Financial Literacy

Politicians seeking to achieve a social goal frequently use taxes as one of their tools. This tool is always a double-edged sword causing predictable side-effects that politicians routinely ignore. It is a lesson as old as civilization and quickly forgotten in spite of numerous examples.

My favorite two examples highlight an immediate and sharp behavioral response:

1. U.S. Congress passed a 10% luxury tax on yacht sales in 1991, intending to grab easy money from the very rich. What actually happened? The rich bought their yachts from overseas instead so U.S. yacht sales fell by 56%. This eliminated 125,000 American jobs in the marine industry as yacht manufacturers went bankrupt or shrank. The policy was so disastrous that the luxury tax was repealed only 2.5 years after it was implemented; but it took decades for the industry to rebound.
2. Sweden passed a 0.50% financial transaction tax in 1984 on stocks and bond trades to raise easy money from the wealthy. Trading dropped so quickly that the tax it raised wasn’t enough to fund the government department in charge of tracking the tax. So the government doubled the tax and expanded it to other kinds of trading. What actually happened? Stock and bond trading dropped by 85%, futures trading dropped by 98%, and options trading went to zero. Within a few years the majority of Swedish securities trading had all moved to London. Since trading plummeted, capital gains tax revenue disappeared and brokerage jobs disappeared. But these weren’t sufficient reasons to repeal the tax to the true believers of tax-the-rich. It wasn’t until the market illiquidity forced the government to pay a higher interest rate to sell their bonds that the tax was finally repealed in 1991. But it took nearly two decades for the industry to return from overseas.

So those tax examples were from long ago, what about right now?

• Last year, the City of Philadelphia passed a 1.5 cents/ounce tax on sugary drinks like Coca-Cola, iced tea, Gatorade, fruit punch, energy drinks and some coffee drinks. The city council claimed this would reduce obesity and the $91 million in new tax revenue would be spent on pre-kindergarten programs in poor areas and shore up the city’s budget. What actually happened? Since the tax raised the price of these sugar products by 30-50%, sales have dropped by 32% so far within in the city and skyrocketed outside of the city limits.
• The Los Angeles Chinatown area pleaded with Wal-mart for years to open a store near them. Wal-mart finally opened that store in 2013 where customers could access much cheaper food, prescriptions, and other items to reduce their cost of living. But, Los Angeles passed a new minimum wage starting at $15/hour in 2017 and going higher in 2018. Wal-mart operates on tiny profit margins, so rather than lose money they closed the store the first month the tax went into effect. Not only has the area lost a large employer, but their cost-of-living just went up without a discount merchandiser – leaving Chinatown economically worse off than before the wage hike.
• San Francisco raised their minimum wage 86% above the federal minimum wage, with additional hikes scheduled up to $15/hour by 2018. The actual result? Unlike the rest of the country, San Francisco has seen prices rise by 10% or more on of all kinds of commodities. What about businesses that rely the most on minimum wage employees? A recent Harvard study concluded that while high-end restaurants are unaffected by a small minimum wage hike, average restaurants are 14% more likely to close for every 10% increase in the minimum wage above the federal level.

There is no magic wand that allows a tax increase to have no impact on behavior. Any price increase is met with a reduction in demand and people will begin searching for alternatives or creating substitutes. Many people still believe there is an immunity bubble around wages and jobs, but +100 years of minimum wage experiments around the world has proven that labor is simply another commodity subject to the rules of basic economics as well. So the next time you hear about a politician’s new tax hike, prepare for the predictable consequences that will blind-side some class of unintentional victims.

The U.S. federal government and several states are in horrific financial condition. But I like to keep an eye on Illinois because they are running the fastest toward a financial cliff. Illinois spends more of its annual budget on state-employee pensions than any other (more than 25% of its state budget), and it also has the most underfunded pension (only 37.6% funded). The result is a $130 billion pension shortfall and the state is checkmated into doing nothing about it:

• Illinois cannot raise taxes higher without more residents and businesses fleeing the state
• The Illinois state constitution forbids reducing pension benefits for any reason

I am curious how this will play out because this situation cannot last for long. The state has long been operating without a budget and not paying vendors; so what would happen if the state goes into a recession? However the Illinois financial calamity unfolds, it could become a model for other insolvent government institutions such as Chicago and the state of California.

When the city of Detroit went through bankruptcy two years ago, its $18B debt was reduced to $7B and the pension benefits to city employees were reduced. The pension trustees had to decide if they wanted to accept a slight reduction or risk the possibility of dramatically larger reductions. Public pensions are simply unaffordable, as the state of New Jersey is finding out. Their state credit rating has been reduced 10 times since 2010 because the already sky-high taxes in New Jersey are not enough to cover their pension shortfall. New Jersey recently raised its gasoline tax “for roads,” but some of the money was diverted to its pensions instead. Philadelphia passed a soda tax to fund “children’s programs,” but instead, some of the money was diverted to fund the city’s underfunded pensions. Government pensions seem to slowly consume all tax revenue.

The implication for state employees is sobering – you accepted a job based on a commitment of a pension, but what if that pension payment is cut by a substantial amount or even goes to zero? If your money is in someone else’s hands, particularly the government’s hands, it is at risk. Federal Social Security payments need to be reduced within a decade as well. There are reports on their website pointing this out to anyone who reads it. But instead of taking action, most people ignore it and hope the politicians will be able to solve the insolvable, or at least kick the can down the road.

The most financially prudent people that I know live off of their investment income from either stock dividends or real estate rents. Any pension and social security payments that they receive are just a small financial bonus. This way, they have no stress about potential reductions to pension or social security payments because they don’t rely upon them. This is the opposite for most people: What is the percentage of retirees whose social security payment provides over 50% of their total income?

• 48% of married couples
• 71% of single retirees

My best advice is to save a minimum of 15% of your income for your retirement. This way you’ll have the money to buy an annuity to create your own monthly pension payment, or build an investment portfolio from which you can withdraw from to support yourself when you stop working.

Under the guise of “helping workers without access to 401(k) plans,” the state of California is creating a new retirement plan. This plan is named the California Secure Choice plan, and in my opinion, this retirement plan will harm both workers and taxpayers. Let’s count a few of the predictable problems with this plan:

1. It is run by a board of politicians and they decided to exempt themselves from any financial regulations.
2. Administrative costs are expected to be among the highest-fee retirement accounts.
3. Taxpayers in the state of California are on the hook for the startup costs and any management fees that exceed their 1% cap on fees.
4. The Board of Directors can direct investments into anything they want; opening the door to corruption and kickbacks.
5. If the arbitrary “reserve fund” becomes sizable from profits, the state of California is permitted to steal that money for state spending.
6. The Board can choose whether it wants to make any financial disclosures; this non-transparency can hide conflicts of interest and corruption.
7. The Board doesn’t want workers to withdraw their money toward self-directed accounts, so the account will “impose cost-saving restrictions;” meaning stiff financial penalties on withdrawals.

To sum up some of the bad ideas put into this plan:

Workers’ money will be put into an unregulated prison, managed by pirates with little transparency, charged high annual fees, plus a large exit fee to rescue their money and get it out. Large investment losses will likely be refunded by California taxpayers and any large gains will be arbitrarily stolen from workers accounts and spent by state politicians. Based on California’s chronic mismanagement of their pensions and budgets, I predict this new plan will dramatically under-perform alternative retirement accounts.

Funding retirement savings is extremely important, but this plan is definitely not one of the solutions. Any worker can open a Roth-IRA, a regular IRA, or plenty of other retirement savings vehicles. California, along with other states, want to auto-enroll workers into the poorest location for retirement savings, such as this California Secure Choice or other 401(k)-similar plans. It is my best advice that no one permits a single penny of their money into any state-run plan.

State and municipal pensions for government employees are underfunded across the country. Government payments into pension funds are predominantly based upon the investment return the fund expects to earn. If the fund earns a lot, then required payments into the fund can be much smaller. However, new accounting rules prevent governments from using overly-optimistic investment return forecasts anymore. As a result, real pension liabilities are far higher than many government officials have been claiming to the public.

For example, the pension for the city of Chicago serves 70,000 workers and retirees. Its pension is in a death-spiral because it is only 32% funded when 100% is required. The new accounting rules increased that shortfall to $18.6 billion, an instant 162% increase in unaffordable pension liabilities for the city. The Chicago pension system (4 different plans) is so underfunded that they have to sell 12-15% of their assets each year to pay out retirement benefits. Using the new rules, Chicago’s pension is currently expected to be broke within 10 years, leaving pensioners without the income they were promised and were relying upon.

Can the state of Illinois raise taxes enough to pay for the state pension shortfall? I don’t think so. Can the city of Chicago raise taxes enough to pay for their municipal pension shortfall? I highly doubt it. Although few states and municipalities are in as bad a shape as Chicago and Illinois, a dozen or so aren’t in much better condition.

Once again, the financial lesson is:

• Financially, you are always on your own.
• It is up to you alone to plan and fund your own retirement.
• When a company or government says that they will provide retirements, it is never a promise that you can rely upon.

The reality for anyone opening or operating a business is to evaluate locating it where you get the best sovereignty services. This is referring to how that area is governed by both local and national authorities. Some considerations include:

• Is crime or corruption high or low?
• Which does the government respect more: protecting liberty or its own control?
• Is there a high or low level of excessive regulations?
• Is there a high or low level of government debt and mismanagement?
• And finally, are taxes high or rising, or are they low or falling?

Taxes are a very big consideration when there is a large gap among different sovereign areas. This is because the companies operating in a high-tax locale cannot compete against a similar company that is domiciled in a low-tax locale. The low-taxed company will continually have more money available for: research, product development, marketing, higher salaries and benefits to attract better workers, buying higher quality raw materials, accessing lower loan rates, and many other reasons. Each year this financial gap will continue to benefit the lower-taxed company and punish the higher-taxed company.

In this way, there is an easy allegory for locating your business in a high-taxed country, state, or city; and that is entering a running competition. In this case, you are the only competitor in the race that must drag a 50-pound weight the entire time. What is your chance of ever winning a race with this limitation? Zero. And each day is a new race for business customers so that your company can thrive.

When companies realize that they are competitively hindered from tax disparities, they relocate to survive. There are countless examples of both individuals and companies relocating when a U.S. city or state raises their tax rates. For a long time now the U.S. has the highest corporate-tax rate in the world, 39.1% while the average for industrialized nations is only 25%.

In order to remain globally competitive, companies have been ex-patriating from the U.S. to more favorable tax locales for years. Whenever a high-profile company leaves the U.S., Washington politicians impose more penalties and regulations that prevent additional companies from leaving. Passing a law that imprisons companies is easier to do than the hard work of making your country more competitive with reasonable tax rates. But imprisoning a company is also self-defeating in the long term because the business will choose to expand overseas where it is treated better, and not here.

One of the last ways that a public company can ex-patriate to a country with more favorable treatment is called a “tax inversion.” This is when a U.S. company merges with a foreign company located in a country with lower corporate taxes, and re-incorporates in that country. Several large companies that you may recognize have done this: Burger King, Sara Lee, Fruit of the Loom, Seagate, and Pfizer. The latest big company that used an inversion to flee high taxes is Johnson Controls. They are a $23 billion dollar automotive-manufacturing company and they will save $150 million – each and every year going forward – by moving to Ireland.

Politicians call moving your corporate domicile an “unpatriotic-tax dodge.” But I view these companies as welcomed heroes that are helping to put pressure on lazy politicians to actually get to work and focus them on completing the correct task: To make the U.S. the most attractive location to domicile any business by every quality metric; which includes a reasonable tax structure for both individuals and corporations. Plus, everyone with these inversion stocks in their portfolios (which is likely to be anyone with a pension or stock fund) will receive permanent financial gains.

The U.S. social security system is a trust fund for retirees once they reach an eligible age. Since its inception, the program has been expanded to cover additional people who do not pay in (such as spouses, ex-spouses, children, and others). This expansion of recipients, combined with unfavorable demographics, and the entire program has become financially unsustainable. The Social Security Administration periodically projects when it will become insolvent. Just 25 years ago, the insolvency date was way past 2070. But every 5 or 10 years, this insolvency date is moved earlier than expected with their latest projected insolvency date being as soon as 2029. That is just 13 years from now.

Along with projections of insolvency, there are groups and famous economists claiming the opposite, that social security will never face decline. The only small adjustment that needs to be made is to remove the income cap so high earners will pay social security tax on all of their income, and in addition, reduce the payout to high earners, then the program will be fine. It is my opinion that these optimistic theories are incorrect, they haven’t examined the arithmetic.

In 2010, social security started paying out more in benefits than is was taking in, part of the coming demographic of a surge of retiring Baby-Boomers. The trust’s assets receive interest income, but in 2015, it was no longer enough to cover net payments and the trust had its first reduction in value, $3 billion in 2015. But this loss of value wasn’t expected to occur for several more years. Every projection of insolvency moves closer in time, not further out in time. This is because the Social Security Administration, like all government forecasts, use impossibly unrealistic outlooks of economic growth and employment that never come to pass.

All of the surpluses that social security accrued for decades will be gone by 2029. Unless benefits are reduced by 29%, the only option is to borrow more money or print more money. Neither of these options are sustainable for long periods. The federal government has already begun reducing social security benefits. They do this by artificially reducing the cost-of-living adjustment that is made once a year. The government takes the inflation rate, then removes any item with high inflation, replaces any item with medium inflation, and so only low or no-inflation items remain. One of the reasons that the official inflation data are manipulated is so that there are small annual payment increases for a host of government payments and debts, including anyone on social security.

My best advice is to not be lulled into a false sense of security – that you’ll be receiving your full-expected social security payment. Provide your own retirement funding through saving and investing so that you don’t have to worry about whether social security benefits will be reduced.

When a central bank imposes negative interest rates on the banking system, the theory is that it makes banks more willing to lend money and bank accounts become less desirable as a location for money. A negative interest rate is actually a tax and everyone avoids taxes, if they are able. The central bank hopes that the tax will prompt people to spend money instead of holding or saving it in a bank. While this may occur, it also prompts other activities, unintended consequences, which counter the central bank’s goal of stimulating the economy with new spending.

Just a few unintended consequences that I can think of include:

1. Banks become disintermediated in the economy as people close accounts, use more cash for transactions instead of credit cards, and seek alternatives to bank accounts to store their money. Again, even this is problematic because the U.S. is a $17 trillion economy with only $850 billion in actual paper currency. The financial system is an upside-down pyramid resting on a tiny portion of actual cash, the rest is digital. If everyone went to the bank to withdraw their money, few people could walk away with cash. When this recently happened in Argentina, Greece, Cyprus, and others, people panic and hoard cash. Again, this is the opposite of the intention of negative interest rates. To reduce or eliminate cash transactions today, many countries are also imposing low limits on allowable cash transactions (France €1,000; Spain €2,500; Italy €1,000; Uruguay $5,000; Greece still limits how much cash you can withdraw from a bank; Denmark, Sweden, and Israel want to phase-out cash altogether; U.S. banks report cash transactions over $5,000 to regulators; Chase Bank now prohibits cash in their Safe Deposit Boxes).

2. If the flight from bank accounts grows large enough, then this would erode banks’ capital, forcing them to sell loans to increase their capital reserve balance. This could stress the banking system, similar to how the subprime loan crisis began in 2008.

3. Where will money land that is withdrawn from the banking system? In my opinion, it will likely go to the same place where excess liquidity has gone since 2008: the U.S. stock market, U.S. real estate, and for the wealthy, expensive trophy collectibles. These three are likely in price bubbles already and these bubbles would be exacerbated by negative interest rates.

4. Retirement plans are ruined. When bonds and savings accounts pay closer to 0% instead of 6%, you have to save a whole lot more money to grow your retirement balances up to their target level. So people are forced to save more instead of spend more to spur the economy. When safe and stable investments pay next to nothing, it also forces everyone to become a speculator in order to earn any return on their money. Speculating is a difficult business for professionals, let alone amateurs. I predict that mass speculation is unlikely to turn out well for retirement account balances.

5. Aside from the U.S. dollar, the world’s reserve currency, many currencies have been debased by various forms of quantitative easing. These currencies become more impaired the more negative that interest rates become. There is a risk that the U.S. dollar will also become an impaired currency as well; as printing money and borrowing more money has been unable to stimulate its weak economy since 2008.

6. Negative interest rates are also likely to create two other inversions. First, the interest-rate yield curve, which normally slopes upward further out in time, may flatten or invert so investors will avoid long-term bonds. The second is commodity contango, referring to the spot price is normally lower than the futures price and this may flip into backwardation, where the futures price is abnormally lower than the spot price. This could create many usual effects, one of which is that commodity ETF’s would likely have automatic losses and move down even though the spot price of their commodity hasn’t moved.

Today, around 20% of the world’s economies have negative interest rates. Canada and other countries in economic struggle are considering joining them. The U.S. has held interest rates near zero for 8 years to jump-start its economy, but that has not worked. So it is likely that negative interest rates could be tried in the U.S. as well. As proof, the Federal Reserve’s latest stress test guidelines in January 2016 included for the first time: negative yields on short-term U.S. Treasuries.

If negative interest rates are introduced by the U.S. Federal Reserve, then my best advice is to consider:

• Holding a few months of expenses worth of cash outside of the banking system. It is better to be early and prepared than late on a short-term run on cash.
• Be nimble with stock market and real estate investments. While these assets will move up in price initially, be ready to exit or at least hedge if they begin a sustained fall.
• If financial assets get into trouble simultaneously (the U.S. dollar, stocks, and bonds), then consider placing some money into hard assets such as precious metals to offset the decline in paper assets.

A normal interest rate is a percentage paid and received on a loan. The borrower pays the interest and the lender receives the interest. This type of transaction goes back thousands of years. In today’s financial landscape, something different is occurring, called negative interest rates. This is when the lender is charged a percentage for the privilege of loaning money to a borrower who received the interest. It sounds crazy but this is what happens when central planners believe they know better than free markets and manipulate economies by decree. Negative interest rates do not occur naturally, they can only be imposed by force from governments that are desperate to avoid deflation in a weakening economy. Today, there are many weakening economies around the world.

The purpose of negative interest rates is an attempt to force companies and individuals to spend money to artificially jump-start economic activity. When you are charged a fee to have money in your checking account then you are going to be more likely to spend it rather than have the bank take it from you bit-by-bit. The general process starts with central banks charging commercial banks to prompt them to lend more money. These banks may or may not pass negative interest rates to business clients and private individuals. However, the longer or more negative the rates become, then the more likely banks pass those negative interest rates on to businesses and individuals.

Which countries are enacting negative interest rates?

1. The Central Bank of Japan just announced negative interest rates. This is on top of buying much of the debt that the Japanese government is issuing.

2. The European Central Bank has had negative interest rates since 2014 and made interest rates to commercial banks more negative, from -0.2% to -0.3%.

3. The Netherlands is upside-down where some banks are paying mortgage holders (who have floating rates) instead of charging those mortgage holders.

4. The central banks of Denmark, Sweden and Switzerland all have negative interest rates as well. One small Swiss bank found that the central bank’s negative interest rates subsumed all of its profit, so it now charges every account at its bank a fee of -0.125%.

One problem with artificially low and negative interest rates is that it causes mal-investment, or asset price bubbles that will pop – instead of sustainable economic activity. Another problem is that businesses and individuals will avoid banks that are chewing up their money with negative interest-rate fees and hoard cash. This is the opposite of what the central banks want – hoarding cash instead of spending money. But don’t you worry, Keynesian economists are forever coming up with additional interventions to take money from the populous to transfer to the government. For example, Miles Kimball, an economist at the University of Michigan who has been a strong proponent of negative interest rates has an idea. To help central banks around the cash hoarding problem, Kimball thinks they should charge a rate between paper bills and electronic money to incentivize people to stay in electronic money. In my opinion, this would exacerbate the cash hoarding problem and the economy would move away from banks to both cash and cryptocurrencies such as bitcoin.

400,000 Teamsters Union members, who are already retired, just discovered that their pension payments may be reduced by 65%. The pension fund, managed by the union and employers, is heading toward insolvency within 10 years. Aside from corruption and mis-management, since 2008, so many small businesses went bankrupt that it left a growing number of employees being supported by a shrinking number of employers (exactly like federal social security). Teamsters members are going to be voting soon on these pay cuts and they are afraid that if they do not accept the reductions, then they will receive zero payments instead.

The state of Illinois has been unable to pass a budget that was due four months ago. Since then, the state has been financially loping along with consent decrees. One of the many ways the state has chosen to free up money is simply not to pay lottery winners. Today, any Illinois lottery winner owed over $600 is given an IOU from the state. Illinois State Lottery tickets are still being advertised and sold, which would be consumer fraud and a prison sentence if any company did this. The amount that the state has withheld from winners is now over $288 million. Lottery winners have formed a class-action lawsuit to sue the state for payments plus interest.

The U.S. federal government brought in a record $3.3 trillion in taxes for the 2015 fiscal year. But that tax haul still wasn’t enough money, there was still an accounting deficit of $439 billion, although the lowest in 8 years. However, this is with an artificially low interest rate engineered by the Federal Reserve. If interest rates were anywhere near normal, the federal deficit would have been about $600 billion higher. Let me state this another way, with normal interest rates, the federal government will be spending one-quarter of all taxes they collect just to pay for the interest on the national debt. This is not a sustainable financial structure.

Whether it is a household, a business, or public institution, financial illiteracy results in a physical calamity, sooner or later.

Brazil, along with other mismanaged economies, has a currency that has been on a sharp, continual devaluation for decades. Once the currency falls near worthlessness, the Brazilian government issues a brand new currency with a different name and the same thing happens again, and again. When you have a chronically-failing currency like this, it is very expensive for the government to sell bonds because investors demand a very high interest rate to offset the falling currency. Rather than do the work to fix the economy and support the currency, the Brazilian government made a classic financial illiteracy mistake: mismatching assets and liabilities.

A year doesn’t pass by without a catastrophic currency mismatch making the news. What happens is someone borrows money in a foreign currency or makes an investment in a foreign currency, and then that currency moves the wrong way and they are financially-wiped out. This happens to individuals, companies, and governments, again and again. People take on an unhedged currency risk, for a relatively small financial gain, and think they will be the sole genius to avoid being crushed by an unfavorable currency move. (You can hedge currency risk, but it is not free, always accurate, and cannot be done for more than a year or two in the future).

Brazil issued their bonds denominated in U.S. dollars instead of their home currency. But in the last year, the Brazilian currency has plummeted by 39%, making the bond payments in dollars increasingly unaffordable. Investors are watching Brazil taking in tax revenue in a weakening currency but making debt payments in a strengthening currency. As a result, Brazilian bonds have been falling so low (yielding over 14%), that they are effectively predicting that these bonds will default. All because of financial illiteracy, a predictable and painful financial outcome for all who are involved, particularly the Brazilian residents.

If Brazil were to ask me, I’d advise them to default immediately so they don’t further deplete their current account and money that is needed to run the government during their current recession. The sooner they face reality, the sooner bond investors and Brazil can act appropriately and restructure these bonds to something affordable and sustainable.