Author Archives: Gray Rinehart

Before I forget: Happy Vernal Equinox, everyone!

And now, on to today’s tax topic:

States and municipalities often vie against one another to offer tax breaks to businesses moving into an area, but not so often to new businesses that are too small or too local.

Most new businesses fail within the first couple of years.

Those two situations together form a nice nexus of opportunity, in which new businesses that do not qualify for other tax incentives could be spared the full brunt of corporate taxation when they are most vulnerable.

We could choose whatever phase-in period was appropriate, but for the sake of argument let’s assume a four-year phase-in. In that case, a business’s corporate tax would be multiplied by x/4, where x is the number of years since the business started. The first year’s taxes would be 25% of normal, the next 50%, the third year’s 75%, and only in the fourth year and thereafter would the business have to pay their full tax. By reducing the tax burden on new businesses, it would give them more money to spend on stabilizing their businesses and making them successful.

Other adjustments could be added based on the size of the business, giving bigger breaks in the early years to businesses with more employees, or possibly based on the type of business. For example, a small manufacturer making a product important to national security might operate on a longer adjustment schedule.

How many businesses that would otherwise fail would succeed under this arrangement? We have no way of knowing. And perhaps it would be counter-productive, in that the businesses that would fail anyway might be better off failing sooner rather than later. But small- and medium-sized businesses are vital to the overall stability and health of our economy, so it seems prudent to give them the best possible chance to succeed.

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This proposal may be a nice adjunct to the Business Activity Tax Simplification Act favored by the National Taxpayers’ Union. That act makes it clear that cities, counties, and states may only levy business taxes on companies whose employees or property are actually within their jurisdiction. Read about the act here.

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Let me admit right up front that I don’t know all there is to know about fractional reserve banking. My degrees are in engineering and management, which seem to be less arcane fields than finance and banking.

Here’s what I understand, and my four regular readers or any curious visitors are welcome to correct me: fractional reserve banking allows a bank to hold a certain amount of money on deposit and lend a higher amount — i.e., lend more than they actually have on hand — charging more interest for the loan than they pay on the deposit, on the theory that the depositors will not claim their money all at once (make a “run on the bank”). As long as the depositors play along, they are safe in having the assets on their balance sheet consist mostly of accounts receivable.

Got it? You put a hundred dollars on deposit at the bank, to keep your money “safe” and receive your miniscule interest payment. If the bank is operating on a 10% reserve, they loan out ninety dollars, charging a higher rate of interest and noting the loan as an account receivable: an asset. The bank has $10 on hand, not $100, but your $100 is listed as a deposit and that $90 loan is an account receivable.

That ninety dollars is spent on something and the money is deposited in another bank or even your original bank. Then, on the basis of that ninety dollar deposit, the bank can loan out eighty-one dollars, which they again note as an asset while keeping only 10% in reserve. As banks repeat this process, they “create” money (and wealth); by the time they’re done, your $100 deposit has become close to $1000 in loans. But the banks hold only a fraction of their money on deposit; hence, they operate on a fractional reserve. (You can read more on this Wikipedia page.)

As I see it, part of the economic crisis we’re in — with the subprime mortgages and derivatives and all the other arcane manipulations of money, which (if I recall correctly) James Fallows referred to a long time ago in the Atlantic Monthly as “paper entrepreneurialism” — was started by banks and other lending institutions accepting far more “receivable” assets while holding far fewer assets in reserve. That is, they took excessive risk by exceeding a reasonable ratio of loans to deposits.

(If that doesn’t make any sense, take a look at this fairly long cartoon video that presents an intriguing look at the fractional reserve system and how it contributes to our mounting debt: “Money as Debt.”)

What does this have to do with taxes?

It seems there should be some way to penalize banks and other lending institutions that take excessive risk, and to do so in proportion to the risk they rake. If the “safe” ratio of loans to deposits is 9:1 — arguments could be made that some other ratio is better — then it seems the further they get from that ratio the more they should pay. Originally, I envisioned this penalty as coming in the form of an “excessive risk tax:” the idea being that an institution operating imprudently such that it may fail (leaving its depositors to collect deposit insurance), or that it may come to the government to be “bailed out” of a situation they could have prevented, should pay more into the government to cover that cost.

Unfortunately, that’s not a good idea: it would place a greater financial burden on an institution that is already operating on shaky ground. And I oppose enacting a regulation or law that would mandate any certain fractional reserve limit — risk taking is not the evil that some people, particularly those who want to protect everyone from everything, seem to think it is.

So what I propose is this: as part of a lending institution’s annual tax preparation, they should state how far they are from the “safe” fractional reserve level — and should do so in the clearest possible way, by providing a simple run chart covering at least the most recent ten years, showing the ideal and their distance from it. Those who show a consistent disregard for prudence would thereby be flagged for extra scrutiny of their books. In addition, the institutions should, as part of their adherence to the Federal Truth in Lending statutes and F.D.I.C. requirements, post that chart for all to see so that every consumer can decide if they want to choose a lender — or a bank — based on their stability as well as whatever interest rate they offer.

If the banks had to disclose how much risk they were taking as well as what return they offered, consumers would be able to choose where to put their money. That’s a reform with real benefit to regular people.

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If you haven’t read The Cheating Culture by David Callahan, I recommend it. It’s disturbing, and I don’t think I absorbed all of its implications, but it’s an important book. I bring it up because it catalogued many examples of corporate cheating — cheating their customers, cheating their stockholders, and cheating the government.

Let me say first of all that I believe the U.S. corporate tax rate is too high, and acts as an incentive for companies to move out of the U.S. to friendlier places. Unfortunately, I don’t see any signs of it coming down under the current Administration and current Congress, because the loudest voices in the public sector seem to cry out in favor of punishing private sector success instead of making more success possible. I fear for the long-term effects.

That said, I don’t believe elevated tax rates justify the kinds of corporate cheating that Callahan wrote about. And one of the potential cheating tactics that seems possible to confront is the practice of reporting earnings on tax returns that differ from earnings reported in annual reports to stockholders.

Until the recent economic and financial turmoil, many companies posted profits every quarter even if it took some creative accounting to record those profits. Some of those companies got caught cooking the books, but usually not until they had collapsed or were close to collapse. They got into this habit in order to satisfy public perception and stockholders’ expectations, because no one wanted to mention the Emperor’s nakedness in terms of how unrealistic those expectations were. I understand that some of those companies that reported near-constant growth and profits in their annual reports, however, somehow produced lower earnings or even losses when it came to filing their taxes.

It doesn’t seem right for companies to tell their stockholders something different than they tell the government, especially if they’re telling their stockholders they made a profit in order to boost their share price, and then telling the government they took a loss in order to avoid paying taxes. Some might argue that this practice is only the difference between preliminary and final numbers, i.e., that it’s just a matter of “corrections” — I understand about honest mistakes, but it seems to me that either their accounting is good at the time it’s done, or it’s not good at all. If there are questions, resolve them before you issue the report with your name on it.

How can this influence tax policy? Let companies file their annual report as their tax return. Or, if that puts too much onus on the IRS to figure out any tax liability, let them submit the annual report along with their tax documents and show that the two match. If they don’t agree, or they differ more than some small allowance, assess a penalty based on the difference. (This would be irrespective of the company’s actual performance, and only related to what the company reported.)

In other words, split the difference between the return and the report, since we apparently can’t have complete faith in either one.

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For those who are interested, The Cheating Culture has its own website at http://www.cheatingculture.com/.

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