among state IRA plans as they proliferate, and make sure that the retirement savings of workers are invested well. While the Department of Labor (DOL) has proposed some rules for state-run automatic IRAs, these rules when adopted should have tougher restrictions — specifically:

1. The DOL should push for uniform rules so there won’t be conflicts for employers. Perhaps states could agree on a standard template for all state IRA plans —- like the uniform state codes promulgated on other subjects.

2. States should be limited to collecting employee contributions and hiring independent asset managers to invest in diversified pools of liquid securities. States should not be responsible for the actual investments.

3. State employees and the asset managers they hire should be subject to the same fiduciary standards mandated by ERISA — the federal pension law. They should be required to act as prudent experts and avoid conflicts of interest.

4. The DOL must require full disclosure by states of the risks of these plans. States should not offer any guaranteed returns.

Automatic IRAs are a small piece of what America should do to forestall a major crisis as waves of baby boomers retire. Automatic IRAs will be even more powerful if sponsored and administered by the federal government, but for now state plans with strong protections may be the most feasible way forward. Sometimes the best way to attack a big problem is with a simple first step.

Editor's note: This piece originally appeared in MarketWatch.

      

 

 

Senator Hatch, chairman of the Senate Finance Committee, is focusing on an important aspect of the agenda for corporate tax reform—allowing U.S. corporations to receive a deduction for dividends paid to their shareholders. That deduction would eliminate double taxation of corporate profits distributed as dividends; instead, these profits would be taxed only to shareholders, not at both the shareholder and corporate levels.

Although Senator Hatch has not disclosed the details of his proposal, a corporate deduction for dividends paid has several advantages. But such a proposal would raise financial and political challenges that would have to be addressed.

Here is a simple example. Under current law, if a firm organized as a corporation had $100 in net income, it would pay 35 percent in federal taxes-- leaving it $65 in corporate income. Then, if the corporation distributed this $65 as dividends to its shareholders, they would pay roughly 20 percent in taxes on these dividends -- leaving it with $52.

By contrast, if such a corporation received a dividends-paid deduction, it could distribute all $100 of its net income as dividends to its shareholders directly and pay no corporate tax on such distributed income. Then its shareholders would pay the taxes on these dividends at the applicable rate -- currently about 20 percent of the $100, leaving them with $80 of income.

However, if Congress passed the dividends deduction for corporations and kept the 20 percent tax rate on dividends for shareholders, the combination would result in a big revenue loss for Treasury. In response, some politicians would push for revenue neutrality -- offsetting those revenue losses with tax increases and/or spending cuts. Both would run into stiff political resistance.

One logical approach would be to increase the 20 percent tax rate on dividends, which is much lower than the top rate on ordinary income (39.6 percent). The lower rate on dividends has been justified mainly because those profits have already been taxed at the corporate level before being distributed as dividends. But that justification would no longer apply if corporations could deduct their dividends.

A dividends-paid deduction also raises thorny issues for pension plans and other tax exempt investors. The goal of the proposed deduction is to tax corporate profits only once. But corporate profits would not be taxed at all if distributed as deductible dividends to tax-exempt shareholders. To address this problem, the proposed deduction would likely include a requirement that corporations withhold a certain percentage of dividends before being paid to tax-exempt shareholders.

Similarly, most foreign shareholders of U.S. corporations reside in countries with U.S. tax treaties that reduce their taxes on US dividends to 5-15 percent. These treaties were signed when profits were taxed at the corporate level before being distributed as dividends. Under the proposal, by contrast, dividends would not be taxed at the corporate level. Therefore, U.S. corporations would likely be required to withhold a higher percentage of dividends before being paid to foreign shareholders.

Despite these issues in implementing a dividends-paid deduction, the plan would have several significant advantages. Most importantly, the deduction should eliminate the current tax bias to finance corporate projects by borrowing money instead of selling stock. Under current law, interest paid by corporations on loans is fully deductible, while dividends paid by corporations are not deductible.

This tax bias favoring debt over equity strongly encourages corporations to increase their leverage -- the ratio of debt to equity. Highly leveraged corporations create greater risks of bankruptcy and financial crises. Moreover, this tax bias impedes raising capital by modern companies based primarily on intellectual capital, rather than hard assets like buildings that typically serve as collateral for loans.

If businesses distribute a substantial portion of their profits to their owners, the dividends-paid deduction would dampen the incentive of businesses to avoid the corporate form in favor of pass-throughs such as partnerships, Limited Liability Corporations (LLCs) and S corporations. All of these pass-throughs tax business profits only once at the owner level, rather than twice at the both entity and owner levels.

Over the last few decades, there has been a sharp shift to doing business as a pass-through and avoiding corporate tax. In 1980, corporations filed 17 percent of all business tax returns; in 2008, this dropped to 6 percent. In 1980, corporations earned 75 percent of all net income of businesses; in 2008, this dropped to 48 percent.

Similarly, if businesses distribute a substantial portion of their profits to their owners, the dividends-paid deduction would in practice lower the average U.S. corporate tax rate below 35 percent, which is almost the highest corporate tax rate in the industrialized world. For example, the corporate tax rate is 20 percent in the UK and 12.5 percent in Ireland.

Because of these large differences in country tax rates, some U.S. corporations have become UK or Irish companies through complex transactions called inversions. Thus, by lowering the effective tax rate on U.S. corporations, the dividends-paid deduction may help discourage other U.S. corporations from inverting.

In short, the dividends-paid deduction would be a good start toward reforming corporate taxes. Nevertheless, to get the deduction passed, Senator Hatch would have to deal skillfully with a series of difficult issues.

Editor's note: This piece originally appeared in Real Clear Markets.

      

 

 

Almost everyone would agree that large banks like JPMorgan and Citigroup should be classified as Sifis — the melodious acronym for systemically important financial institutions, whose failure would produce widespread shocks to the financial system.

To reduce the chances of failure, regulators have imposed a broad array of extra requirements for capital, liquidity and risk controls on these Sifis.

The need for these requirements is less clear for two other categories of financial institutions currently labelled as Sifis: midsize regional banks and large insurance companies. Both types of institutions have been unsuccessful in getting their Sifi label dropped by regulators or legislators.

However, activist hedge funds have taken a more fruitful tack, pushing for structural changes to avoid the label at some midsize banks and large insurers.

In the Dodd-Frank Act of 2010 that sought to prevent systemic risks building in markets, Congress effectively applied the label to any banking institution with more than $50bn in assets.

But size is not a good indicator of potential adverse effects on the financial system. For instance, the dozen or so US bank holding companies with between $50bn and $100bn in assets are primarily regional institutions with low profiles in the global financial system.

One counter example is CIT Group, a banking institution that has made so many acquisitions it has crossed the $50bn threshold. It is headed by John Thain, former chief executive of Merrill Lynch, who seemed comfortable with Sifi status. Nevertheless, his strategy met resistance late last year, when CIT announced his March retirement and the probable divestiture of a large leasing unit.

On February 1 2016, a new activist hedge fund, Hudson Executive Capital, announced it had bought a chunk of CIT’s stock to push for a reduction of its assets below $50bn.

At the same time, Hudson announced it had taken a stake in Comerica, a regional bank with between $50bn and $100bn in assets. The Hudson activists reportedly believe that both regional banks would do better if they were not Sifis, or they were acquired by a megabank with systemically risky status.

In a parallel move, Carl Icahn, the well-known activist investor, bought a substantial position in AIG, a large insurer that was labelled a non-bank Sifi by US regulators. Under the Dodd-Frank Act, federal regulators have the authority to label non-banks as Sifis if they pose a serious potential threat to the financial system. In Mr Icahn’s view, AIG should sell or spin off enough problematic units to avoid the extra burden of being a Sifi.

Of course, AIG did threaten the financial system in 2008 by writing a lot of credit default insurance on mortgage-backed securities. But AIG is no longer in that business. Instead, it engages primarily in property casualty insurance and other traditional insurance businesses.

Does a traditional insurance business, if very large, threaten the whole financial system? Again, size per se should not determine the answer. As federal regulators have recognised, Sifi status should depend on a variety of risk-related characteristics of the insurer, such as its capital and leverage ratios, its vulnerability to rapid redemptions and its role as a counterparty in complex transactions.

In addition, federal regulators have stressed the importance of the factor of “substitutability” when determining if a non-bank is a Sifi. In other words, if a non-bank became insolvent, would other financial institutions readily be able to replace the functions of the insolvent company?

This factor is clearly relevant to large insurers, which are big buyers in the market for high-quality bonds. Would the failure of a large insurer have a devastating impact on this market? That seems unlikely since there are so many other companies prepared to fill the gap by buying high-quality bonds.

These arguments against Sifi status by midsize banks and large insurers are worthy of consideration. But their requests for exemption from Sifi status have not been grantedby the regulators or legislators.

Filling the vacuum, activists investors have been pushing to reshape the parameters of which institutions should be labelled Sifis. These activists are leading the fight for structural changes at certain midsize companies and large insurers that would, in practice, relieve them from the extra burden of being labelled a Sifi.

Editor's note: This piece originally appeared in the Financial Times.

      

 

 

As voters in Idaho, Michigan, Mississippi and Hawaii heads to the polls on Tuesday for the GOP primary, they should take a closer look at the frontrunner’s tax plan and what that could mean for their wallets.

Donald Trump's plan would sharply reduce the top tax rate on individual income from 39.6% to 25% and broadly reduce rates for individuals with lower incomes. His plan would also lower the tax rate on corporate income from 35% to 15%, and apply this 15% to other "business income."

While his plan limits certain tax preferences and deductions, it does not include any reductions in federal spending. As a result, the Trump plan increases the federal deficit over the next decade by $10 trillion or $12 trillion, according to several estimates that do not include macroeconomic changes in GDP, investment and employment. Of course, these so-called "static" estimates do not reflect the potential tax revenue from the economic growth resulting from lower tax rates. However, even under "dynamic" scoring, which takes into account a broad range of macroeconomic effects of tax proposals, his tax cuts would still expand the federal deficit over the next decade by $10 trillion -- on top of the $10 trillion increase in the federal deficit already projected under current law.

Let's consider two prominent analyses of the Trump tax plan — one by the Tax Foundation and the other by the Tax Policy Center. Despite their different methodologies, they both estimate that the Trump plan would cut tax revenues by over $10 trillion in the next decade.

Starting with a "static" analysis, the Foundation estimates that the Trump plan would cut tax revenues by $12 trillion. Then, using "dynamic" scoring, the Foundation says that the lower tax rates will generate higher GDP growth and more jobs. Nevertheless, the Foundation still concludes that the Trump tax plan will reduce tax revenues by $10.18 trillion over the next decade.

Most importantly, the Foundation's prediction of more economic growth is based on a dubious assumption about the Trump plan —"provided that the tax cut could be appropriately financed. " In other words, the Foundation assumes that Trump's plan would offset its huge tax cuts by similar reductions in federal spending. Yet, Trump’s plan contains no such spending reductions.

By contrast, the Center uses a model that allows for individual behavior responses but not macroeconomic effects, such as the rise in interest rates. The Center initially estimates that the Trump plan would decrease tax revenues by $9.5 trillion over 10 years. The Center then increases this estimate to $11.2 trillion to reflect the incremental interest that the US Treasury would pay on the additional $9.5 trillion in national debt — since the Trump plan has no cuts in federal spending.

Could Trump find $9.5 trillion in spending cuts to finance his tax cuts?

He seems to oppose lower benefits for Medicare and Social Security. If entitlement cuts are out of bounds, then he would need to slash all discretionary federal spending by 80%. This means debilitating cuts in defense budgets and key domestic programs like education and research.

Although the Center does not do a "dynamic scoring" of Trump's plan, the Center recognizes the potential economic growth resulting from the lower tax rates in the plan. Nevertheless, the Center explains that unless Trump's enormous tax cuts are offset with very large spending cuts, "they'd increase the national debt and drive up interest rates, thus neutralizing their economic benefits.” The Center's concerns about the impact of budget deficits on the national debt are echoed by the Congressional Budget Office (CBO). In a recent report based on current law, the CBO estimates that the cumulative deficit would be $9.4 trillion between 2017 and 2026.

This would bring the total national debt to approximately $30 trillion — without the tax cuts in the Trump plan. A high and rising national debt would raise the interest rates on US Treasuries, which would in turn decrease savings and increase borrowing costs in the private sector. Both would lower economic growth in normal times. Moreover, the CBO worries about the risk of another financial crisis — where "investors would become unwilling to finance the government's borrowing needs unless they were compensated with very high interest rates."

So even though interest rates are super low today, we should all share CBO's concerns about our fast-growing national debt over the next decade. We cannot afford an additional $10 trillion in national debt from tax cuts without a related proposal to constrain federal spending. We need a more balanced package of lower tax rates, fewer tax preferences and appropriate spending limits.

Editor's note: This piece originally appeared in Fortune.

      

 

 

The U.S. is facing a retirement crisis. About one third of Americans have no retirement savings, and most don't have enough savings to retire comfortably. One main cause of this financial shortfall: more than 60 million American workers have no retirement plan offered to them by their employer.

The U.S. Department of Labor (DOL) recently issued a rule proposal intended to encourage more employers to offer a retirement plan to their workers. Specifically, the DOL proposed to exempt from ERISA, the federal pension law, state-sponsored plans for individual retirement accounts (IRAs). These state plans would require employers that do not already offer any retirement program to forward to the plan a state-specified percentage of their workers' salaries. These monies would be invested as retirement savings, unless workers opted out of this state-sponsored plan.

The DOL proposal is an understandable response to the failure of Congress to pass federal legislation for a similar program called the Automatic IRA -- with regular contributions from workers without retirement plans unless they opted out. However, the DOL proposal gives too much leeway to the states in offering their own versions of the Automatic IRA.

Here is the background to the DOL proposal. Most employers without retirement plans run small businesses with fewer than 100 workers. These employers do not want the financial burdens of operating and contributing to a retirement plan.

Of course, their workers could apply and contribute to an IRA at a financial institution; that contribution would be excluded from their taxable income. Nevertheless, despite good intentions to save for retirement, most of these workers never get around to opening their own IRA.

By contrast, workers in firms above a certain size without retirement plans would be required to contribute to a state IRA plan -- unless they chose to opt out, initially and then annually. Such an opt-out procedure, as opposed to an opt in application, has been shown to dramatically increase worker participation in retirement plans.

Given the multiple opportunities for workers to opt out, the DOL proposal correctly characterizes state IRA plans as "voluntary." That is legally necessary for these plans to avoid violating ERISA's preemption of most state retirement laws. For the same reason, the DOL proposal narrowly confines the role of private sector employers to connecting their payrolls to state IRA plans; these employers are not permitted to make contributions to these plans.

On the other hand, the DOL proposal undermines a key purpose of ERISA: Congress did not want to impose different state requirements for retirement plans on private sector employers. For example, California requires any employer with more than 5 workers to connect its payroll to the state IRA plan, while Illinois requires such a connection for any employer with more than 25 workers.

To reinforce its position that state IRA plans are not preempted by federal law under ERISA, the DOL proposal further provides that a state must be "responsible for investing the employee savings or for selecting investment alternatives for employees to choose." This provision is based on the premise that state governments, rather than employers, will make administrative and investment decisions for retirement plans in the best interests of plan participants. Yet this premise could be questioned, since some states have not done a good job in running retirement plans for their own employees.

Under ERISA, pension managers are fiduciaries -- personally responsible to act prudently and solely in the best interests of plan participants. Unfortunately, the DOL proposal does not expressly subject state officials responsible for a state IRA plan to strict fiduciary standards or tough prohibitions against conflicts of interest. These ERISA standards and prohibitions should become express conditions of the DOL exemption.

The DOL should be particularly concerned by the serious discussions among certain state officials about offering "guaranteed" returns to workers in state IRA plans. There are few real guarantees in the financial world. That's why the Automatic IRA was designed at the federal level as a defined contribution plan, where retirement benefits would be based on investment performance. But "guaranteed" returns would turn state sponsored IRAs into defined benefit plans -- creating new fiscal challenges for states that already face large unfunded pension obligations.

Fortunately, most states seem ready to adopt a more sensible model for their IRA plans. They want to hire professional firms to process IRA contributions and invest them in appropriate funds. These funds would include default investments for workers who don't make any investment choice -- such as diversified balanced funds with a fixed mixture of stocks and bonds, or target date funds that gradually increase their bond over their stock component as a cohort of workers approaches retirement age.

In short, it would be optimal for Congress to adopt an Automatic IRA as a defined contribution plan with uniform federal rules. If that is not politically feasible, the DOL should try to minimize conflicts among state IRA plans and to constrain the role of state governments in investing worker contributions.

Most importantly, the ERISA exemption of DOL should include conditions requiring states to hire qualified financial professionals to invest worker contributions in diversified funds, independently managed with appropriate asset allocations. Those conditions would be designed to assure that state IRA plans would advance the best interests of participating workers.

Editor's note: This piece originally appeared in Real Clear Markets. 

      

 

 

Christmas came early for Congress this year as politicians from both sides of the aisle came together to pass – by wide margins – a US$1.8 trillion package of tax cuts and new spending.

At year end, Washington seemed awash in a spirit of holiday cooperation with the president praising new Speaker Paul Ryan. But does the bipartisan approval of the budget deal really mean that Democrats and Republicans have learned to play together nicely in the Congressional sandbox?

Definitely not.

This legislative package was adopted with little rancor because both parties agreed to lift existing caps on discretionary spending and to cut taxes without trying to raise offsetting revenues. So both sides got most of their desired list of Christmas presents – increases in defense and domestic spending plus expanded tax incentives for businesses and individuals.

The big losers were future taxpayers who will have to shoulder the burden of higher interest payments. As the size of the national debt balloons and the rate of interest gets back to normal levels, these payments will consume more of the annual budget and leave less room for spending on defense as well as domestic programs (except for entitlements such as Social Security and Medicare).

Even before this year-end legislation, the national debt was already huge relative to the size of the US economy. While declining annual budget deficits in the last few years have created the impression of fiscal responsibility, the U.S. national debt has more than doubled over the last decade.

Debt from sea to shining sea

In 2005, the U.S. national debt owed to public investors was $5 trillion, or 35% of GDP. By the end of 2015, this amount had risen to over $13 trillion, or 74% of GDP.

Yet this metric of national debt owed to public investors does NOT include over $5 trillion in intra-governmental debt – money that one part of the government owes another – owed to programs like Social Security. Thus, the total outstanding national debt is currently almost $19 trillion and growing steadily.

Despite the rising debt, however, Congress chose to extend and expand tax credits and deductions for businesses and individuals without trying to find offsetting revenues.

The largest tax breaks for business were making permanent the tax credit for research and a tax exemption that allows companies with “active financing” operations overseas to shield such financing income from US tax, while allowing many businesses to immediately expense their capital investments. The largest tax breaks for individuals included expanding credits for low-wage earners and extending deductions for local-state sales taxes.

As a result, the Joint Committee on Taxation estimated that these changes would cost $680 billion over the next ten years. If we tack on the extra interest incurred as a result, the price tag for the tax deal in terms of additional debt would rise to $830 billion over the next ten years.

Estimating the impact of new spending

The debt impact of the new spending is harder to estimate.

For fiscal year 2016, the total spending would be approximately $1.15 trillion. That spending level, together with lost tax revenue, implies a budget deficit above $500 billion for 2016, according to my estimates, compared with $439 billion last year. If Congress continues to disregard its own previous agreements on spending limits, the total increase in the national debt could easily exceed $5 trillion during the next decade.

Going forward, Congress cannot afford to continue to hand out tax benefits without offsetting revenues and to increase discretionary spending across the board. These practices will drive up the US government’s debt to levels that crowd out private borrowing and limit valuable social programs. This is my conclusion based on years of studying fiscal issues – starting when I was president of Fidelity Investments, then as a member of the President’s Commission to Strengthen Social Security under George W. Bush, and more recently while teaching at Harvard and MIT.

My conclusion is supported by the General Accounting Office (GAO), which estimated two long-term fiscal paths for the U.S.

Emphasizing that federal spending increases will be largely driven by an aging population with associated medical and retirement costs, the GAO warned that 

• a fundamental imbalance between revenues and spending over the long term would lead to continued growth in national debt as a share of GDP, and 


• a substantial increase in national debt as a share of GDP would limit the federal government’s flexibility to address future challenges driven by an aging population.
  

A disastrous outlook

The first set of estimates by the GAO were based on favorable assumptions – most of which were violated by the recent tax and spending legislation. For example, the GAO assumed that discretionary spending would remain at historically low levels, and that expiring tax breaks would not be extended.

Even under these favorable assumptions, the long-term fiscal outlook for the U.S. was disastrous.

Under the first scenario estimated by the GAO, national debt held by the public would exceed 100% of GDP in 2033. In that year, payments for Social Security, Medicare and Medicaid plus interest on the national debt would equal total federal revenues.

The results were worse in the second scenario when the GAO used assumptions that are more consistent with the measures adopted in the recent year-end legislation. Under the second scenario, the national debt held by the public would exceed 100% of GDP by 2027 or 2028, and payments for retirement and medical entitlements plus debt interest would equal federal revenues.

In short, Congress was lulled into complacency by two years of budget deficits under $500 billion, declining from $1.4 trillion in 2009.

Within a few years, however, the demographic forces in the U.S. will push our national debt above our GDP and threaten the funding of many important programs. So Congress should not repeat the sins underlying the recent display of bipartisanship.

In the future, Congress should not approve tax cuts without offsetting revenues or ignore existing caps on discretionary spending.

      

 

 

Like most American cities, Boston has promised to pay most of the health care premiums for its employees after they retire — which can be as early as age 45 or 50. Boston also subsidizes the Medicare premiums of its retired employees after age 65.

As a result, Boston reported an unfunded liability for retiree health care in 2013 of over $2 billion (that is a B!). This equated to a liability of over $3,000 per city resident — the fifth highest per capita of large American cities. And these figures did NOT include Boston’s share of another almost $2 billion in unfunded health care liabilities for retired employees from the MBTA.

The good news. In fiscal 2014, Boston contributed $154 million toward retiree health care — more than 10 percent of its total payroll (including schools) for that year. This sum covered its current benefit premiums plus $40 million to help pre-fund its future liabilities for retiree health care. Moreover, Boston committed to keep contributing current benefit premiums plus $40 million to pre-fund such future liabilities.

The bad news. Boston is using two overly optimistic assumptions in estimating what it would take to address its future costs for retiree health care.

Boston is assuming that it can meet its commitment by making large payments out of each year’s budget despite more retirees and rising premiums. This works out to be an average increase of 4.5 percent per year according to Stanford professor Josh Rauh. Can Boston really devote $400 million out of its 2035 budget to retiree health care given competing priorities like police and schools?

Similarly, Boston is assuming an investment return after expenses of 7.5 percent per year on its pre-funded contributions for retiree health care. Such a high investment assumption has gotten many pension funds in trouble; it can be achieved only by investing in stocks and other risky assets. But a more prudent approach would be a diversified portfolio of stocks and U.S. Treasury bonds.

If Boston assumed a more realistic 3 percent annual increase in its health care contributions and an annual investment return of 5 percent, Boston would have to report unfunded liabilities for retiree health care of $3 billion — instead of $2 billion — under the new accounting rules. In either case, Boston together with the Massachusetts Legislature should seriously consider adopting the following reforms:

• Raise the minimum eligibility for retiree health care from 10 years to 20 to 30 years of service. We want to reward long-term, not short-term, public service.

• Stop all city subsidies to retirees after they become eligible for Medicare at age 65. The premiums in Medicare are already progressive relative to income.

• Require higher premium contributions by Boston employees now under age 35 when they retire. This is a reasonable way to transition to more cost-sharing.

• Increase co-payments and deductibles, except for preventative care, for Boston employees once they retire. These will substantially reduce unnecessary tests and hospital visits.

More dramatically, Boston could reduce its health care costs by requiring its retirees to acquire their insurance policies through the Massachusetts exchange under Obamacare. For example, a gold policy (better than a bronze or silver) would cost $1,319 per month for a family of four with parents age 50 and income of $50,000 per year. But the federal premium subsidy would be $945, so Boston and its retirees would have to pay only $374.

Of course, the above reforms should be fully discussed with the relevant unions. Unlike pension benefits, retiree health care plans are not constitutionally protected. Indeed, the Supreme Court has recently ruled that health care benefits should generally be renegotiated at the expiration of a collectively bargaining agreement. So let the negotiations begin soon!

Editor's Note: this piece first appeared in the Boston Herald.

      

 

 

On October 29, China adopted a policy of two children per family, instead of one. This change is, in large part, intended to mitigate the adverse demographic trend plaguing China’s social security system: the rapidly declining ratio of active to retired workers. The ratio is falling from over 6:1 in 2000 to under 2:1 in 2050.

However, the new two-child policy is not likely to have a big impact on the worker-retiree ratio, so China’s retirement system will remain under stress. To sustain social security, China needs to implement other reforms — moving from a local to a national system and expanding the permissible investments for Chinese pensions.

The one-child policy always had exceptions, such as for rural and ethnic communities. These exceptions were broadened in 2013 to cover couples where both were only children. Yet the birth rate did not take off.

Why? A combination of rising levels of urbanisation and housing costs, more education and jobs for women, and rapidly increasing expenses for child rearing. These factors have driven fertility rates down in other south-east Asian countries, such as Singapore and South Korea, without any government restrictions on family size.

Indeed, if China’s two-child policy were to lead to many larger families, the result could well be a lower ratio of workers to retirees for the next two decades. That is because women with two children are less likely to take jobs outside the house until their children have left the nest.

Given the declining worker-retiree ratio, the key to stabilising social security is ensuring that current pension contributions are used to fund the future retirement benefits of current workers.

Since the pension reforms of 1997, urban employers have been required to contribute 20 per cent of each worker’s wages to social security, while workers have to contribute 8 per cent of their wages to an individual retirement account. These high contributions could form the foundation of a viable pension system.

However, such contributions are made to local governments, which often “borrow” a large portion to pay the legacy pensions of pre-1977 workers at state-owned enterprises. These workers were promised retirement benefits during the era of the “iron rice bowl”, when the Communist party took care of worker welfare. At that time, no one tried to fund the future retirement benefits of SOE workers.

The flow of pension contributions and benefits through local governments not only undermines funding of the current pension system, but also erects barriers to labour mobility.

When workers move from one city to another to get a better job, they remain tied to the pension plan in their original city unless they can obtain a residency permit (hukou) for the destination city. And the retirement benefits from an inland town will be much lower than those under the Beijing pension plan.

To address both the funding and mobility problems, I suggest that China’s national government should assume responsibility for legacy pensions and, in return, local governments should stop handling pension contributions and benefits.

Then the national government could ensure that current pension contributions are dedicated to the retirement benefits of current workers. In addition, Beijing could build a computerised central repository of all pension contributions, wherever workers held jobs in China.

At the same time, China should adopt more flexible rules on investing pension contributions. At present, pension investments are generally limited to Chinese government bonds and bank deposits, which pay low interest rates. The main exception is the National Social Security Fund, which was established to help local governments finance the pension system.

The NSSF now has a group of investment professionals who are allowed to invest pension assets in stocks and bonds, including foreign securities.

Thus the NSSF could invest current pension contributions in an internationally diversified portfolio with higher long-term returns than government bonds and bank deposits.

Moreover, the NSSF could play a significant role in developing a longer-term perspective in China’s capital markets, rather than one dominated by day traders.

In short, while the two-child policy is a step in the right direction, it will not move the needle on China’s declining ratio of workers to retirees. To sustain social security, China’s national government should establish separate trusts with current pension contributions, which would be invested to provide future retirement benefits for current workers.

Editor's Note: this piece first appeared in The Financial Times.

      

 

 

Editor's Note: This blog post originally appeared on Forbes.

Starting in 2016, push comes to shove for small businesses under the Affordable Care Act, better known as Obamacare. As of January 1, small businesses, broadly defined as firms with 50 to 100 full-time employees, must comply with the ACA’s employer mandate and provide qualified health insurance to their workers or face stiff penalties. But this requirement poses a big threat to the financial stability of small employers—and not for the reasons you might think.

Obamacare includes a myriad of regulatory incentives and exemptions that define the parameters of the employer mandate. However, these have inadvertent consequences. Most important, exemptions in the ACA encourage small firms to self-finance their health care plans—that is, pay their workers’ health care bills directly, rather than covering them through a traditional insurance policy. Most large companies in America (above 3,000 employees) engage in self-funding, but that is done now by only about 16% of small companies of between 50 and 100 employees. According to my research, that number is set to rise.

It’s understandable that small companies see self-funding as the superior option. By financing their own health care plans, they stay exempt from the community rating requirements that restrict how much insurers may vary premiums based on factors like age and smoking status; they also stay exempt from the federal and state taxes on most health care premiums that are paid to traditional insurers.

But these benefits pose significant risks for small businesses. While a big company usually has a diversified employee base and financial resources that can help absorb substantial overruns in health care expenses, a small company has neither. One big claim can wipe out a small company.

To limit their risk, small companies usually purchase stop-loss insurance, which kicks in when an employee incurs unusually high medical expenses. But here’s where things get dangerous: The handful of large reinsurers that sell stop-loss insurance do not typically require small businesses to constrain their health care costs. In other words, if a reinsurer believes a small firm has an expensive health care plan, it will simply charge a higher premium with a higher deductible. Since stop-loss policies are issued on an annual basis without guaranteed renewal, an unexpected rise in the health care costs at a small firm can lead to much higher premiums the following year or an abrupt cancellation of the policy.

A doomsday scenario is not far-fetched. Say an employee at a small company is diagnosed with some obscure but deadly type of cancer. He needs intensive therapy for two or three years at a cost of millions of dollars. The stop-loss insurer may pay for his care for one year but then get out of the contract as soon as possible. No other reinsurer will take on the policy, so the employer gets stuck with the bill. And for many small companies, a bill like that would be financially devastating.

With Congress gridlocked, it’s not politically feasible to pass amendments to the ACA to limit self-funding, so a solution must come from the states. Although states are not permitted to regulate the health care plans of employers, they are able to regulate stop-loss insurers. Some states have prohibited stop-loss insurers from providing policies to small companies; others have banned stop-loss policies with very low deductibles.

These measures are a good start, but we need more. One possible improvement would be for state regulators to require that every stop-loss reinsurer under its jurisdiction provide small firms with advance notice of three months before canceling a stop-loss policy or materially raising its premiums. The notice would give the employer a bit of leeway to figure out an alternative.

Another idea would be to expand and enhance the role of the brokers that small companies hire to handle their reinsurance needs. Today brokers get paid a commission on each reinsurance policy they sell to a small firm. But perhaps brokers could be paid differently, and then they could play a consultant role by helping small businesses institute cost controls to get better deals from reinsurers.

A final possibility would be to extend the reach of the new health insurance exchanges operating under the Small Business Health Options Program, or SHOP. SHOPs are already operating in most states for firms with under 50 full-time employees, and they will be expanding soon to firms with fewer than 100 employees. States should actively encourage small businesses to consider using the exchanges rather than self-funding. And the federal agencies should try to extend more financial subsidies to small firms and their employees who utilize the SHOPs.

The dream of the ACA, to extend affordable, quality health care coverage to nearly all uninsured Americans, is laudable. But unless reforms of self-funding are instituted soon, the dream could turn into a nightmare for many small businesses.

     

 

 

When policy makers and commentators express concerns about how little most American workers have saved for retirement, they should focus on three related facts:

1.  Roughly half of all American workers are employed by a firm that does NOT offer them any retirement plan.

2.  Only 14% of small firms -- with fewer than 100 employees -- offer them any type of retirement plan.

3.  42 million workers --approximately one third of full-time workers in the private sector -- work for small firms.

Of course, these employees of small firms have the right to go to a financial institution, file an application for an Individual Retirement Account ( IRA ), and enjoy federal tax deductions for their IRA contributions. Yet relatively few overcome the forces of inertia and take the time to open an IRA on their own. Only about 5% of employees without a retirement plan at work contribute to an IRA on a regular basis, according to best estimates.

In response to these problems, Mark Iwry and David John (both from Washington think tanks at the time) developed federal legislation that would create the Automatic IRA. This legislation would require all employers without a retirement plan, and with over a specified number of employees, to connect their payrolls to a retirement plan at a qualified financial institution. Then, approximately 3% of the salary of these employees would be contributed each month to this retirement plan, unless they decided to opt out.

Such opt-out plans have been very successful in raising the participation rate of employees in retirement plans, especially low-income and minority employees. In addition, the Automatic IRA does NOT require any contribution by the employer to the retirement plan of its employees. And the proposed legislation has garnered considerable support from both Democrats and Republicans. Nevertheless, Congress has not come close to passing the Automatic IRA.

As a result, several states have enacted their versions of the Automatic IRA -- namely, California, Illinois and Oregon -- and other states are conducting feasibility studies of establishing their own state-sponsored Automatic IRAs. Given the federal inaction on this subject, it is critical that states adopt well-designed plans and that the Labor Department provide supportive legal guidance.

To make a substantial impact, state versions of the Automatic IRA must REQUIRE small firms without retirement plans to connect their payrolls to the state sponsored retirement plan. The Obama Administration has already established the MyRA program that ALLOWS, but does not require, employers without a retirement plan to connect their payrolls to a federal retirement plan investing in U.S. Treasuries. So far, the voluntary adoption of the MyRA program by small employers has been modest.

On the other hand, the small business lobbies in certain states oppose any requirement for firms to connect their payrolls to the state version of the Automatic IRA. To diffuse this opposition, states should impose this requirement on firms having more than 25 employees as Illinois has done, rather than more than 5 or 10 employees. Almost all firms with more than 25 employees have some type of electronic payroll system, which minimizes the costs for connecting to the state retirement plan. Moreover, states should provide a state tax credit to small firms to help defray their start up costs for setting up the connection.

Some states are now considering guaranteed returns for their versions of Automatic IRAs. California, for example, wants to announce a guaranteed rate of return for retirement contributions in advance every year. While this desire is understandable in light of the 2008 crisis, it would be very expensive to obtain guaranteed returns at more than minimal yields in the private sector given the volatility of the securities markets.

As mentioned above, the myRA already invests employee contributions in U.S. Treasuries -- in reality, the only investment with a guaranteed investment return if held to maturity. But U.S. Treasuries have relatively low yields and are an inappropriate investment strategy for long-term retirement assets. A better choice would be a diversified balance fund, composed 60% of a S&P index fund and 40% of a high-quality bond index fund.

Most importantly, to have effective Automatic IRA plans, states need these plans to be exempted from ERISA (Employee Retirement Security Act), the federal law governing pensions. ERISA contains protections for participants in corporate retirement plans, though much less so for IRAs. Nevertheless, most small firms will vehemently oppose any Automatic IRA plan if they become ERISA fiduciaries simply by connecting their payroll to a state sponsored retirement plan.

Unfortunately, the Department of Labor has not yet confirmed that the Automatic IRA is exempt from the fiduciary provisions of ERISA -- which would impose liability on participating employers for imprudent actions or potential conflicts of interest. It is clear that these provisions do not apply if all contributions to the plan are voluntarily made by employees. But there is considerable legal debate about whether an IRA with an opt-out procedure meets the voluntary standard for this purpose.

In my opinion, an opt-out procedure with advance disclosure to employees should be considered voluntary participation by the Department of Labor. To reinforce this argument, states should give employees 60 days to opt out after receiving appropriate disclosures. States should also provide that employees have the chance to opt out of the Automatic IRA each and every year.

Through interpretive guidance on ERISA, the federal government should support the state versions of the Automatic IRA. If the state experiments in this area succeed, perhaps Congress will apply the lessons learned from the states and enact the Automatic IRA on the federal level.

Editors Note: this op-ed originally appeared in Real Clear Markets.

     

 

 

The corporate aspects of the tax plan recently announced by presidential candidate Jeb Bush are aimed at achieving the worthwhile goals of economic growth and job creation. However, these goals are likely be undermined by the plan's treatment of foreign profits of U.S. multinationals and unrealistic projections of tax revenues from rate cuts.

Almost everyone would agree that the current U.S. system for taxing foreign profits of U.S. multinationals is seriously flawed. In theory, such profits are taxed by the U.S. at its standard corporate tax rate of 35 percent -- one of the highest in the industrialized world. In fact, such profits are NOT subject to any U.S. corporate tax as long as they are held overseas. As a result, such profits of U.S. multinationals are effectively "trapped" overseas -- they are generally not repatriated to build US plants, buy U.S. start-ups or pay dividends to their American shareholders.

The Plan on taxing PAST foreign profits of U.S. multinational is sensible -- a one-time tax of 8.75 percent paid over a period of years. That could raise close to $180 billion in revenues. Since U.S. multinationals reasonably relied on the existing U.S. tax rules for foreign profits by holding them abroad, these corporations should be taxed at a modest rate on such past profits.

In the future, however, Jeb's plan calls for a pure territorial system -- foreign profits will be taxed only in the country where they are "earned." This plan, if adopted, would strongly encourage U.S. multinationals to transfer their intellectual property (patents, copyrights and trademarks) -- which can be moved easily at minimal cost -- to tax havens, like the Bahamas, where they pay little or no corporate taxes.

The company could further lower its global tax burden by licensing this IP for a significant fee to its operating subsidiaries in countries with relatively high corporate tax rates, like Japan. The Japanese subsidiary would reduce its corporate taxes there by deducting licensing fees received in the Bahamas -- where they would not be subject to corporate tax.

Although the U.S. tax code now includes various anti-abuse protections that limit such transfers and cross-licensing, these protections would all be eliminated if the U.S. adopted a pure territorial system for taxing foreign profits of U.S. multinationals, as Jeb’s plan would do. For this reason, other leading Republic tax thinkers -- like former head the House Ways and Means Committee David Camp -- suggested a minimum tax on corporate revenues related to IP. Jeb’s plan needs similar types of anti-abuse protections for IP income.

By contrast, manufacturing or research facilities of multinationals cannot be moved so easily; they have to be located in a country with skilled labor and well-developed infrastructure. To be attractive, many countries with relatively low corporate tax rates, including Switzerland and Singapore, are very willing to offer additional tax incentives, luring major U.S. multinationals with effective tax rates below 10 percent.

Suppose General Electric solicited bids to locate its new factories for wind turbines. In a territorial system, this bidding would turn into a "race to the bottom" -- with the winning country almost certainly offering a corporate tax rate substantially below 10 percent and the U.S. rarely winning. To prevent such a race, the U.S. and other industrialized countries should recognize that these tax subsidies undermine free and fair trade so they should be limited by international trade agreements.

These bidding challenges would remain even if the U.S. corporate tax rate fell from 35 percent to 20 percent as Jeb proposes. Yet a 15 percent decrease in the corporate tax rate would cost the federal government approximately $1.8 TRILLION over 10 years. The already large federal debt would rise markedly if we reduced the corporate tax rate without replacing the lost revenue by closing down existing tax loopholes and preferences.

Despite once working on Wall Street, Jeb Bush boldly proposes to tax incentives fees earned by hedge fund managers as ordinary income rather than capital gains. While this change would hit those managers hard , it raises less than $20 billion in tax revenues over 10 years.

Even bolder, Jeb proposes to stop businesses from deducting most of the interest they pay on their debt -- which unfortunately encourages corporations to take on too much debt and thereby increases the likelihood of bankruptcies. Moreover, allowing deductions for interest, but not for dividends on stock, distorts the capital allocation process -- it particularly hurts newer firms without hard assets to back loans. And putting strict limits on corporate interest deductions would raise a lot of tax revenue -- perhaps as high as $600 billion in 10 years.

However, these limits on interest deductions are paired by Jeb's plan with a big revenue loser -- "expensing" all corporate investments in the first year, instead of spreading these deductions across their useful life as we now do. For instance, if Google spent $15 billion on an electric car factory with a useful life of 15 years, the company would currently be permitted to deduct on average $1 billion per year for 15 years. Under Jeb’s plan, by contrast, Google would be allowed to deduct the full $15 billion in the initial year of the factory’s operation.

The immediate deduction of all capital spending reflects an economic philosophy of taxing consumption rather than investment. However, in my view, expensing of capital investments should be retained and expanded only for small businesses -- on fairness grounds. Most small businesses would not benefit from a sharp reduction in the corporate tax rate because they are generally not corporations. Instead, most small businesses are organized as pass-through partnerships from a tax perspective and do not pay a corporate tax as an entity.

In short, I would embrace the two revenue raisers in Jeb’s plan, expand expensing only for small businesses, and reduce the corporate tax rate from 35 to 25 percent. That 10 percent rate reduction would cost roughly $1.2 trillion over 10 years -- a feasible number without the expensing of all capital investments. The rest of the plan raises roughly $800 billion in tax revenues over 10 years -- $180 billion from the one-time tax on past foreign profits, $20 billion from taxing incentives fees as ordinary income and $600 billion by strict limits on interest deductions.

Jeb would have to find another $400 billion in revenue raisers to offset a corporate rate reduction from 35 to 25 percent. These might include spreading out deductions for advertising, moving to different tax accounting for inventory, and eliminating tax preferences that mainly benefit one industry or set of firms. Although these reforms will not be easy politically, they are worth the effort to make the Plan into a fiscally realistic proposal.

Editor's Note: This post originally appeared on Real Clear Markets.

     

 

 

Every  day, 10,000 baby boomers — Americans born from 1946 to 1964 — leave the work force. Most of them have not saved enough for retirement; at least one-fifth have basically no retirement savings. Our economy has a shortage of skilled workers.

Keeping older Americans on the job therefore benefits everyone: It is crucial to maintaining economic growth, and it will help the boomers to preserve and increase their savings if longevity continues to rise.

Sadly, Social Security, which was enacted 80 years ago this week, encourages older workers to leave the work force. There are remarkably strong disincentives to work for people who take their benefits early, between 62 and full retirement age (66, rising to 67 by 2027).

Wait a minute, you might be thinking: Aren’t my benefits permanently lower if I start collecting Social Security before full retirement age? And don’t I get the maximum level of benefit if I wait until I’m 70 to collect?

Workers who are financially savvy and in good health know this, and many opt to wait. But about two-thirds take their benefits early; 1 to 2 percent wait until age 70, even though the retirement benefit level is a shocking 76 percent higher (after adjusting for inflation) than at 62.

There are many reasons for this. Some workers are laid off, or encouraged to retire via incentive programs from their employers. Others find their productivity is lagging. Many face age discrimination.

Moreover our fear of death leads us to take benefits early so we don’t lose them. But that logic, while understandable, is mistaken. The real danger is not kicking ourselves in the grave. It’s living to 100 without a decent income. American women who have made it to age 60 will live, on average, until 86; men, on average, until 83. But we can’t count on dying on time.

We aren’t taught to think of Social Security benefits as insurance against a catastrophic event — namely, living to 100 or, gasp, beyond.

Starting at age 62, through age 65, annual earnings above $15,720 are taxed at a whopping rate of 50 percent, for those who take their benefits early. (A smaller monster tax, 33 cents on the dollar, applies to wages over a higher threshold — currently $41,880 — earned between Jan. 1 and your birthday in the year you turn 66.)

Without the earnings test, low-wage earners would work 50 percent more, and middle earners 18 percent more, according to a 2000 study by Leora Friedberg, an economist at the University of Virginia. A 2008 study by Steven J. Haider, at Michigan State University, and David S. Loughran, at the RAND Corporation, found that the earnings test significantly reduced the labor supply of early retirees.

Now, here’s the really odd part. The earnings penalty is actually a sheep in wolf’s clothing. Under an arcane provision known as the adjustment of the reduction factor — ARF, for short — if you earn too much between 62 and 66, the loss of benefits will be made up to you, at 66, in the form of a permanent benefit increase.

Come again? You get taxed and then you get untaxed?

Precisely.

Consequently, millions of older Americans believe they face a huge tax on working, which, if they understood the ARF, they’d ignore.

The best birthday gift we can bestow to Social Security is simply to eliminate the “now I tax you, now I don’t” combination of the earnings test and the ARF.

This would significantly improve work incentives for early Social Security beneficiaries. And here’s the best part: It shouldn’t cost Uncle Sam a dime. A tax that’s fully handed back, after all, doesn’t produce any net revenue.

So much for helping young retirees stay active. What about even older folks — for example, those 70 or older? Fewer than 12 percent of them are still on the job.

Giving them a lower tax rate might turn this statistic around. You don’t need to be a rabid supply-sider (we certainly aren’t) to recognize that lowering payroll taxes on Americans over 70 could induce at least some additional work force participation (and perhaps even pay for itself, through higher income tax revenue).

Specifically, we’d give those over 70 a pass on paying Social Security’s 12.4 percent payroll tax — the 6.2 percent paid by employees and the 6.2 percent paid by their employers. The former would encourage older workers to keep working; the latter would help overcome the bias of some employers against keeping on employees beyond age 70. But we’d also change Social Security’s benefit formula to keep anyone over 70 from getting a higher benefit based on post-70 earnings.

Telling young retirees they face a monster tax on working and then burying the fact that it will be repaid is ludicrous. It’s inducing baby boomers to call it quits or work part time.

Congress can and must end this insanity. It should also nudge those over 70, few of whom now work, to get back on the job. Both the boomers and Uncle Sam will be richer for it.

This op-ed originally appeared in The New York Times.

     

 

 

Abstract

Institutional investors are the majority owners of most publicly traded companies but allow activist hedge funds with smaller positions to push through corporate changes. The author offers various reasons why institutional investors may be reluctant to actively participate in proxy fights but then suggests several practical forms of investor engagement that support long-term value creation. So, in future campaigns by hedge funds, institutional investors should actively participate to ensure that the outcome promotes long-term growth instead of temporary price spurts.

Across the world, a clamor is rising against corporate short-termism—the undue attention to quarterly earnings at the expense of long-term sustainable growth. In one survey of chief financial officers, the majority of respondents reported that they would forgo current spending on profitable long-term projects to avoid missing earnings estimates for the upcoming quarter.¹

Critics of short-termism have singled out a set of culprits—activist hedge funds that acquire 1% or 2% of a company’s stock and then push hard for measures designed to boost the stock price quickly but unsustainably. ² The typical activist program involves raising dividends, increasing stock buybacks, or spinning off corporate divisions—usually accompanied by a request for board seats.

Majority Owners Defer to Hedge Funds with Much Smaller Holdings

A substantial majority of the stock of most public companies in the United States is owned by a concentrated group of mutual funds, pension plans, and other institutional investors. ³ Many of the largest institutions, such as Vanguard and CalPERS, say they are focused on building long-term shareholder value rather than short-term profits.

So, an activist with 1% or 2% of a company’s stock has no power to get its reform program adopted unless it can win the support of the institutional investors that own a majority of the company’s stock. And if those institutions vigorously advocate a long-term approach to shareholder value, they should be able to block any program that does not meet that objective.

In fact, institutional investors usually do not take an outspoken position for or against proposals by activist hedge funds—with the notable exception of Laurence Fink, the CEO of BlackRock. In a recent letter, he warned US companies that they may be harming long-term value creation by capitulating to pressure from activist hedge funds to increase dividends and stock buybacks. ⁴

In many cases, however, company executives have given in to activist pressure by adopting new strategies or adding board members without holding a shareholder vote. For example, an activist named Harry Wilson with a relatively small position in General Motors pressed the company to deploy $5 billion of its cash to buy back its stock. ⁵ This move probably does not make sense in the long term since General Motors needs a large cash cushion to deal with possible downturns. Yet General Motors agreed to Wilson’s proposal without putting it to a shareholder vote.

Institutional Reluctance to Push for Corporate Reform

Perhaps institutional investors are merely talking publicly about long-term value as they privately root for the hedge funds to boost the short-term stock price. Nevertheless, there are systemic reasons why institutions are generally reluctant to be proactive in pushing for long-term reforms in corporate strategy or leadership.

• Over 30% of US stock assets under management are now held in index mutual funds or exchange-traded funds that are based on indexes. Although large and diversified managers, such as State Street Global Advisors, may follow most of the stocks in the S&P 500 Index, many managers of index funds have no analysts with in-depth knowledge of most stocks in the particular index. Hence, such index funds are not in a good position to analyze an activist’s program for a specific company.
• Actively managed funds tend not to publicly assert a strong position on either side of a proxy fight unless doing so meets a cost–benefit test. ⁶ The cost of participation is high because it includes management time and potential litigation. On the benefit side, even a holding of $400 million in one stock may be less than half of 1% of the fund’s overall assets.
• If either type of fund expends significant resources in supporting or opposing an activist’s program, it faces a serious free-rider problem. Although the fund incurs all the costs of the campaign, most of the benefits go to other shareholders who have not contributed to the costs.
• Given these cost–benefit challenges, a number of asset managers have effectively outsourced their voting decisions to such proxy advisory firms as Institutional Shareholder Services (ISS) and Glass Lewis—which may or may not have a long-term perspective. According to Stanford University researchers, four sizable asset managers have disclosed that they uniformly follow the voting recommendations of one proxy adviser.⁷
• In contrast, activist hedge funds frequently concentrate a large portion of their assets in the stocks of a few target companies. Managers of these funds receive an incentive fee equal to 20% of realized gains. Thus, the cost-to-benefit ratio in proxy fights is much better for concentrated activist funds than for diversified mutual or pension funds.
• Moreover, activist hedge funds can control a much higher percentage of proxy votes than their economic exposure to a target company’s shares through a practice called empty voting. For example, asset managers can lend their shares to a hedge fund and then not recall them for a contested proxy vote; ⁸ alternatively, hedge funds can cast a significant portion of the votes in a target company’s election while maintaining an economically neutral position by shorting the target’s stock.⁹

Encouraging Institutional Investors to Engage

So, what can be done to encourage institutional investors to take more vigorous positions on activists’ proposals? To begin with, securities regulators, CFA Institute, and other relevant groups should publicly stress that when institutional investors are the largest shareholders in a company, they should play a decisive role in determining the outcome of an activist campaign against that company. In other words, big owners should act like big owners.

In that role, institutions should carefully study any proposal’s impact on a company over many years, depending on the type of company and its history of delivering long-term results. The long term is much longer for electric utilities and drug companies than for software developers. The market has been supportive of mature companies that seem successful at long-term investments, such as Google and Shell. ¹⁰ Other companies, however, waste corporate capital in research projects or in huge acquisitions that are poorly conceived and/or executed.

In a 2014 bulletin,¹¹ the US Securities and Exchange Commission (SEC) helpfully emphasized the duty of investment managers to diligently implement their proxy-voting policies. However, the bulletin expressly allows investment managers, with the consent of their clients, to adopt policies of voting consistently with the directors of a target company or certain types of activists—or of not voting proxies at all. Thus, the SEC guidance may inadvertently lead to less independent evaluation of activist proposals by small equity managers or to no proxy voting by index fund managers trying to minimize costs.

In a 2010 release, the SEC announced a major initiative to rethink the “plumbing” of the proxy process, including the subject of empty voting, but this project seems to have been delayed.¹² Now is the time for regulators across the globe to examine the complexities of empty voting and adopt a well-designed rule against acquiring votes without comparable ownership. Even without any government action on empty voting, institutional investors can include in their stock loans a provision retaining the right to vote the stock in the event of a proxy fight.

But long before any proxy fight is in the offing, institutional investors should push for their vision of sustainable long-term growth through engagement with the companies they own. In the United Kingdom, for example, the Investor Forum was recently established to promote a long-term approach through shareholder engagement with British companies.¹³ At the request of either investors or companies, the Investor Forum will facilitate engagement on specific issues of value creation. More generally, it is promulgating guidelines on how investors can collectively discuss issues without running afoul of such legal rules as those that require filings by substantial shareholders acting in concert.

On the legal front, some US institutions have been especially concerned about the barrier imposed by SEC Regulation FD (Fair Disclosure) to in-depth investor engagement with publicly traded companies. A corporate target would be reluctant to provide material nonpublic information to selected shareholders, because Regulation FD requires it to promptly post that information on its website. However, this barrier can be overcome by an exemption in Regulation FD that allows a company to release nonpublic information to a select group, such as long-term institutional holders, if they sign an agreement to keep the information confidential—and not trade on the information until it becomes public.¹⁴

Another form of investor engagement is the participation of institutional shareholders in the process of nominating directors with a long-term approach to corporate growth. In Sweden and Norway, a public company must invite its five largest shareholders to join a meeting of its nominating committee to discuss the selection of directors. ¹⁵ Germany and other EU countries allow shareholders with at least 5% of a company’s voting stock to nominate a director to its board. Even in the United States, where a federal appellate court rejected the SEC’s proxy access rule on procedural grounds,¹⁶ several corporate giants (e.g., General Electric) now allow director nominations by shareholders owning at least 3% of their stock for at least three years.¹⁷

Perhaps most important, institutional investors can promote a long-term orientation by rejecting a company’s compensation plan if it puts too much emphasis on short-term results. In almost every country, shareholders can now vote on binding or advisory resolutions about corporate compensation reports.¹⁸ Most companies base their cash bonuses on only the prior year’s performance, although stock awards usually encourage a longer time horizon through vesting requirements. If institutional investors want companies to take a long-term approach to corporate growth, they should push for a three-year performance period for determining cash bonuses.

Conclusion

If institutional investors are dissatisfied with a company’s performance, they no longer have only two choices—sell the stock or oppose management. If institutional investors are serious about supporting long-term value creation, they can pursue this goal through various forms of investor engagement with the company. Then, if a hedge fund launches a proxy fight, they should vigorously participate to make sure the outcome promotes corporate growth over the next several years rather than the next few months.

^{1. John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” NBER Working Paper 10550 (June 2004).}

^{2. See, for example, Natalie Mizik, “The Theory and Practice of Myopic Management,” Journal of Marketing Research, vol. 47, no. 4 (August 2010): 594–611.}

^{3. Ronald J. Gilson and Jeffrey N. Gordon, “The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights,” Columbia Law Review, vol. 113, no. 4 (May 2013): 863–928.}

^{4. Andrew Ross Sorkin, “Quit Bowing to Investors, Fellow Chief Urges,” New York Times (14 April 2015): B1.}

^{5. Greg Gardner, “GM, Wilson Compromise, Agree on $5B Buyback,” Detroit Free Press (9 March 2015). Even worse, Wilson obtained a lot of information on General Motors through serving as a US government adviser during the company’s bankruptcy process in 2009.}

^{6. Robert C. Pozen, “Institutional Investors: The Reluctant Activists,” Harvard Business Review, vol. 72, no. 1 (January–February 1994): 140–149.}

^{7. David F. Larcker, Allan L. McCall, and Gaizka Ormazabal, “Outsourcing Shareholder Voting to Proxy Advisory Firms,” Stanford University Working Paper 2105 (June 2014). Four fund complexes—Charles Schwab, Neuberger Berman, Loomis Sayles, and Invesco—have publicly stated that they follow the proxy-voting recommendations of Glass Lewis. Similarly, two Pennsylvania State University researchers found that more than 25% of funds indiscriminately voted with ISS across all companies in their portfolios over a five-year sample period; Peter Iliev and Michelle Lowry, “Are Mutual Funds Active Voters?” Review of Financial Studies, vol. 28, no. 2 (February 2015): 446–485.}

^{8. Paul Ali, Ian Ramsay, and Benjamin Saunders, “Securities Lending, Empty Voting and Corporate Governance,” CIFR Working Paper 023/2014 (May 2014).}

^{9. Wolf-Georg Ringe, “Empty Voting Revisited: The Telus Saga,” Butterworths Journal of International Banking and Financial Law, vol. 28, no. 3 (March 2013): 154–156.}

^{10. “The Business of Business: An Old Debate about What Companies Are for Has Been Revived,” Schumpeter (blog), Economist (21 March 2015): www.economist.com/news/business/21646742-old-debate-about-what-companies-are-has-been-revived-business-business.}

^{11. SEC, “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms,” Staff Legal Bulletin No. 20 (IM/CF), 30 June 2014.}

^{12. SEC, Concept Release on the U.S. Proxy System, file no. S7-14-10/17 C.F.R. pts. 240, 270, 274, and 275 (14 July 2010).}

^{13. See www.investorforum.org.uk.}

^{14. See Regulation FD, 17 C.F.R. § 243.100(b)(2)(ii).}

^{15. Gretchen Morgenson, “Time to Coax the Directors into Talking,” New York Times, bus. sec. (29 March 2015): 1, 6.}

^{16. Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011).}

^{17. Sarah N. Lynch, “General Electric to Allow Shareholders to Nominate Directors,” Reuters (11 February 2015): www.reuters.com/article/2015/02/11/us-general-electric-proxy-idUSKBN0LF2FE20150211.}

^{18. Robert Pozen and Theresa Hamacher, “The (Advisory) Ties That Bind Executive Pay,” Financial Times (3 November 2013): www.ft.com/cms/s/0/eabb294e-4170-11e3-b064-00144feabdc0.html#axzz3cp7YQcQH.}

     

 

 

Executive compensation is closely scrutinised by politicians and public investors. Oracle, the software company, was criticised last year for paying its three top executives more than $35m each.

Yet public reports of executive pay have often been misunderstood because they include accounting estimates of contingent compensation that may never be received. As such, I welcome the recent proposal from the SEC, the US financial regulator, that would mandate the reporting of pay actually received by corporate executives.

The key differences between accounting-based compensation and actual compensation is down to stock awards, restricted shares and stock options, which most companies (including Oracle) award their top executives.

These differences are caused by two main factors. First, stock-related awards are often subject to vesting conditions. Options may vest only after the executive has been in office for a specified number of years, or the stock-related awards might be tied to company performance.

As such, the estimated value of the compensation assigns a probability to these conditions being met, but this estimate will be far off the actual compensation if these conditions are not met.

Second, there may be a significant change in stock price between the time it is granted and the time of receipt of stock-related compensation. If the stock price is higher than the assumption, the actual compensation earned will be higher than the estimate. Conversely, the executive could actually earn far less than the estimate if the stock underperforms.

Let us take a simple example to illustrate how actual compensation can differ from accounting estimates. Company X awards 100,000 shares of restricted stock to its chief executive when the share price is $1 per share; 25,000 of these shares will vest each year over the next four years, but only if Company X’s revenue growth exceeds 7 per cent during that year.

The company may value these restricted shares at $75,000 at the time it is granted, assuming the earnings meet the target in two of the four years and that the share price rises to $1.50. However, the chief executive might end up earning zero if growth never exceeds 7 per cent. Or the package could be worth $400,000 if earnings surge ahead every year and the stock price zooms up to $4.

Similarly, Company Y awards its chief executive 100,000 stock options when its shares are trading at $1 per share. The options have an exercise price of $1 per share; they vest after 4 years and expire 10 years after being granted. 

The value of these options might be $30,000 at the date they are granted. However, the range of compensation the chief executive actually receives can vary significantly. If the stock price stays the same or declines for 10 years, those options will be worth zero. If the stock price rises to $2 in the fourth year, the chief executive could exercise the options to realise an income of $100,000.

The difference is clearly significant.

Canada and Australia require disclosure of all components of executive pay on the date it is granted, similar to the current US model. In contrast, the UK has adopted an approach much like the one proposed by the SEC, providing information both when compensation is awarded and when it is earned.

Elsewhere, detailed compensation reporting is not universally required; it is optional in some countries in the EU. Reporting may be required for company directors only, which means that there may not be data for highly paid executives who do not sit on the management board. And regulations may not be specific, giving companies considerable leeway on what needs to be reported and when.

In short, regulators in all countries should clarify who is covered by their disclosure rules on executive compensation, and how exactly stock-related awards should be reported under their rules. Moreover, regulators should follow the lead of the SEC in requiring public companies to report the actual compensation received by their top executives each year. Such reports will help public investors better assess whether the actual compensation of top executives reflects the actual performance of their companies in a given year.

     

 

 

Editor's Note: This blog post originally appeared on the Wall Street Journal

New government accounting rules enable local officials to get unfunded obligations to retirees under control.

The budgets of many cities and states will soon be disrupted by new accounting rules for retiree health plans. Local governments pay most of the health-insurance premiums for their retired employees—for example, from age 50 until Medicare at age 65, and sometimes for life. Nationwide, the total unfunded obligations of these plans are close to $1 trillion, according to a comprehensive recent study in the Journal of Health Economics.

The accounting rules, adopted in June by the Government Accounting Standards Board (GASB), require local governments for the first time to report their obligations for retiree health care as liabilities on their balance sheets. Local governments must also use a reasonable and uniform methodology to calculate the present value of these liabilities. These are both steps forward, enhancing transparency and accountability.

The new rules further provide an incentive for local governments to establish a dedicated trust with assets invested today to help pay health-care benefits in the future. But here the GASB takes one step backward, by allowing local governments to make overly optimistic assumptions, including excessive returns for the trust.

Local government health plans for retirees are on average only 6% funded, according to the Pew Charitable Trust. Because most cities pay these health-care costs almost entirely out of current budgets, they increasingly face two unattractive alternatives: raise taxes, or cut spending for such services as schools and police.

However, a handful of cities, such as Los Angeles, prefund their retiree health-care obligations. They contribute considerably more than necessary to pay insurance premiums for current retirees, setting aside and investing assets now to help pay future benefits.

The new GASB rules will encourage local governments to join this prefunding club. Here’s an example of the math. Suppose a city currently reports a $1 billion liability for its retiree health-care obligations, based on an average life of 20 years for benefit payments and a discount rate of 5%. Under the new GASB rules it must use the interest rate on high-quality, tax-exempt bonds with a maturity of 20 years, or 3.3% today. That means the city’s reported liability for retiree health care would increase by 35% to approximately $1.35 billion.

Suppose, instead, the city contributes $100 million to a qualifying trust. The city assumes that the trust’s investments will earn an average annual return of 6%, and that each year it will contribute enough to pay the premiums for current retirees so the trust doesn’t run out of money in the future. Under these conditions, a trust will reduce the city’s unfunded retiree health-care liabilities from $1.35 billion to as low as $750 million.

Forcing cities to report to the public their long-term retiree health-care liabilities—calculated under a reasonable and uniform method—should provoke taxpayers to pressure officials to negotiate less-expensive benefits with the unions. It might also give unions a better sense of the trade-offs between asking for wage increases and higher benefits.

Nevertheless, a word of warning. If a city establishes a trust, taxpayers have to ensure that the government follows through with the necessary annual contributions—and that the government doesn’t hide true health-care liabilities by unrealistic projections of investment returns. As former New York Mayor Michael Bloomberg once said, while assuming a conservative investment portfolio will earn 8% a year is “absolutely hysterical,” reducing it to 7.5% or 7% is merely “totally indefensible.”

     

 

 

Tax experts from around the world gathered two weeks ago in Washington DC to push forward a Euro-led project for the prevention of BEPS -- base erosion and profit shifting. This project is aimed at getting multinational companies to locate facilities and jobs in real countries, instead of post office boxes in tax havens.    

The corporate tax rates in Europe are already 10% to 15% lower than the 35% rate in the U.S. If Europe moves forward with BEPS, that will put more pressure on US large companies to move people and plants abroad -- unless Congress substantially reduces the U.S. corporate tax rate.

While almost everyone wants to reduce the U.S. corporate tax from 35% to 25%, almost no industry is willing to give up its current tax preferences to achieve this rate reduction on a revenue neutral basis. This means that the national debt would not rise because revenues lost by rate reduction would be offset by revenues gained by restricting existing tax preferences.   

Therefore, Congress should finance a substantial lowering of the U.S. corporate tax rate largely by reducing the tremendous bias in the current tax code for debt and against equity. Most importantly, companies may deduct interest paid on all their debt, but may not deduct any dividends paid on their shares. As a result, the effective tax rate on corporate debt is negative 6.4%, as compared to positive 35% for corporate equity, according to the Congressional Budget Office.

This tax bias for debt has major negative implications for the US economy. To begin with, this bias strongly encourages financial institutions and other firms to maximize their leverage -- their debt relative to their equity. High leverage increases the risk of bankruptcy and magnifies any financial crisis because a business under pressure has little equity cushion to absorb losses.

The tax bias against equity makes it much more expensive for small businesses and knowledge-based companies to raise capital. Because they do not have the hard assets sought by banks to collateralize loans, such companies are forced to sell large chunks of their equity.

More generally, the tax bias against equity and for debt leads to substantial distortions in how projects are financed. Optimally, a company would choose the most suitable form of financing for each project based on its economic features, not tax benefits. But the huge difference in effective tax rates pushes companies to finance projects with debt rather than equity whenever feasible.

One way to remedy this imbalance would be to allow companies to deduct dividends on equity as well as interest on debt. However, this remedy would mean a significant loss of tax revenue for the Treasury and an even higher national debt.

Alternatively, Congress could limit the interest deductions of companies -- for example, to 65% of the interest they pay on their debt. I have calculated that, during the years 2000 to 2009, such a limit would have increased tax revenue by enough to reduce the corporate income tax rate from 35% to 25% on a revenue neutral basis. Although predictions about the next 10 years are inherently imprecise, I would forecast that a 65% limit on corporate interest deductions could, alone, finance a reduction in the corporate income tax rate to 25% to 28%.  

What would be the main questions and responses to a 65% limit on interest deductions for corporations?

1. Would the sudden imposition of such a limit be disruptive to corporate borrowers and bond investors?

This legitimate objection should be met by a gradual phasing in of the limit. For example, Congress might allow a full deduction of interest on outstanding bonds, and then reduce the deduction limit gradually from 100% to 65% over several years.  

2. Would the 65% limit on interest deductions increase the effective cost of capital for US corporations?

No, on average the cost of raising capital would be the same -- because the 65% limit on corporate interest deductions would be offset by the reduction in the corporate tax rate from 35% to 25%. To take a simple example, suppose a company had pre-tax income of $339 and paid $60 of interest on its debt. It would deduct $21 less -- $39 of interest instead of $60 -- but would benefit more by a 10% rate reduction on $300 in taxable income (after the $39 deduction).

3. Despite this same result, on average wouldn't some corporations be in a better position, and others in a worse position, if Congress adopted the 65% limit on interest deductions and reduced the corporate tax rate from 35% to 25%?

Yes, there would be winners and losers depending on how much debt a corporation had incurred. Companies with relatively low levels of corporate debt would be left with more after-tax income, while companies with relatively high levels of debt would wind up with less after-tax income.

In specific, corporations with interest deductions exceeding 50% of their pre-tax income would be in a worse position. But this is the type of corporation that poses a substantial risk of bankruptcy, especially in times of financial crisis.

4.   Would the 65% limit on interest deductions lead business executives to switch their legal format from a corporation to a pass-through entity like a partnership?

This incentive to switch would result if the 65% limit were applied only to corporations. However, this result could be avoided if this 65% limit were applied to the debts of all businesses, regardless of their legal format.

Moreover, if the 65% limit on interest deductions were used to reduce the corporate rate from 35% to 25%, as I propose, this combination would mitigate the current disadvantage of double taxation (at the corporate and shareholder levels) of corporations. Thus, this combination would reduce the current incentives for businesses to switch from corporations to pass-through entities like partnerships.

5. Would the proposed 65% limit on interest deductions lead to higher cost loans if applied to banks?

Yes. This is an area where the proposal's impact on one industry would have adverse implications for the US economy. If banks have lower after-tax returns on their deposits, they are likely to charge higher interest rates on their loans.

In addition, banks would argue that their deposits should have a better tax treatment than other debt instruments because most bank deposits are insured by the FDIC and therefore not as risky. For both these reasons, I would modify my proposal to allow banks to deduct 80% to 90% of the interest they pay on FDIC-insured deposits.

Of course, these modifications to my original proposal -- gradual phasing in the 65% limit, and allowing banks to deduct more interest on bank deposits -- would mean fewer taxes to support a revenue-neutral reduction in the corporate tax rate. Similarly, less tax revenue would be generated if Congress decided it was politically more acceptable to allow small businesses to deduct 100% of their initial $100,000 in interest payments and 65% thereafter.

Nevertheless, any reasonable set of limits on interest deductions by corporations can finance a significant reduction in the corporate tax rate, while mitigating the tax code's current bias for debt and against equity. To fill the gap left by any legislative compromises on interest deductions, Congress would have to enact other forms of corporate tax reform to bring the corporate rate down to 25%.   

     

 

 

In the business world, experience is generally considered to be positive. When it comes to corporate directors, however, tenure is increasingly viewed with suspicion. Yet the trend towards board term limits is based on faulty logic and threatens performance.

In the US, the Council of Institutional Investors, which represents many public pension funds, urges its members to consider length of tenure when voting on directors at corporate elections. The council is concerned that directors become too friendly with management if they serve for extended periods.

Institutional Shareholder Services, the proxy voting advisory firm that is a powerful force in corporate governance, penalises companies with long-serving directors by reducing their “quick score” governance rating. Under the current methodology, a company loses points if a substantial proportion of its directors has served for more than nine years. Although ISS recognises that there are divergent views on this, it concluded that “directors who have sat on one board in conjunction with the same management team may reasonably be expected to support that management team’s decisions more willingly”.

But the assumption that lengthy director service means cozy relationships with management simply is not supported by the facts.

First, there is a lot of turnover in executive ranks. According to Spencer Stuart, the recruitment firm, in 2013 chief executive officers of S&P 500 companies held their jobs for just seven years on average. This figure has been falling over the past few decades.

Second, new research has found that experienced directors add value. In a study, economists at the University of New South Wales defined an experienced director as one with more than 15 years of service on the same board. This is superior to the typical definition in other studies, which look at average or median tenure for the entire board. They then looked at the performance of 1,500 companies from 1998 to 2013, including those with and without experienced directors.

The study found that experienced directors were more likely to attend board meetings and become members of board committees. Companies with a higher proportion of experienced directors paid their chief executives less, were more likely to change chief executives when performance faltered and were less likely to misreport earnings intentionally. These companies were also less likely to make acquisitions, which often expand a chief executive’s power while diminishing shareholder value. When they did, the acquisitions were of higher quality.

So, term limits do not increase director independence. Just the opposite: long tenure appears to help directors counterbalance chief executive authority. While term limits help companies refresh the board with new faces and talents, which can be desirable, they can lead to the loss of considerable experience and knowledge. This expertise is especially important in a complex company with global operations.

The assumption that lengthy director service means cozy relationships with management is not supported by the facts.

Of course, some directors may lose interest in a company, stop contributing to board discussions or start missing board meetings. They should be replaced regardless of their tenure.

Each year the nominating committee should make an inventory of the skills, experiences and characteristics the company needs. This analysis should take into account changes in the relevant industry and board norms, including director diversity. Then the nominating committee should evaluate whether these needs are being met by current board members or whether board composition should be adjusted.

In addition, the committee should conduct a rigorous annual review of the performance of each director. Unfortunately, some performance reviews of directors are superficial; others suppress criticisms of individual directors. If it does an effective review, it will be prepared to ask an underperforming director to step down, regardless of length of board service.

Careful assessments of board composition and director behaviour are more likely to contribute to corporate performance than mechanistic term limits.