Tax Credits Sound Good, But …
A Wedge Between Work and Reward
Not Sexy But Still Attractive
First off, congratulations to the Pittsburgh Steelers on winning Super Bowl XLIII. I was just glad it was a good game; near the end of the third quarter it looked like Pittsburgh would run away with it. I love the NFL and all the fun times I spend with friends and family watching the games, and am always sad to see the offseason come. But it was a great season, and I can’t wait for free agency and draft talk to get going.
Now, time for a rant.
I rarely ever delve into the murky, stinky waters of politics in my Cabot Wealth Advisories, and really, I’m not going to start now. If you’ve listened to the news, you probably know about the good and bad of the $800 billion (and growing) stimulus package that will soon be taken up in the Senate. I’m actually optimistic that the Senate–the chamber where swiftly passed bills in the House come under closer scrutiny–will be able to pass a workable, bi-partisan bill. Let’s keep our fingers crossed.
However, my rant today is based on policies that have been adopted by Democrats, Republicans and Independents alike. I’m talking about the various tax credits currently in the tax code, and the income thresholds that apply to them. Some aspects of the current stimulus bill include these thresholds.
For instance, if you have one child, you can chop your Federal tax bill by a whopping $1,000 per year. I certainly don’t have a problem with that! What I do take issue with is that the credit phases out if your adjusted gross income (think income, less 401(k) or health care deductions, plus capital gains) tops $110,000 for a couple or $75,000 for a single parent.
Then we have President Obama’s “Making Work Pay” tax credit, which is part of this stimulus bill. If you have a job and you’re married, you and your spouse will get $1,000 back on your taxes … assuming your income is under $150,000. Anything above that, and it begins to phase out.
There’s also a home buying tax credit being bandied about to help boost housing demand. Basically, if you’re buying a primary residence before July 1 and haven’t bought a house in a few years, you might be able to get a $7,500 credit on your taxes … if your income (for married couples) is below $150,000.
There are other examples, but you get the hint. All of the credits sound great. But the income limitations are creating some bad incentives.
So what’s wrong with these income thresholds, you ask? Why should a couple making $300,000 or $500,000 or $1,000,000 a year get to claim a child tax credit, or get a bunch of money if they buy a new home? It’s a good question, which I hope to explain here.
Socially, I agree that “the rich” don’t need most of these tax breaks. The last thing I want to see is some scumbucket (I love that term–it is one of my Dad’s favorites) officer from Merrill Lynch or Citigroup get an extra few thousand bucks after paying themselves a few million in bonuses … after their company went up in flames. Despicable.
But economically, these income thresholds create more than a few problems. First, as my beautiful wife repeatedly points out, income levels vary widely by region. If you make $200,000 in, say, North Carolina, it’s different than if you make $200,000 in New York City. (My wife works in the employee relations side of the HR field.) Yes, I realize you get paid more in New York City, but the cost of living–from food to transportation to parking and housing–is a different ballgame totally. So the income limitations are pretty arbitrary.
Another problem is the incentive effect. I’m no tax accountant (thank heavens!), but let’s examine a hypothetical couple living the white-picket-fence style of the American dream–married, good job, two kids, living in suburbia around Boston … you get the picture. Let’s say the couple is cranking out a solid $100,000 per year.
However, now let’s say an opportunity arises for the couple to take a chance, and move to a different, riskier company (or start-up their own operation) that could pay them, say, $175,000. That’s a pretty good bump! But how much of that increase would they actually keep?
Right off the bat, you know that 25% to 28% of any extra earnings goes to the Feds. Probably another 5% or so is going to state taxes. And some of that income bump will likely get paid into FICA (Social Security and Medicare). So right then and there, you’re probably talking about a 35% marginal tax rate–for every extra dollar earned, the couple is only keeping 65 cents.
Then you have to throw in the various tax credits. For instance, with two kids, this couple was keeping $2,000 a year that it would normally pay in taxes. If they take the new job and earn more money, that credit would likely disappear entirely. (Again, I’m not a tax expert, and I don’t know all the exact phase out schedules–but I think that’s right.) And remember, that’s $2,000 out of this couple’s pocket … probably the equivalent to $3,000 or more of pre-tax income.
The couple also wouldn’t get the $1,000 (or the full $1,000) from the “Making Work Pay” rebate (again, that’s out of pocket), and if they were planning on buying a new house, you can forget about the potential $7,500 tax credit for that.
That doesn’t even get into potential income thresholds for capital gains and dividends, which may be raised in a couple of years for those above a certain income limit. (The rate could go back to 20% or more, compared to 15% today.) And let’s not forget about certain education-related tax credits for the kids, which again, could phase out above a certain income level.
All told, of the extra $75,000 the couple will get paid, they might only keep half that or less. That’s a huge “wedge” between risk-taking and reward. (By risk taking, I’m not talking about crazy hedge funds leveraging themselves 100-to-1; I’m talking about an entrepreneur starting a new company with a new product.) And the bigger that wedge, the less risk-taking the economy will have, and the less growth we will have.
Incidentally, that is why capital gains and dividend tax rates are probably the most important for economic growth–both are direct taxes on innovation and risk taking, so when they’re hiked, you get less funding from venture capital firms and wealthy individuals for new, exciting enterprises … which means a smaller chance of launching the next Google or First Solar or Amazon.com or whatever.
But back to my larger point, the U.S. tax system is basically creating an incentive to earn up to $100,000 to $150,000 per year … but then the wedge appears in force. Above those levels, and it pays much less (read: the effective marginal tax rate is onerous) to work harder and take chances. I find it admirable that many less fortunate workers are able to get some tax breaks, but it would be far better to get rid of these credits and just lower the income tax rates directly for those folks.
Again, I’m not saying that $150,000 is pocket change, or that we should be handing out checks to the wealthiest Americans. My point is that this big wedge is hurting the economy by discouraging risk-taking by those who actually have the capital (extra money) to take the chances. There are better ways to help those in need, while keeping rewards in place for people to take chances.
Tell us what you think about tax credits on our blog, http://www.iconoclast-investor.com. We’ll publish some of the best comments here.
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With that out of the way, let’s get to the market. Though last month was the worst January on record, not much has changed in terms of the market’s overall stance–the bulls are not in control, but the selling pressures, while gradually picking up, are not anywhere as intense as they were most of last fall. So a potential bottom-building process continues.
And much of the market’s potential leadership remains the same–education, biotech and now some precious metal stocks are hanging in there well. But instead of harping on another stock from one of those groups, I thought I’d mention a slow, steady grower that’s been acting superbly in recent weeks … and is sitting at a great entry point.
It’s Dollar Tree (DLTR), the discount retailer, which sells a variety of common goods (beauty care, home goods, etc.) for a buck. Here’s what I wrote about the company in Cabot Top Ten Report back on December 1:
“Discount retail remains in favor and Dollar Tree is one of the leaders in the group, making its second appearance in Cabot Top Ten Report in the past month. The company operates 3,500 deep-discount stores across the country, selling a bunch of basic consumables (beauty products, candy, decorations, toys and so on) for about a buck each. The overall story might not be sexy, but it’s simple: Consumers, even those with money to spare, are cutting back, with many going to discount locations to pick up necessary items. Dollar Tree’s earnings report last week confirms that trend–revenues rose a solid 12%, while earnings advanced 24%, ahead of estimates and miles ahead of its general retail peers. That pushed the stock toward new-high ground, and led to estimate hikes across the board. It’s not going to be a big winner, but it should do well in this environment.”
Since then the stock has crept higher, but generally has remained in very tight trading range. I like that the stock popped higher on great volume in mid-January after a fellow discount retailer reported a great quarter. Now the stock is prepping for a breakout–I think you could buy half your normal position here, keep a tight stop-loss just under 41, and possibly look to average up on a powerful move above 44.
Just be aware that earnings are due out February 25, so if you’re still holding it at that point, and don’t have a profit cushion, you might trim ahead of the report–no use taking a big risk in this environment. For now, the set-up looks terrific, so if you’re game, pick up a few shares.
All the best,
For Cabot Wealth Advisory
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