Brookings: Experts - Robert C. Pozen

Complex Funds Need Better Risk Disclosure

Robert C. Pozen and Theresa Hamacher — Sun, 05 May 2013 00:00:00 -0400

Risk matters as much as return in any mutual fund investment, but assessing the risk of a specific mutual fund can be a challenge. Even though mutual funds have become increasingly complex, their risk disclosure was designed for a simpler era, when funds used only traditional investment strategies.

Funds continue to inform investors about risks primarily by using words. In the prospectus sent to fund buyers, funds describe the types of investments they may own, along with discussions of the factors that may affect the value of those investments.

Verbal risk disclosure worked well when funds held publicly traded stocks and investment-grade bonds. The risks of the underlying assets – which were well understood and easily compared – equated to the risk of the fund.

However, as funds began to venture into non-traditional securities and investment techniques, this qualitative approach to describing risk created as much confusion as clarification. Funds added a paragraph of disclosure for every new asset type or strategy that they thought they might want to use.

Pulling a comprehensive view of a fund’s risk from this voluminous disclosure is no easy task. Is a blue-chip stock fund that uses short sales and derivatives extensively riskier than a high-yield bond fund that engages in the occasional credit default swap? Or is it vice versa?

To help investors better evaluate overall risk, regulators require that funds highlight the most relevant risk factors. These key risks are at the core of the summary fund descriptions sent to potential buyers (called the summary prospectus in the U.S. and the key investor information document or Kiid in Europe.)

And since regulators recognize that a picture is worth a thousand words, these summary documents must include a bar graph showing how a fund’s past performance has varied from year to year. These charts do make it easy to evaluate volatility, but only if the fund has been around long enough to experience a full market cycle using the same investment approach.

To make comparisons easier, European regulators also require that funds provide a synthetic risk and reward indicator, ranking funds on a single scale from one (least risky) to seven (most risky). While useful in concept, the SRRI may not be providing much insight to investors, since funds investing in similar assets generally all fall within the same one or two SRRI categories. In addition, the SRRI is calculated from past returns, giving it the same limitations as the performance bar chart.

What fund investors need are standardized risk measures that are objective, quantifiable and forward-looking. Here are two such measures that regulators might consider.

Leverage limit: Leverage is directly correlated with risk. It is also a tool that more and more funds are using, most often through derivative securities.

Funds might be required to publish a limit on leverage, so that investors can understand how much market exposure they will have relative to their investment. This limit might range from one times assets – for a traditional fund – to three times for an aggressive fund using derivatives extensively.

The published leverage limit would help ensure that investors find the fund that is right for them. For example, a retirement plan sponsor may limit fund choices to those with lower leverage limits, while an aggressive investor may seek out funds with higher limits.

Non-traditional investments: Funds have long moved beyond blue-chips stocks and bonds and now offer investors access to a wide range of asset classes. Investments in derivatives, commodities or real estate are readily available to fund investors these days.

While these alternative asset classes provide investors with increased diversification, they are subject to special risks. They may be more difficult to price – and more likely to experience wide swings in valuation during market turmoil. Derivatives and other structured securities are subject to counterparty risk, meaning that their value depends on the solvency of the financial institution guaranteeing payment.

To give investors a sense of their exposure to these risks, as with the leverage limit, funds might be required to disclose their maximum percentage in alternative assets that are less liquid or hard to value. This disclosure would only be needed if the name of the fund did not indicate that it focuses on alternative investments.

But to ensure that product innovation is consistent with investor protection, the fund industry needs better disclosures. Greater use of standardized, quantitative risk measures would help investors choose among new types of funds.

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Financial Times

Image Source: Toru Hanai / Reuters

Charities Have Little to Fear from Effect of Deduction Rule on Contributions

Robert C. Pozen and Theresa Hamacher — Fri, 12 Apr 2013 00:00:00 -0400

As April 15 approaches, high-income taxpayers may be thinking about the impact of recent legislation limiting their itemized deductions. Under one part of the legislative package from January, itemized deductions are reduced once income exceeds a certain threshold: $250,000 for single taxpayers and $300,000 for married couples.

This is called a Pease reduction, after the original author of the provision. Charitable organizations are concerned that Pease will reduce the incentive for wealthy taxpayers to make charitable contributions. However, these concerns are based on a misunderstanding of how Pease affects itemized deductions.

To understand how Pease works, consider an affluent married couple — I will call them Joe and Judy. They have a combined taxable income (technically, “adjusted gross income”) of $500,000 and itemized deductions of $70,000. Under Pease, Joe and Judy’s itemized deductions are reduced by 3 cents for every dollar that their income exceeds $300,000. Their income is $200,000 more than the $300,000 threshold, so their itemized deductions are reduced by $6,000, from $70,000 to $64,000.

Now, suppose Joe and Judy gave an additional $1,000 to charity. If they did, their itemized deductions would rise from $70,000 to $71,000. Pease would still reduce these deductions by 3 cents for every dollar earned above $300,000, or $6,000, just as before. After the Pease haircut, Joe and Judy would have itemized deductions of $65,000 ($71,000 minus $6,000). So, as a result of their charitable contribution, their usable itemized deductions increase by $1,000, from $64,000 to $65,000. In other words, Joe and Judy effectively get the full deduction for the $1,000 charitable gift.

What’s going on here? The key point is that Pease reduces taxpayers’ itemized deductions based on their income, not on the amount of their deductions. Even if Joe and Judy had $200,000 in itemized deductions, the Pease haircut would only reduce their deductions by $6,000.

By contrast, suppose the joint income of Joe and Judy rose by $50,000 — from $500,000 to $550,000. Their income would now exceed the $300,000 threshold by $250,000, so Pease would reduce their itemized deductions by $7,500 (or 3 percent of $250,000), instead of the $6,000 before. In other words, the Pease haircut grows as the couple’s income increases.

Pease mainly functions as a stealth marginal tax rate increase on the wealthy, not as a mechanism for limiting deductions. Effectively, every dollar above the $300,000 threshold generates $1.03 in taxable income: one dollar from the income itself and 3 cents from the reduction in itemized deductions. For taxpayers in the top 39.6 percent bracket, Pease increases the effective marginal tax rate by roughly 1.2 percentage points — from 39.6 percent to 40.8 percent.

Of course, it’s possible for Pease to reduce itemized deductions by so much that the taxpayer decides to take the standard deduction instead of itemizing. If so, charitable organizations would have a very good reason to be concerned: Only itemizers can claim a charitable deduction.

However, this happens in rare situations, when itemized deductions are very low compared with the taxpayer’s income. For instance, a married couple, like Joe and Judy, with earnings of $500,000 would need to have itemized deductions less than $18,200 for this situation to arise. So long as they had more than $18,200 in itemized deductions, they would itemize even after the Pease haircut, meaning that Pease would not affect their incentive to claim a charitable deduction. In fact, Internal Revenue Service data show that itemizers with income between $250,000 and $500,000 claim, on average, more than $55,000 in itemized deductions.

So, in nearly all circumstances, charitable organizations need not fear the impact of Pease. Pease will raise the tax bill of affluent individuals based on the income that they earn, not the itemized deductions that they claim. Although high-income individuals may not like the cutback in their itemized deductions, Pease does not diminish the tax savings resulting from their charitable contributions.

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Washington Post

New Tax Provision on Deductions Won’t Hurt Charitable Giving

Robert C. Pozen — Mon, 01 Apr 2013 00:00:00 -0400

In the recent tax legislation to avoid the fiscal cliff, Congress reinstated a limitation on itemized deductions for affluent taxpayers, known as Pease (after its original author, the late Rep. Donald Pease). Under Pease, itemized deductions are modestly reduced depending on how much a taxpayer’s adjusted gross income exceeds a specified threshold — $250,000 for an individual and $300,000 for a married couple.

Many commentators have voiced concerns that Pease will discourage wealthy taxpayers from making charitable donations. However, these concerns are misguided. Even under Pease, virtually all affluent taxpayers will be able to get the full deduction for any additional gifts to charity.

Here’s how Pease works for a typical affluent married couple (let’s call them Andy and Amanda), who have a combined income of $400,000 and itemized deductions of $50,000. Under Pease, a taxpayer’s itemized deductions would be reduced by 3 cents for every dollar of income that exceeds the threshold ($300,000 for a married couple). Since Andy and Amanda’s income is $100,000 above that threshold, their itemized reductions would be reduced by $3,000, from $50,000 to $47,000.

Yet, Pease does not undermine the incentive for affluent taxpayers to increase their itemized deductions. To see why, suppose Andy and Amanda gave an additional $1,000 to charity. Here’s what would happen. Their itemized deductions would rise from $50,000 to $51,000. Pease would then reduce these deductions by 3% of their income above $300,000, or $3,000 — no change there. So, after the Pease haircut, their itemized deductions would be $48,000 ($51,000 minus $3,000) — which is $1,000 higher than it was before they made the additional $1,000 contribution. In other words, this additional contribution is completely deductible.

This benign result occurs because Pease cuts back on the couple’s deductions based on the level of their income, not on the amount of their itemized deductions. As long as Andy and Amanda have joint income of $400,000, they will lose $3,000 in itemized deductions — regardless of whether their itemized deductions are $50,000 or much more.

By contrast, suppose the joint income of Andy and Amanda rose by $50,000 — from $400,000 to $450,000. Since their income rose, their Pease haircut would increase from $3,000 to $4,500 (which equals 3 percent of $150,000 — the amount by which $450,000 exceeds $300,000). Again, this $4,500 reduction occurs whether their itemized deductions are $50,000 or much higher.

Thus, Pease does not actually “limit” itemized deductions in any meaningful way. Instead, it functions as a stealth increase in the marginal tax rate for affluent people like Andy and Amanda. For every dollar of income earned above the $300,000 threshold, their taxable income increases by $1.03 — one dollar from that income itself, and three cents from the reduction in itemized deductions. For taxpayers in the top 39.6 percent bracket, this represents a roughly 1.2 percentage point increase in their effective marginal tax rate to a total of 40.8 percent.

In theory, Pease could eliminate enough itemized deductions to induce affluent taxpayers to take the standard deduction instead of itemizing their deductions. In this situation, a charitable organization should be concerned about disincentives for affluent taxpayers to make charitable donations, since only itemizers can claim a charitable deduction. However, for these disincentives to influence behavior in practice, taxpayers must have extremely low levels of itemized deductions relative to their income.

For instance, if a married couple making $1,300,000 per year had at least $42,200 in itemized deductions, they would still find it worthwhile to itemize even after the Pease haircut. By comparison, taxpayers with income between $1 and $1.5 million on average claim more than $160,000 in itemized deductions, according to IRS data. Thus, there would only be a handful of millionaires with so few deductions that Pease would have a meaningful impact on their charitable donations.

Moreover, Congress provided that Pease in no event may reduce itemized deductions by more than 80 percent. Of the 2 million taxpayers subject to Pease, only 44,000 would be affected by this 80 percent cap.

In short, despite the passage of Pease, the attraction of itemized deductions has not fallen for virtually anyone. Any increase in charitable deductions will almost always be fully deductible under Pease. Ironically, because the fiscal cliff legislation raised the top statutory income tax rate from 35 percent to 39.6 percent, the new legislation might actually enhance the attraction of charitable deductions to affluent taxpayers.

Authors

Robert C. Pozen

Publication: Boston Globe

Corporate Tax Reform Without Tears

Robert C. Pozen — Sun, 31 Mar 2013 00:00:00 -0400

Economists have long recognized the damaging effects of the high U.S. corporate tax—at 35%, the rate is the highest in the industrialized world. Over the past few years, politicians in both parties have come to understand that the corporate tax system itself is dysfunctional, causing resources to be misallocated and encouraging corporations to invest overseas.

In February 2012, President Obama proposed a substantial reduction in the corporate tax rate to 28% from 35%. This year, the president has spoken positively about corporate tax reform if it is revenue-neutral, meaning the rate cut should be paid for by broadening the corporate tax base.

This is progress toward a bipartisan solution. Lowering tax rates and broadening the tax base is a central tenet of conservative economic philosophy. High tax rates distort decisions on the margin, as do many specific deductions, exclusions and deferrals. Lower tax rates and a broader base allow the market to allocate resources with less interference from the government.

But what is the best way to meaningfully broaden the corporate tax base? Eliminating tax credits to specific industries, such as green energy, is a good place to start. Unfortunately, repealing these provisions wouldn't raise enough revenue to make a significant dent in the corporate tax rate. Larger corporate tax expenditures, such as the research and development credit, have strong political support on both sides of the aisle.

Congress could also raise revenue by requiring U.S. corporations to immediately pay tax on all of their foreign profits. Currently, corporations may defer taxation on their foreign profits until they bring them back into the U.S. However, almost all Republicans would prefer for the U.S. tax system to move in the other direction: taxing only those profits earned in the U.S. (with some exceptions to prevent such abuses as shifting profits abroad to take advantage of lower rates).

Given the importance of reducing the corporate rate—and the infeasability of the other options for paying for it—Rep. Kenny Marchant (R., Texas) and Rep. Jim McDermott (D., Wash.) are floating a proposal to modestly restrict the deductibility of gross interest expense for corporations. This change would meet two crucial criteria: It would raise a significant amount of revenue and significantly reduce economic distortions caused by the tax code.

Based on Internal Revenue Service data from 2000 to 2009 (the most recent available), I estimate that disallowing roughly 30% of interest deductions (that is, allowing for a 70% deduction for gross interest expense) would have fully paid for a reduction in the corporate tax rate to 25% from 35%.

Limiting interest deductions for corporations would also correct, to a degree, a serious imbalance. When a corporation finances an investment by issuing debt, the interest payments generate a stream of tax deductions. When a corporation finances an investment by using its cash on hand or by issuing new shares of stock, there are no analogous tax deductions.

Because of this difference, many corporations choose to maintain a debt-intensive capital structure—primarily for tax reasons instead of underlying economics. As a result, the economy will tend to be overly leveraged relative to a true free market. This makes corporations overly at risk of going bankrupt, increasing the fragility of the economy.

Some corporate officials have criticized such a limit on interest deductions based on the fear that it would increase their tax burden. This is false, on average, since the proposal would be structured to be revenue neutral.

Here's a simple example. Consider a corporation with taxable income of $100 million, calculated after deducting interest expense of $90 million. Currently, it would pay $35 million in corporate tax—35% of its $100 million taxable income. If interest deductions were capped at 70%, $27 million of interest expense would become nondeductible, increasing the corporation's taxable income to $127 million from $100 million. At a 25% tax rate, it would pay $31.75 million in corporate tax—slightly lower than under current law. In other words, because the proposal would be revenue-neutral, some corporations will pay a little more and others a little less.

A more legitimate concern is how existing debt would be treated under this proposal. Corporate executives have made financing decisions based on good-faith beliefs about the tax law going forward, so it might be unfair to deny a full deduction for interest payments on existing debt. Any restrictions to interest deductions should be phased in very slowly and should not apply to debt issued before some relevant date.

Congress need not finance the entire rate reduction by restricting interest deductions. For instance, Congress could cap interest deductions at a higher level—say, 80%—and finance the rest by limiting other deductions and credits now available to corporations.

But there's a particularly strong case in favor of restricting interest deductions: It could raise significant amounts of revenue while at the same time reducing economic distortions. This proposed change should be the core of any revenue-neutral legislation to reduce the corporate tax rate to 25% from 35%.

Authors

Robert C. Pozen

Publication: Wall Street Journal

A Fresh Take Needed For Risky Funds

Robert C. Pozen and Theresa Hamacher — Sun, 24 Mar 2013 00:00:00 -0400

The investment management world used to be simple. Mutual fund managers sold stock and bond investments to the general public subject to stringent regulation, while unregulated hedge fund managers served only the very wealthy with much riskier investment strategies.

But this once-clear distinction is melting away as mutual funds have started to look more like hedge funds, and vice versa. The blurring of the lines has created more choice for retail investors – along with significant challenges for regulators.

The convergence of mutual funds and hedge funds has its roots in consumer demand. In an environment of low returns on traditional asset classes, investors have been willing to consider alternatives to stocks and bonds if they offer the prospect of greater gains.

In response, mutual fund sponsors have developed funds incorporating strategies that, until now, have been used almost exclusively by hedge funds. These strategies often involve leverage, either through borrowing or the extensive use of derivatives, and they frequently emphasize alternative investments such as commodities, real estate and privately placed securities.

At the same time, the sponsors of these “alternative mutual funds,” as they are known, are increasingly likely to be hedge fund managers. Legislation passed in the wake of the financial crisis has subjected these managers to some of the regulations that previously applied only to firms catering to retail investors.

As a result, more hedge funds are willing to consider managing regulated mutual funds that can be sold to the general public. They calculate that the additional regulatory burden will be modest compared with the potential pay-off.

Recent sales of funds with a hedge fund approach give them cause for optimism. Morningstar reports that US investors have moved almost $40bn into alternative and commodity mutual funds over the past two years – while pulling $185bn out of traditional stock funds. Growth in “alternative Ucits”, the European equivalent, has been similarly strong.

Though investors may have embraced these new funds with enthusiasm, regulators have been decidedly more sceptical. In the US, that is partly because existing regulations – which were largely developed in the pre-derivatives era – are a poor fit for the new strategies. For example, the limitations on a fund’s use of leverage never refer to derivatives, by default giving fund managers considerable leeway in their use.

By contrast, regulation in the European Union addresses derivatives explicitly. Funds may use these instruments to create leverage synthetically, provided that their managers have established a process to monitor and manage risk.

But the high level of leverage permitted under these rules – up to three times assets – has raised regulatory eyebrows in prominent EU member states and in some jurisdictions outside Europe, such as Hong Kong, which allow sales of European funds within their borders. These regulators question whether the more aggressive funds are appropriate for the majority of individual investors.

These questions highlight the deficiencies of the current regulatory regime when applied to hedge fund-like mutual funds. This regime is based on two key principles: disclosure of risks to prospective investors and ensuring that funds have the ability to redeem investors upon request. Fund investments have generally been restricted to those consistent with the redemption principle.

As funds have grown more complex, regulators have become keenly aware of the limitations of the disclosure approach. They have tried to make it easier for investors to compare funds by standardizing the information presented in the US “summary prospectus” and the EU’s “key investor information document”, better known as the Kiid.

European regulators have recently gone a step further, by requiring that funds provide a Synthetic Risk and Reward Indicator, ranking funds on a single scale from one (least risky) to seven (most risky). The SRRI is computed from past volatility using a defined formula.

While a laudable effort, the SRRI may be too reductive to provide much insight to investors. An analysis by Lipper found that funds investing in the same segment of the market tended to fall within the same one or two SRRI categories, making it difficult to distinguish funds on the basis of this tool alone.

Therefore, regulators should carefully consider other approaches to mutual funds that are run like hedge funds. These alternative funds might be labelled so that they can be clearly differentiated from traditional mutual funds. And they should be subject to more marketing restrictions if offered to retail investors.

A new model for fund regulation is needed to ensure that product innovation is consistent with investor protection.

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Financial Times

The 529 College Savings Plan Needs an Update

Robert C. Pozen — Wed, 13 Mar 2013 11:44:00 -0400

In this economy, a college education is more important than ever: The unemployment rate for college graduates is 3.8 percent, compared to 7.8 percent for everyone else. Yet, the exploding costs of education are causing some students to graduate with heavy debt burdens.

The federal government has a multi-pronged agenda for dealing with this crisis, including loans and grants. To bolster this agenda, policymakers should direct their attention towards another pillar of education policy: increasing individual savings for college.

Currently, the federal government encourages individual college savings by authorizing states to run so-called “529 plans.” 529 plans receive a significant tax subsidy: investment gains are free of tax, so long as the proceeds are used to fund higher education expenses. Adding to their appeal, many states also grant a credit or deduction for contributions to a 529 plan.

Despite these attractive features, 529 plans haven’t caught on with the public at large. A report by the General Accountability Office (GAO), the federal government’s watchdog, found that only 6 percent of families with children own either a 529 account or its cousin, a Coverdell account. A report by Sallie Mae found that only one quarter of college savers used a 529 plan.

Furthermore, 529 savers tend to be well-off. The GAO report discovered that the median 529 plan account-holder had yearly income of $140,000, compared to about $40,000 for everyone else. Thus, the tax benefits of 529 plans, to the tune of roughly $2 billion per year, disproportionately go to well-off households.

Updating the 529 Plan Model

Why do few middle income families use 529 plans? To some extent, the slow economy has caused college savings to take a backseat to retirement savings or pressing needs. This economic reality will pose challenges to any educations savings scheme.

Nevertheless, some modest reforms to 529 plans could make them more attractive to middle-income families. Most critically, the government should do a better job at spreading the word about these plans. According to the Sallie Mae report, only 37 percent of those without a 529 account even knew of the plans’ existence. At no great expense, the federal government could expand the mandate of the Department of Education (ED) to include marketing 529 plans.

As part of this marketing campaign, ED should guide people through the sometimes confusing choices that people face when they consider investing in a 529 plan. These choices can be overwhelming to many families. Currently, an individual can invest in the 529 plan of almost any state, each of which has several separate investment options and widely varying fees.

The ED should make clear that the choice is actually relatively simple for many people. If you live in one of the 29 states (plus the District of Columbia) that offers special tax breaks to contributions to that state’s 529 plan, you should contribute to your state’s own plan. State tax deductions or credits typically outweigh any differences in fees.

For everyone else, the ED should establish a consumer-friendly website that compares the 529 plans of all states—with a prominent emphasis on fees. While there are already private websites that analyze plans of different states, a standardized method for comparing these plans would be useful.

Flexibility Is Needed

Lastly, the federal government should provide more flexibility to 529 account-holders whose children decide not to attend college. If the 529 account is ultimately not needed for education, the earnings will be taxed at regular tax rates plus 10 percent—a hefty penalty. While parents should start a college savings plan when their children are very young, they might fear that none of their children will attend college years later. (Parents may freely switch beneficiaries between family members in the same generation.)

To reduce this risk, the government should allow parents—if none of their children attend college by age 30—to transfer the investments in a 529 account into a Roth IRA for their own retirement. That way, parents could be confident that their savings could be used whether or not their children decide to go to college.

The government could make up for any lost revenue by phasing out the tax-advantaged Coverdell education savings account. Currently, Coverdell accounts are used by a very small number of sophisticated investors, mostly to save for private secondary school expenses. Eliminating the Coverdell account would also reduce the overwhelming number of decisions that middle class families must make when establishing a college savings plan.

In short, the tough economy is making it hard for families to save for education, preventing some young people from attending college and saddling the rest with too much debt. While 529 plans are not a panacea, better marketing and design of these plans can generate more college savings.

Authors

Robert C. Pozen

Publication: Yahoo! Finance

Image Source: © Mike Segar / Reuters

U.S. Tax Reform: Reducing the Tax Code’s Bias for Debt

Robert C. Pozen — Mon, 18 Feb 2013 00:00:00 -0500

To begin with, let me summarize the specifics of my proposal, which I detailed in Tax Notes. My proposal would reduce the U.S. corporate tax rate from 35% to 25%. I would finance such a rate reduction by limiting deductions for the gross interest expense of corporations (I call this provision the “interest cap”). Non-financial corporations would be allowed to deduct 65% of their gross interest expense, while financial corporations would be allowed to deduct 79% of their gross interest expense. There would also be special rules for corporations that would have reported a loss for tax purposes, but for these restrictions on interest deductions.

My piece in Tax Notes was not intended to set a specific proposal in stone, but rather to illustrate the general strategy: reducing the corporate tax rate while limiting interest deductions. I believe that such a combination would reduce the tax code’s bias in favor of debt, while making the U.S. a more attractive location for discrete, profitable investment projects.

With that said, let me address the main objections to my proposal.

Winners and losers

The most common objection to my proposal is that it would create winners and losers. While that objection is true, it is true because my proposal would substantially correct a significant distortion within the tax code in favor of debt finance. As a result, some corporations that are taking advantage of this bias in the tax code might see a higher tax burden under my proposal.

However, any revenue-neutral tax reform is mathematically guaranteed to create winners and losers. So, in my view, the primary criterion for evaluating a tax reform proposal should be whether it would reduce economic distortions.

I believe that my proposal would meet this criterion by moving the tax code closer to a neutral position between debt- and equity-finance. Under my proposal, corporations would no longer issue debt mainly because interest payments are deductible and returns to equity (dividends or share appreciation) are not. This means that corporations would make financing decisions for economic reasons rather than tax reasons—leading to a more efficient allocation of resources.

Transition relief

Other commentators in the International Tax Review article objected to the idea of applying the interest cap to pre-existing debt. I share this concern: corporations have made decisions about issuing debt based on good faith beliefs that the current treatment would continue.

I had been hesitant to allow for a broad grandfathering of existing debt. If the tax reform legislation allowed such grandfathering—effective on the enactment of the legislation—then corporations could rush to issue long-maturity debt shortly before the enactment of the legislation. In my piece, I proposed instead a 10-year, linear phase-in of rate reductions and restrictions to interest deductions.

However, I would accept an alternative approach: grandfathering existing debt effective as of January 1 of the year in which the legislation was first introduced (rather than at the date of enactment). That could substantially reduce any rush to issue debt shortly before the enactment of the legislation. The corporate tax rate could then be gradually reduced in a revenue-neutral manner.

Net interest versus gross interest

Observers frequently argue that my interest cap should apply solely to net interest expense, rather than gross interest expense. I disagree for two reasons.

First, applying the interest cap to net interest expense would raise only a small amount of revenue—enough to finance a reduction in the corporate tax rate by about 1.5 percentage points, based on estimates by the Congressional Research Service. As a result, the U.S. corporate tax rate could not be reduced to a level competitive with most industrialized countries.

Second, restricting net interest deductions would (by itself) increase effective marginal tax rates (EMTRs) on debt-financed investment to nearly the same extent as restricting gross interest deductions (though average tax rates on debt-financed investment would be substantially different).

Consider a hypothetical non-financial corporation that has $300 million in gross interest income and $500 million in gross interest expense. Imagine it is considering a marginal investment that would cause it to incur an additional dollar in interest expense. Under my proposal, that corporation could deduct 65 cents of that additional dollar. If I instead applied the restrictions to net interest expense, that corporation could still deduct 65 cents of that additional dollar. This corporation’s incentives—on the margin—essentially do not depend on whether the interest cap applies to net or gross interest expense.

Yet, as mentioned above, applying the interest cap to gross interest raises much more revenue, and thus can finance a much more significant reduction in the corporate tax rate. The reduced corporate tax rate mitigates the increase of EMTR on debt-financed investment and sharply reduces the EMTR on equity-financed investment. According to the model developed by the Congressional Budget Office, the average EMTR facing non-financial corporations would be roughly unchanged under my proposal.

By contrast, applying the interest cap to net interest expense could not finance a reduction in the corporate tax rate sufficient to offset the increase in EMTR associated with the interest cap. Thus, financing a corporate tax rate reduction by restricting net interest expense would cause the average EMTR facing corporate investment to increase.

Alternative approaches

Lastly, some commentators argue that we should reduce the distortions to financing decisions by cutting shareholder-level taxes on dividends and capital gains, rather than imposing an interest cap. While there are many good reasons to support lower dividend and capital gains taxes, such tax relief would in fact work against the goal of raising revenue to reduce the corporate tax rate. If corporate executives wish to reduce shareholder-level taxation, then they must put forward specific revenue or spending proposals to offset the revenue loss.

In fact, though most corporate executives want a 25% corporate tax rate, they have not been willing to eliminate or restrict the large tax preferences built into the tax code—such as the deduction for domestic production activities and the research and development credit. The items usually identified for repeal—such as accelerated depreciation for corporate jets or credits for green energy—are too small to finance any meaningful reduction of the corporate tax rate.

In these times of tight budgets, any proposal for tax reform must be at least revenue-neutral. And while I support “comprehensive” tax reform, this seems to be a long-shot.

A continuing process

I want to thank International Tax Review for giving me the opportunity to respond to the earlier article. But it is equally important to thank all those who commented on my proposal for that article. The thoughtful comments will help me refine the proposal—both to bolster the U.S.’s global competitiveness and to reduce the distortive effects of the tax code.

Authors

Robert C. Pozen

Publication: International Tax Review

Image Source: © Jessica Rinaldi / Reuters

A Win-Win: Compromise on Foreign Profits

Robert C. Pozen — Thu, 07 Feb 2013 00:00:00 -0500

In last year’s State of the Union, President Obama argued in favor of reforming how the U.S. taxes the foreign profits of U.S. corporations: “From now on, every multinational company should have to pay a basic minimum tax.” While an international minimum tax is a sound idea, it should be part of a broader effort to fix our dysfunctional system for taxing foreign profits.

Currently, foreign profits of U.S. corporations are subject to a Hobson’s choice. Such profits are subject to a 35 percent tax rate if repatriated to the U.S. parent company. But if a corporation keeps that money permanently outside of the U.S., it typically owes no U.S. tax on those profits.

This bifurcated tax treatment leads to two related economic problems. First, corporations can reduce their tax burden by artificially shifting their profits from the U.S. to a tax haven, such as Bermuda or the Cayman Islands. Because highly mobile intellectual property (such as patents, brand names, and the like) has become an increasingly important driver of corporate profits, corporations have been able to shift more and more of their profits to tax havens. In 2008, U.S. corporations reported profits in Bermuda over 1000% of that island’s GDP.

Second, U.S. corporations have a huge disincentive to bring any profits earned in a foreign country back to the U.S. If a corporation did repatriate those profits, it would owe the difference between the 35 percent U.S. corporate tax rate and the local corporate tax rate. As a result, trillions of dollars in cash is currently being held by overseas affiliates of U.S. corporations—cash that cannot be invested in the U.S. by the parent company.

An international minimum tax, as President Obama has proposed, is a smart way to reduce profit-shifting—the first problem. Such a minimum tax should allow a credit for foreign taxes paid (as allowed under the current system); if the minimum tax were 17 percent and the local tax rate were 5 percent, the U.S. would impose an immediate tax equal to the difference between the two rates (12 percent in this case).

However, the international minimum tax would not address the second problem of today’s system: the incentive for U.S. corporations to keep their cash in the hands of their foreign affiliates. The U.S. could fix this second problem if it taxed foreign profits at 35 percent regardless of whether they were repatriated. But such a “worldwide system” of taxation would put U.S. corporations at a significant disadvantage to their foreign competitors. For instance, McDonald’s would face a 35 percent tax rate on the profits they earn in their restaurants in the United Kingdom, while a U.K.-based competitor (say, Harry Ramsden’s) would pay the U.K. rate of 24 percent.

Most jurisdictions take the opposite approach, taxing only those profits earned within their borders (with limited modifications to try to prevent egregious forms of profit-shifting). This system, known as the “territorial system” of taxation, is also the proposed solution of the GOP. If Congress enacted a territorial system, it would essentially remove the tax-related barriers blocking corporations from using foreign profits to invest in the United States. However, it would also strongly encourage the transfer of corporate profits to tax havens—especially income attributable to intellectual property or mobile investments.

Fortunately, there is a sensible compromise in the offing: policymakers could combine President Obama’s proposed international minimum tax with the GOP’s proposed territorial system. Here’s how this combination could work:

First, there would be an international minimum tax rate equal to, say, 17 percent. If a corporation paid less than 17 percent to a foreign government, it would immediately owe the difference to the U.S.—reducing the incentive to artificially shift profits to tax havens.

Second, if a corporation paid more than 17 percent in taxes to a foreign country, it would be allowed to repatriate that income freely to the United States and owe no (or minimal) taxes. This would substantially reduce the incentive to keep cash in the hands of overseas affiliates.

By imposing an international minimum tax, this combination would ensure that all corporate profits were taxed at some reasonable rate by some government. And by allowing corporations to easily repatriate profits earned in most foreign countries, this combination would strengthen the competitive position of multinational corporations based in the United States. President Obama proposed the first half of this combination in last year’s State of the Union; I hope he finishes the job in this year’s speech.

Authors

Robert C. Pozen

Image Source: © Darley Shen / Reuters

35 Percent Is Way Too High For Corporate Taxes

Robert C. Pozen — Tue, 29 Jan 2013 10:53:00 -0500

If there's one policy agreement between Republicans and Democrats, it's that the 35% corporate tax rate in the United States should be reduced to 28% or 25%. The current rate, highest in the advanced industrial world, disincentivizes investment and encourages corporations to relocate overseas.

Unfortunately, the deficit is a major hurdle facing any proposal to reduce the corporate tax rate. Because of the fiscal pressures facing the government, most politicians recognize that any corporate tax rate cut must be paid for by eliminating tax preferences and "loopholes." But few politicians have identified enough revenue-raising measures to offset the cost of a significant reduction of the corporate tax rate-cutting the rate from 35% to 25% would cost roughly $1.2 trillion over ten years.

I believe that there is a sensible answer: a modest limit to the deductions that corporations claim for the interest they pay on their bonds and other debt.

Admittedly, interest deductions probably won't be the first target for politicians. Most likely, politicians will first take a close look at the myriad of provisions designed to benefit specific industries. For instance, the fiscal cliff deal extended tax benefits for car racing facilities, railroads, mining companies, and various alternative energy companies. Indeed, many of these preferences have highly suspect economic justifications; unfortunately, these special deals are too small for their repeal to raise a significant amount of revenue.

Politicians might then turn to some of the larger tax preferences that corporations enjoy, collectively known as "tax expenditures." However, they will likely find it unwise, or politically infeasible, to repeal any of these large tax expenditures, such as accelerated depreciation or the research and development credit. Most Democrats and Republicans view these policies as being essential to economic growth. In any case, the bipartisan Joint Committee on Taxation has estimated that the elimination of virtually all corporate tax expenditures would not be sufficient to reduce the corporate tax rate to 25%.

Another approach would be to change how the U.S. taxes the foreign profits of U.S. corporations. Currently, U.S. corporations can avoid paying U.S. tax on foreign profits so long as they keep those profits overseas. Congress could raise a significant amount of revenue if it required U.S. corporations to immediately pay U.S. taxes on their foreign profits-beyond the foreign taxes that they already pay. However, this change would make our corporate tax system even more out of step with the rest of the world; most foreign countries require corporations to pay tax only on profits that were earned in that country (with exceptions designed to prevent abusive tax-shifting).

Thus, if policymakers are serious about reducing the corporate tax rate, they will need to consider other revenue-raising measures. To merit serious consideration, such reforms should offer the potential for meaningful new revenue, and they should also make sense from a policy standpoint.

My proposed limits to interest deductions (which I call the "interest cap") would meet both criteria. Currently, corporations may fully deduct the interest they pay on their bonds and other forms of debt. This deduction costs the Treasury a significant amount of money, and encourages corporations to take on too much debt, increasing the fragility of the economy.

Using data from 2000 to 2009 (the most recent available), I estimate that a 65% cap on deductions for gross interest would have paid for a reduction in the corporate tax rate from 35% to 25% over those ten years. In other words, corporations would be able to deduct 65% of their gross interest expense, rather than 100%; from 2000 to 2009, this modest restriction would have been enough to finance the entire rate reduction to 25%.

My proposed "interest cap" would also reduce a significant distortion in the tax code. Currently, if a corporation finances an investment with debt, it can deduct the interest that it pays on that debt. If a corporation finances an investment by issuing new shares of stock, or by using money in the bank, there is no equivalent deduction. As a result, the tax code effectively encourages corporations to load up on debt. This makes companies more vulnerable to downturns-exposing their employees to a greater risk of layoffs and prolonging recessions in the broader economy.

I acknowledge that the treatment of financial institutions under my proposal is a tricky issue. Financial institutions typically borrow significant amounts of money in their daily operations. On the one hand, a vibrant financial sector is a critical component of a healthy, growing economy, and the "interest cap" could constrain these daily operations. On the other hand, excess debt within the financial sector can be especially damaging, as it has the potential to increase the severity of financial crises.

To balance these competing demands, my proposal would apply the interest cap to financial institutions, but at a lower rate. They would be allowed to deduct 79% of their interest expense-less than the 100% that they may deduct currently, but more than the 65% that nonfinancial corporations could deduct.

Undoubtedly, certain debt-intensive industries will lobby against my proposed cap on interest deductions. But policymakers should resist such pressure: any revenue-neutral tax reform must necessarily create winners and losers. Instead, policymakers should focus on setting the stage for broad-based economic growth by reducing the distortions in favor of debt-finance, and by bringing our corporate tax rate in line with the rest of the world.

Authors

Robert C. Pozen

Publication: Real Clear Markets

Image Source: © Robert Galbraith / Reuters

How to Slash the U.S. Corporate Tax Rate

Robert C. Pozen — Sun, 20 Jan 2013 11:47:00 -0500

Both Republicans and Democrats agree that the 35 per cent corporate tax rate in the US is too high. Yet discussions over the corporate tax fizzled out during the recent fiscal cliff negotiations, partially because of the budgetary maths. Neither party has identified enough revenue increases to offset the $1.2tn cost over 10 years of lowering the corporate tax rate to a more reasonable 25 per cent.

We would like to offer a proposal: limiting the tax deductions for the interest that corporations pay on their bonds and other debt they issue. This change alone could raise the required revenue for a 10 percentage point reduction in the corporate tax rate. And this change would also improve the allocation of capital and deter excessive leverage.

Although there are three alternative approaches to financing a corporate rate deduction, none of them are large enough or politically feasible.

Read the full op-ed at FT.com »

Authors

Robert C. Pozen

Publication: Financial Times

Image Source: © Brendan McDermid / Reuters

Embrace Career Change, But Still Stand for Something

Robert C. Pozen — Thu, 03 Jan 2013 14:56:00 -0500

Imagine that an electric company wants to build a loud, ugly power line on your property. They ask, "How much would we need to pay you to make this happen?" You'd probably demand a lot of money.

Now imagine that that power line already exists on your property. How much would you pay the electric company to get rid of it? Would you pay the same amount — or less?

Most people insist on a larger payment to build the power line than they'd be willing to pay for its removal. This difference is an illustration of status quo bias, a cognitive trait most people share. When presented with a potential change, we usually weigh the potential losses more heavily than the potential gains.

This tendency is completely understandable. Unfortunately, it can also prevent you from getting ahead.

Change is ubiquitous in most facets of our lives. On a basic level, you will likely change jobs more often than you might predict. In a recent study, the Bureau of Labor statistics found that the average person in their sample held eleven jobs between the ages of 18 and 46 — meaning a job-switch once every 2.5 years.

In the broader world, economic, demographic, and technological changes are forcing us all to cope with change whether we want to or not. The financial crisis of 2008 was not some once-in-a-lifetime event; rather, it was one of six financial crises since 1986. On a longer time scale, an aging population has slowed economic growth in Japan and Russia; a growing population has played a key role the impressive economic ascendance of countries such as Brazil and China. Meanwhile, computing power has consistently grown over the past thirty years, changing the way that people shop, learn, and socialize, while also making business logistics much more efficient.

So how can you take advantage of a rapidly changing world? You shouldn't set your career path in stone, or else you'll be tremendously vulnerable to external events beyond your control. At the same time, if you blow whichever way the wind blows, you'll get blown over. So how do you embrace change, while still standing for something?

Embracing Change

Prepare for change by maximizing your options at each step of your career, so that you can be ready to react to whatever the world throws at you. Be proactive. At your current workplace, look for untapped growth opportunities for your organization. Can you expand the customer base? Or use cloud computing in a new way? If you're the first to spot a possible new initiative, you're the likely candidate to lead it.

Get comfortable with uncertainty. No matter your current line of work, you can make smarter decisions by recognizing that the future is inherently unknowable. Be wary of "hockey-stick" projections that use facts from the past to predict fast-growing sales or profits far in the future. Those projections rarely take into account factors such as diminishing returns or potential competitors.

Carefully scrutinize mathematical models that use rigid assumptions about the past. For instance, many models for mortgage-backed securities in the mid-2000s relied on default rates from the previous decade, neglecting the fact that many current mortgage products were different in significant ways. These models failed spectacularly when their assumptions were proven false.

Standing for Something

Although change pervades most aspects of our world, two principles have remained the same over centuries: economic fundamentals and personal integrity. It's easy to get caught up in daily buzz and the latest trends, but these principles are critical for long-term solutions.

In every generation, a group of companies seems to ignore the basic economic fundamentals of profits and losses. In the late 1990s, it was the dotcom companies; many of them shortly went out of business. In the near future, some social media companies might meet the same fate. While growing revenues and alluring ideas can capture the public's interest, ultimately businesses can only survive if they turn a profit.

Similarly, your friends, colleagues, employers, and customers will always put a high premium on your integrity and your reputation. Unfortunately, Warren Buffett was exactly right when he said, "It takes 20 years to build a reputation and five minutes to ruin it."

So, it's critical that you establish for yourself a clear code of ethics. Think about not only your ethical strengths, but also your ethical weaknesses. Write down a situation in which your ethics might be tested. What would you do to maintain your integrity in that situation? When in doubt, apply the New York Times test. How would you feel if your actions were reported on the cover of the New York Times?

In sum, be prepared to learn new skills, take advantage of new trends, and adapt to unforeseen crises — if you don't, you'll be left behind as the world changes without you. But never lose focus on economic fundamentals and, especially, your own personal integrity.

Authors

Robert C. Pozen

Publication: Harvard Business Review

Make 2013 the Year to Resolve the Money Fund Debate

Robert C. Pozen — Thu, 20 Dec 2012 09:00:00 -0500

The road to money market fund reform has been politically arduous. In August, Mary Schapiro, then the Chairwoman of the SEC, was forced to call off a vote on money market fund reform. Three of the five commissioners had indicated that they were not prepared to support the rules under consideration. Fortunately, two of the three dissenters have recently expressed receptivity to some reforms in certain circumstances.

To break through the impasse within the SEC, the commissioners should consider a compromise first proposed by Walt Bettinger, President and CEO of investment services firm Charles Schwab. That proposal would affect money market funds held by large institutions—such as pension funds and corporate treasuries—while leaving retail investors largely unaffected.

To understand this proposal, you need to understand how money market funds work. Money market funds are required to invest solely in short-term securities issued by high-quality corporations and governments. In exchange for these restrictions, money market funds are allowed to fix their share price—known as the net asset value, or NAV—at $1.00 per share, even if the true market value of their investments fluctuates slightly.

Regulators argue that this “stable NAV” makes money market funds vulnerable to runs. One rule supported by Chairwoman Schapiro would have required money market funds to adopt a fluctuating NAV. In other words, funds would have to calculate their NAV based on market prices, as is required of stock and bond mutual funds.

To see the regulators’ logic, imagine that you’re a corporate treasurer with a large investment in a money market fund. You begin to notice that some of the fund’s investments have declined slightly in value. If you act quickly, you can still sell your shares for $1.00 each. If you wait, the value of the fund’s investments could decline further, possibly requiring the fund to “break the buck”—that is, report an NAV less than $1.00.

Given this choice, you might very well decide to sell right away. Even worse, several of your colleagues running other corporate treasuries might also decide to sell their shares immediately—effectively triggering a run on that fund.

However, this dynamic mainly affects large institutional investors, which carefully monitor their holdings and can quickly redeem a large portion of a fund’s shares. By contrast, retail investors are likely to be unaware of any slight fluctuations and generally redeem much more slowly than large institutions. As a result, retail money market funds are much less susceptible to runs.

Therefore, I advocate that institutional money market funds should be required to adopt a fluctuating NAV. On the other hand, money market funds held solely by retail investors should be allowed to continue using a stable NAV at $1.00 per share.

Regulators will need to carefully establish rules which define money market funds as “retail” or “institutional.” I believe that funds with a maximum account size less than $1 or $2 million should qualify as “retail funds,” but regulators may also need to consider other factors, such as concentration of ownership.

In any case, these rules should be designed to ensure that individuals and small businesses can continue storing their cash in money market funds with a stable NAV. Such retail investors typically use money market funds as an alternative to bank deposits; a fluctuating NAV could lead many retail investors to flee money market funds entirely.

Driving retail investors out of money market funds would deprive high-quality corporate and municipal issuers of a critical source of short-term loans. And it is not clear whether the banking system has enough capital to support a huge influx of retail deposits from money market funds.

My proposal would also maintain the stable NAV for any money market funds—retail or institutional—which invest solely in securities issued or guaranteed by the U.S. government. Because the assets of such funds are highly safe, they are much less vulnerable to runs.

In short, regulators should require a fluctuating NAV for institutional money market funds that invest in non-government securities. This proposal would improve the stability of the financial system, while also protecting retail investors. This is the type of balanced solution that could break the deadlock at the SEC on money market fund reform.

Authors

Robert C. Pozen

Image Source: © Mike Stone / Reuters

From Investment Management to Time Management

Robert C. Pozen — Sun, 16 Dec 2012 14:58:00 -0500

Editor's Note: The Financial Times spoke with Robert Pozen about this new book, Extreme Productivity, and discussed his thoughts on how to squeeze time from your day as well as his views on asset management. The full interview can be found at ft.com (subscription required).

Why did you write the book?

A couple of years ago, I was teaching a full load of classes at Harvard Business School and someone asked me to do an interview about personal productivity. They were amazed I could get my articles in on time while carrying this workload and they wanted to know how I did it. Anyway, the interview was such a hit on the Harvard Business Review blog and I saw that a lot of people were interested, so it turned into a book. It only took me nine months to write the book.

Your top tip for making people productive?

Email is becoming a problem. Everyone is overwhelmed by emails. People send you hundreds. I have this rule that I think should be applied to the most important emails – OHIO, otherwise known as only handle it once. If you get an email from your boss, respond. Don’t put it off until next week or the week after.

I also have another tip for readers. The trick is not to read more words per minute. It’s to read fewer words per minute, but read the words that are important for your reading. If I am reading the Boston Globe, I am only reading it for sports, so I skip over the other bits of the newspaper. When you read a history book or a science book, I think you should read the introduction and then immediately skip to the conclusion and go back to the body of the book later. If you want to be a speed reader, you have to think first about what your purpose in reading is.

Authors

Robert C. Pozen

Publication: Financial Times

Extreme Productivity: Taking Time to Make Time

Robert C. Pozen — Mon, 10 Dec 2012 15:32:00 -0500

Editor's Note: Robert Pozen speaks with the Harvard Business Review about his new book, Extreme Productivity: Boost Your Results, Reduce Your Hours (HarperCollins Publishers).

In Extreme Productivity, Pozen offers performance-enhancing tips on everything from how to sleep better on overnight business flights (window seat, no alcohol, earplugs, and eyeshades) to dealing with employees' mistakes ("No matter how spectacularly the project flopped, don't attack the person").

Classic productivity books often focus on time management, but Extreme Productivity takes a much broader look. It reads more like a businessperson's handbook. Did you intend that?

It takes a lot more than organizing your schedule to be productive. I wanted to discuss skills that have been critical in my own career. Communication is one—reading, writing, and speaking. Another is how you operate within your organization and deal with both those above you and those who report to you. I also wanted people to think about how they are managing their careers in the evolving context of their own professional and personal lives.

The book addresses aspects of business life that are vexing to many of us. For example, what are some ways to make meetings more productive?

You should not schedule meetings that last more than an hour, or 90 minutes at the most. There are tremendous diminishing returns in lengthier meetings. When you only have an hour, you don't waste time on nonproductive tangents. You also need to think about how you structure the meeting. When meeting materials arrive in your email five minutes before the meeting starts, it's a signal that the person in charge hasn't laid the groundwork for a productive use of time. There should be adequate time in advance for everyone to prepare for a thoughtful discussion.

All meetings should have an effective close. People should think, "What are the to-dos, and who's going to do them?" Senior executives tend to think that they can accomplish this by just telling people what to do. But there's a big difference between assigning a task to be completed by next Tuesday vs. introducing a challenge, getting buy-in on addressing that challenge, and having everyone come together on a way it can get done by a mutually agreed deadline.

On the subject of management styles, you write about the wisdom of adapting your personal style to that of your boss. What if your boss's style is interfering with your productivity?

By "adapting," I don't mean that your style needs to be the same as that of your boss, but you should be in sync and try to make sure your skills complement each other. For example, if your supervisor is a "big-picture" thinker, you could balance that by being detail-oriented. The notion is to understand your boss and position yourself accordingly. And if the differences you have with your boss are compromising your ability to do your job, you just have to take the leap and talk about it directly.

Those are sensitive conversations. How do you make them productive?

People fear that if they air their differences with their bosses, they may be fired, but that's not my experience. If you raise topics politely, explain your perspective on the issues, and stay away from personal attacks, I think most bosses will respond positively. Even better, go into that conversation with a suggestion or two that would lead to better results. You may think you're sticking your neck out, but if the conflict is there and neither of you addresses it, you are probably not long for that job anyway.

You take exception in the book to the practice, at many professional firms, of organizing work around billable hours. How does that hurt productivity?

The most obvious answer is that there is a negative financial incentive to solving problems quickly and efficiently. Hourly billing is a deeply ingrained model of measuring work, but it comes from a time that predated our knowledge-based economy. When your goal is a great marketing plan or a brilliant idea for a software system, it doesn't matter if it took 2 hours or 20 hours. The client is paying for the quality of the solution.

What do you think about the issue of flexible work hours?

There's a long way to go yet, but once you embrace the concept that results are the most important factor in evaluating performance, if someone leaves early or comes in late in order to take care of a family matter, it's a non-issue—as long as that person is getting their work done and achieving good results. And that concept of being able to attend to outside obligations should be as important to those at the organization's highest levels as it is to middle managers.

We often find that work obligations overwhelm our best intentions when it comes to spending time with family. How do you juggle conflicting priorities?

Many managers insist that their jobs routinely require them to stay late at the office, but when you press them, they admit that isn't true. Some occasional emergencies need to take precedence over everything else, but unless you work in a hospital, those situations are rare. Even if you have to catch up with work after dinner, take a couple of hours every day to connect with the people in your life who should matter most.

You stress the importance of reading, writing, and public speaking. Any hints?

When it comes to reading, prioritize. Determine which information is most important to you, and spend more time reading that information care- fully. I've worked with a number of high-school students, and what I tell them about writing is just as valid for managers: begin with an outline. It keeps you from getting halfway through and not knowing where you should go from there. With public speaking, don't read from a script. Instead, have one piece of paper with an introductory sentence, brief notes on four or five points that you want to make, and a conclusion sentence.

You advise against doing too much career planning. Why?

I think people should keep their options open. An annual self-assessment is a wonderful tool, but it is not productive to sit in a room and try to figure out where you want to be in 10 or 20 years. Instead, think about what you can do in the next year or two to broaden your learning, experiences, and choices. Career planning should be an exercise you engage in throughout your life, and it should take into account the changes that occur along the way.

Authors

Robert C. Pozen

Publication: Harvard Business Review

Getting Wall Street Accountability Right

Robert C. Pozen — Mon, 19 Nov 2012 14:36:00 -0500

When it comes to the financial crisis of 2008, there's certainly no shortage of blame. But who should be legally liable for any wrongdoing that occurred? In my view, enforcement actions should be brought for two primary purposes: to increase accountability and deter future wrongdoing. In most cases, that means focusing attention on the individuals who committed the alleged bad acts, not the corporate entities. Unfortunately, the SEC and other agencies have often brought actions against the corporate entities instead. Here are two particularly egregious examples.

Bank of America and Merrill Lynch

The SEC brought an enforcement action against Bank of America in connection with its acquisition of Merrill Lynch in the fall of 2008. The suit alleged that Bank of America failed to disclose in the merger proxy statement that Merrill was planning to pay $5.8 billion in year-end bonuses to top employees. As a result of this omission, Bank of America shareholders were allegedly defrauded: they might not have approved the acquisition had this information been revealed.

In August of 2009, Bank of America agreed to settle this case with the SEC by paying a $33 million fine. Because corporations are ultimately owned by their shareholders, this fine would have effectively been paid for by the victims of the alleged fraud-the shareholders of Bank of America. The settlement did not involve any enforcement actions against any of the Bank's executives responsible for the material omission in the merger proxy.

With these concerns in mind, Judge Jed Rakoff (a U.S. District Judge in New York) took the extraordinary action of rejecting this proposed settlement. He wrote that, by assigning liability to Bank of America's shareholders, the settlement did not "comport with the most elementary notions of justice and morality."

The SEC argued that such fines would deter future fraud by encouraging shareholders to more actively monitor management's activities. However, Judge Rakoff didn't buy this argument, and neither did John Coffee, a professor at Columbia Law School. In a paper on shareholder litigation, Coffee wrote:

"[E]nterprise liability in this context is akin to punishing the victims of burglary for their failure to take greater precautions. Although this strategy might produce some enhanced monitoring, it offends social norms, including the public's basic sense of fairness, to punish the victim for conduct that it did not cause."

In 2010, Judge Rakoff reluctantly approved a larger, restructured settlement, which was somewhat more effective at repaying the "legacy" Bank of America shareholders that were originally defrauded.

JPMorgan and Bear Stearns

In October, the State of New York filed suit against JPMorgan, alleging serious wrongdoing on the part of Bear Stearns (which JPMorgan acquired in the spring of 2008). The suit alleges that Bear Stearns caused harm to third parties by misrepresenting the quality of mortgages underlying securities that the firm sold to them.

If JPMorgan had purchased Bear Stearns under "normal" circumstances, JPMorgan's shareholders would have been a reasonable target of the lawsuit. Typically, if one corporation (call it A Corp.) buys another (call it T Corp.), A assumes all of T's former liabilities-its bonds, pension obligations, and, yes, its legal liabilities.

The transfer of legal liability relies on the logic that A could have performed due diligence prior to acquiring T, and reduced its offer price to account for any potential legal liability. Thus, the expected cost of future lawsuits flows through to T's shareholders, as it should in the normal case.

But JPMorgan's acquisition of Bear Stearns was different. JPMorgan purchased Bear Stearns at the behest of top federal officials-who needed JPMorgan to quickly announce a deal in order to quell a potential financial panic. Furthermore, the offer price was effectively set by these federal officials. There was no opportunity for JPMorgan to learn about Bear Stearns' legal liability, nor to adjust its offer price accordingly. Indeed, JP Morgan initially walked away from the acquisition because it did not have enough time for due diligence.

Thus, punishing JPMorgan's shareholders does nothing to align incentives-it merely punishes shareholders for acts in which they are blameless. Even worse, this fine discourages companies from engaging in "white knight" acquisitions at the request of federal regulators. In the future, company executives will demand broad guarantees against losses from the government before taking over any troubled institutions.

Target the individuals instead

Government officials should think twice before bringing securities cases against only a corporate entity. That typically punishes shareholders-who are likely to be innocent bystanders, or even victims themselves. Instead, officials should sue the individuals responsible for the alleged bad act

Targeting individuals can certainly be a challenge: criminal prosecutions must meet strict standards. In civil suits, individual damages or fines as part of settlements are usually covered by an executive's insurance policies or the company's indemnification provisions.

However, if officials can assign blame through a civil court judgment (or voluntary admission of culpability), they can generally force executives to pay out of their own pocket. Even if officials decide to settle these cases-allowing the individual to "neither admit nor deny" wrongdoing-they can insist that executives waive their insurance and indemnification rights from the relevant corporate entity. This approach would more effectively deter corporate officials from engaging in socially damaging behavior, while reducing the adverse impact on innocent shareholders.

Authors

Robert C. Pozen

Publication: Real Clear Markets

The SEC vs. J.P. Morgan

Robert C. Pozen — Tue, 13 Nov 2012 14:43:00 -0500

J.P. Morgan Chase & Co. announced last week that it had agreed to settle a multiyear probe by the Securities and Exchange Commission. The probe alleges that Bear Stearns (which J.P. Morgan acquired in early 2008) failed to disclose key information about the mortgage-backed securities it sold—such as the low quality of the mortgages underlying them. Under the proposed settlement, J.P. Morgan will pay an undisclosed amount, but no individuals will be charged.

The agreement punishes the wrong people. Instead of fining J.P. Morgan—which acquired a failing firm at the behest of the federal government—the SEC should take action against the individual executives who committed the alleged wrongdoing.

Typically, a corporation that buys another assumes all of its financial obligations, including its legal liabilities. The logic here is that the buyer will look into these obligations—perform "due diligence"—and adjust its offer price to account for any potential legal liabilities of the company that it wants to buy. This logic holds, for instance, in the case of the federal government's billion-dollar lawsuit against Bank of America regarding alleged wrongdoings by Countrywide Financial before the merger of those two companies.

But J.P. Morgan's acquisition of Bear Stearns was largely completed over the course of a single weekend at the behest of the federal government. Recall that on the evening of Thursday, March 13, 2008, Bear Stearns was forced to seek an emergency loan from the New York Federal Reserve in order to continue operations. The next day—Friday, March 14—its stock dropped by nearly 50%.

Federal officials believed that Bear Stearns would not survive another business day—and that its failure could trigger a wave of panic in the financial markets. So Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson took the exceptional step of asking J.P. Morgan to make an offer to purchase Bear Stearns. The deal needed to be announced—and the framework for the deal completed—before the Asian stock markets opened on Monday, March 17.

With that tight deadline, J.P. Morgan could never have completed its due diligence. For this reason, J.P. Morgan initially begged off—but acquiesced only after the regulators pressed hard. The firm agreed to absorb some of the costs of Bear's toxic assets.

As Rep. Barney Frank (D., Mass.), the co-author of the Dodd-Frank financial reforms, said last month, J.P. Morgan "would never have sought to acquire [Bear Stearns] absent that urging" from the federal government. The SEC's problematic actions in this case have broader implications for the future. If J.P. Morgan is punished for the actions of Bear Stearns, government officials might not be able to find any "white knights" when the next crisis arises.

So who should be held accountable if Bear Stearns did engage in a massive fraud involving mortgage-backed securities? Optimally, government officials should bring criminal or civil suits against the responsible senior officials at Bear.

To win a criminal case, however, a prosecutor must generally prove intentional misconduct by the defendant beyond a reasonable doubt. That is a tough standard to meet, especially when midlevel executives follow bad policies prevalent at a firm. And the Justice Department could not meet the standard when it tried to go after two former hedge-fund managers at Bear Stearns in 2009.

There is a better approach: The SEC can bring civil cases against the top executives who set the bad policies at a troubled institution. The agency has the authority to bring judicial or administrative proceedings against controlling persons of a firm for the acts of their subordinates. The remedies include imposition of significant fines on senior executives and barring them from the securities industry.

In the past when the SEC has settled such suits, senior executives were usually not required to admit the validity of the allegations. In such cases, any financial penalties are typically covered by insurance policies or indemnification, rather than being paid out of the executives' pockets. When executives are required to pay personally, there generally must be a voluntary admission or court judgment of culpability.

In the future, if regulators have provided substantial financial assistance to a troubled institution, they should litigate any charges of serious misconduct directly against its senior executives—settling only if these executives admit wrongdoing or waive their insurance and indemnification from the institution.

This approach would more effectively punish executive misconduct. And regulators would not feel compelled to seek damages for such misconduct from firms like J.P. Morgan that made acquisitions requested by the government.

Authors

Robert C. Pozen

Publication: Wall Street Journal

Exercise Increases Productivity

Robert C. Pozen — Wed, 24 Oct 2012 11:53:00 -0400

Everyone knows that exercise can improve your health. Exercise is a key part of managing your weight and maintaining healthy hearts, lungs, and other bodily systems. But did you know that exercise can make you more productive? The latest research shows that a regular exercise routine can make you happier, smarter, and more energetic.

A habit of regular exercise will help keep you mentally sharper throughout your entire life. As you age, your body generates fewer and fewer brain cells (a process called neurogenesis). However, early research in mice suggests that exercise can help prevent this slowdown. In other words, by the time they reach their 50s, 60s, and 70s, people who exercise might have more brain cells than their more sedentary peers -- giving them a major advantage in the workplace.

Over a shorter time-frame, an exercise routine can give you more energy throughout the day. Most of your cells contain components called mitochondria, often referred to as the cell's "power plant." Mitochondria produce the chemical that your body uses as energy, known as ATP. Physical exercise stimulates the development of new mitochondria within your cells, meaning that your body will be able to produce more ATP over time. That gives you more energy to exert yourself physically, but it also means more energy for your brain, boosting your mental output.

To obtain these benefits, you don't need to sweat up a storm. In a randomized controlled trial, researchers from the University of Georgia split people into three groups: low-intensity exercise, moderate-intensity exercise, and a control group (no exercise). During the six-week experiment, both "exercise" groups reported growing levels of energy (compared to the control group), but there was no discernable difference between the moderate- and low-intensity exercise groups. In fact, the low-intensity group reported less fatigue than the moderate-intensity group.

This experiment suggests that exercise can make you feel more energized within a few weeks. By contrast, the effect of exercise on your mood is immediate. When you exercise, your body releases several different chemicals in your brain, collectively known as neurotransmitters. Although the mechanisms aren't fully understood, these neurotransmitters seem to reduce the discomfort of exercise and create the sensation often referred to as "runner's high."

This experience is highly pleasant, as British economist George MacKerron discovered in a unique, ongoing experiment. MacKerron and his team recruited over 50,000 volunteers to download an app to their smartphone. Roughly once a day, the volunteers' phones "beep," at which point each person reports what they are doing and how happy they are. The preliminary results? Exercise makes people very happy -- only sex makes people happier. And the happier you are, the more productive you can be.

Despite all these benefits, many people find it hard to exercise regularly. They buy expensive equipment and wear the latest fashion in gym clothes, but they don't actually get around to working out. To get into an exercise routine, I suggest in my new book, Extreme Productivity, that you organize a group of friends or family to work out together to keep you honest. This group of people can exert peer pressure on those mornings, lunches, or afternoons when you just don't want to exercise.

Fortunately, working out with others is also more fun, as researchers found by studying elite male rowers at Oxford University. The rowers first exercised on a rowing machine in the company of their teammates; the next day, they performed the same workout at the same intensity, but by themselves. After each session, researchers tested the pain tolerance of each of the athletes, finding a higher pain tolerance when the rowers worked out together. The researchers concluded that exercising with others enhances the release of the pain-suppressing (and happiness-inducing) chemicals in your brain.

The evidence is compelling. A modest exercise habit can help keep you sharper into old age, give you more energy to take on the day, and improve your mood. So stop making excuses, find a group of like-minded peers, and start exercising today!

Authors

Robert C. Pozen

Publication: Huffington Post

What’s the Answer for Corporate Taxes?

Robert C. Pozen — Tue, 23 Oct 2012 10:37:00 -0400

President Obama and Governor Romney may have their differences on tax policy, but both candidates agree that the United States needs to cut its corporate tax rate. Including federal, state, and local taxes, corporate profits are currently taxed at 39.1 percent, the highest rate in the industrial world. This high corporate tax rate distorts investment decisions and encourages corporations to relocate overseas.

However, given the federal government's large deficits, any reductions in corporate tax rates should be paid for by broadening the tax base. In February, President Obama released a corporate tax reform framework that endeavored to do just that. Although Governor Romney is less specific, he has suggested a willingness to broaden the corporate tax base to pay for rate reduction.

An Imperfect Solution

Unfortunately, revenue-neutral corporate tax reform will prove very difficult for either candidate. Oft-mentioned tax breaks, such as those favoring hedge fund managers or green energy firms, are simply too small for their repeal to have a substantial effect on tax revenues. And both President Obama and Governor Romney have called for the expansion of other, larger corporate tax breaks, such as the credit for increasing spending on research and development. Thus, if either candidate wants to reduce the corporate tax rate, he will likely have to search for other revenue-raising measures.

One particular reform should get a close look: limiting the deductibility of corporate interest expense. Such a reform could raise a large amount of revenue and would improve economic efficiency by treating different investments more equally. President Obama has suggested this approach be "considered," as has Congressman Dave Camp (R-MI), the Chairman of the House Committee on Ways & Means.

Significant New Revenue

According to the IRS, corporations with net income paid $2.1 trillion in corporate tax between 2000 and 2009 (the most recent years with available data). During this same period, these corporations claimed over $8.5 trillion in gross interest deductions—at a 35 percent tax rate, those deductions were worth almost $3 trillion.

Based on an analysis of data like these, I calculate that the corporate tax rate could have been reduced from 35 to 25 percent from 2000 to 2009, financed solely by disallowing roughly 30 percent of gross interest deductions. In other words, corporations would have been able to deduct nearly 70 percent of their gross interest expense, instead of 100 percent as under current law. The revenue raised from this limitation (at a 25 percent tax rate) would have been roughly equal to the revenue loss resulting from the rate cut.

Of course, this simple estimate misses some key factors. First, interest rates and corporate leverage will likely be lower over the next 10 years than over the past 10 years, reducing the value of interest deductions. Second, such a reform would need to give special treatment to the financial sector, which would face a large burden under this proposal. Nevertheless, this back-of-the-envelope calculation shows that limiting the deductibility of corporate interest expense could play a large role in rate-reducing corporate tax reform.

Reducing the Bias Toward Debt

Disallowing a modest portion of the interest deduction would also improve economic efficiency by reducing the tax code's large bias toward debt-financed investment. Currently, corporations can deduct the returns to a debt-financed investment (interest expense), but not the returns to an equity-financed investment (dividends or stock appreciation). This differential treatment leads some corporate managers to make financing and investment decisions for tax reasons, instead of economics.

Even worse, when a corporation takes on too much debt, it increases its risk of bankruptcy—an event which imposes significant costs on the corporation's employees, customers, and suppliers. Because these costs affect external parties, corporate managers won't be sufficiently motivated to take these costs into account when deciding how much debt to take on. Thus, these managers are likely to choose a level of debt that is too high from the standpoint of society as a whole.

Banks will argue that limits on interest deductions should not apply to them because borrowing money is the "raw material" in the lending process. However, as recent history has demonstrated, the demise of one large bank can trigger a cycle of panic, fire sales, and more bank failures. So, while the financial sector should be given special treatment under this type of reform, it should not be exempted entirely.

In short, the U.S. urgently needs a reduction in the corporate tax rate implemented on a revenue neutral basis. As part of the tax package to achieve this goal, Congress should include some limits on the deductibility of corporate interest expense. Such a limitation would raise enough revenue to allow a substantial reduction in the corporate tax rate, increasing the global competitiveness of the U.S. Such a limit would also reduce the tax bias in favor of debt by decreasing the effective tax rate on equity—without raising the average cost of capital in the U.S.

Authors

Robert C. Pozen

Publication: Yahoo! Finance

Social Media Is a Thorny Issue in the U.S.

Robert C. Pozen — Sun, 21 Oct 2012 05:00:00 -0400

Twitter and Facebook may have become the preferred channel of communication for many individuals and businesses around the world. But within the investment management industry, social media is still an emerging technology.

Ill-fitting regulations are a primary reason for industry’s hesitancy about the new media. We believe that these regulations need to be changed to make it easier for both investors and those working in the industry to keep up with the latest information.

To date, regulators on both sides of the Atlantic have opted to apply existing rules governing advertising and promotion to an investment manager’s use of social media.

These rules generally require that communications with the public paint an accurate picture for potential investors. For the Financial Services Authority in the UK, the catchphrase is “fair, clear and not misleading.”

The broad requirements may be supplemented by more specific guidelines governing the content of advertisements. In the United States, the Securities and Exchange Commission bans the use of testimonials, which the SEC staff has interpreted to be “statement[s] of a client’s experience with, or endorsement of, an investment adviser”.

While the SEC’s testimonial rule may seem simple and logical, many of the most basic social media features can fall afoul of it. For instance, clicking the Like button on a fund manager’s Facebook page can be a deemed a testimonial, as can a comment on a blog post.

As a result, U.S. investment managers can’t be very social in their social media sites. They often do not accept any user-generated content, such as comments on posts. And if they do, they will monitor submissions closely and quickly take down any that could raise eyebrows at the SEC.

And star rating systems, like the one on Amazon? Forget about it! Recent attempts to create systems for providing client feedback on financial advisers have been stalled by regulatory concerns.

In short, it’s hard for investment managers in the United States to use their own social media sites to collect customer feedback. And investors end up the losers, since they can’t tap into the collective experience for guidance.

At the same time, the advertising rules – which apply to everyone who works at a business – have had a chilling effect on the business use of social media by the employees of U.S. investment managers.

Take that pesky Like button again. From a U.S. regulatory perspective, whenever an employee of an investment manager Likes a site, he or she is effectively endorsing it.

It should be no surprise then, that – rather than risk endorsing questionable sites – many fund management companies completely ban the business use of social media by most of their employees.

These bans have had the unfortunate side effect of creating an information blackout for investment industry employees. If employees can’t Like pages, they can’t subscribe to the news stream from those pages, making it much more difficult for them to monitor the industry developments that keep them up to date and better prepared to serve investors.

In our view, the SEC needs to refine its interpretation of the advertising rules to better accommodate social media.

First, the SEC should presume that, barring evidence to the contrary, user-generated content does not constitute a testimonial or endorsement.

Yes, it’s possible for a fraudster to manipulate Likes or comments, and the SEC should continue to be able to pursue enforcement actions when there are indications of malicious intent or collusion with fund promoters.

In the preponderance of cases, however, input from users is not intended to deceive and may even serve to reveal shady practices. This feedback can give potential investors valuable perspectives on the information and services provided by the fund manager.

Second, the SEC should recognise that fund management companies cannot control social media posts as easily as they could control traditional advertising and encourage them to establish internal enforcement programs. An effective program – including employee training – would provide a fund management company with some protection from liability, especially in the case of minor violations.

Regulators across the European Union should develop a uniform approach to fund advertising – perhaps as part of the Ucits regime – to promote the appropriate use of social media by the fund industry. Both investors and industry employees would benefit from a freer flow of information about funds in the social media.

Authors

Robert C. Pozen

Publication: Financial Times

Skimming Your Way to 'Extreme Productivity'

Robert C. Pozen — Mon, 15 Oct 2012 13:23:00 -0400

It's easy to get overwhelmed by a stack of reading materials sitting on your desk. It can take hours to read a long academic paper or a dense government report—hours that you can't spare.

Some professionals address this challenge by trying to read as many words per minute as possible, in the style of Evelyn Wood. But even if you successfully increase your reading speed, you probably aren't digesting much of the material.

So if you want to read faster, you shouldn't try to read more words per minute. Instead, you should read fewer words per minute—those words most relevant to your work.

When I was mentoring a few students in high school, I gave them an exercise to help them read faster. After they read a chapter from their chemistry textbook, I asked them to write out the main points that they would need to remember for their final exam two months later. Then I told them to look back through the chapter and see how quickly they could have read the chapter if they were focused on finding those main points. Before long, they were reading chapters in half the time—and still doing well on their exams.

Here's how to apply this lesson to your professional reading. First, before you even pick up a text, you should ask yourself why you're reading that particular text. Are you trying to understand the main ideas? Are you trying to find one specific fact or detailed example? Are you trying to judge the rigor of the author's argument? Don't start reading until you're satisfied that you know your purpose for reading.

Next, read the introduction (or executive summary). Pay special attention to the "thesis statement" or "theme paragraph." That sentence or paragraph can effectively unlock the structure and ideas of the entire text. After reading the introduction, skip directly to the conclusion. The conclusion tells you where the author is headed. If the introduction poses a question, the conclusion often answers it and provides the key takeaways.

In fact, depending on your reading purpose, the introduction and conclusion may have given you all you need to know. If not, you can move on the body of the text to help you clarify key points or explain confusing concepts.

To quickly read the body of a text, start by taking a look at its structure. Many articles have "roadmap" paragraphs at the end of the introduction, which describe how the article is organized. Most likely, the text has headings that separate the various sections. Pay close attention to the roadmap paragraph and the headings. Ruthlessly skip those sections that don't appear to be relevant to your purpose.

If a section is relevant to your reading purpose, you still don't have to read it word for word. Instead, you should actively skim those sections: read the topic sentence of every paragraph and then decide whether the rest of that paragraph is worth reading.

This decision, of course, will depend on your reading purpose: certain paragraphs are important for finding examples and unimportant for understanding the main points, and vice versa. I usually skip the rest of a paragraph if I can tell that it will just recite the conventional wisdom. I pay close attention to material that appears to challenge the commonly accepted worldview.

Unfortunately, "skimming" often gets a bad rap. Many people think that someone who skims is just being lazy. Sometimes, they're right: if you're just passively moving your eyes across the page, you probably aren't learning anything. But my strategy isn't passive at all: after reading every topic sentence, I actively decide whether the rest of that paragraph is worth the 20-30 seconds of my time that it would take to read it. When reading a long article, that answer, quite often, is "no."

So don't read the full text of every article, paper, or memo that is handed to you. Probably, most of the text won't help you achieve your goals: either you'll already understand some of the material or a large portion of the text will cover a topic only tangential to your work. Instead, decide on your reading purpose, and actively skim the text to satisfy that purpose.

Authors

Robert C. Pozen

Publication: CNBC