There are two contradictory forces and one inefficiency at work when income tax rates are changed:

• First, there is the familiar Laffer Curve effect which effectively says as you increase taxes on labor people substitute untaxed leisure.  I.e. you get less of what you tax.  That is fairly uncontroversial as a theoretical construct, but there is little agreement on how large the effect is.  It can be called the substitution effect.
• Second, there is a countervailing effect called the income effect.  If people need a certain amount of money to live then arguably raising tax rates (thus reducing their consumable income) could lead them to work more to get the same amount of money.
• Third, the inefficiency is that at high rates people may do economically inefficient things to avoid the taxes (hold on to things to avoid capital gains taxes, use non-qualified deferred comp, put more in retirement plans than they would otherwise, set up a C corp. and retain the earnings in that entity, etc.) those are considered inefficient because it isn’t what people would choose to do absent the high taxes so there is a reduction in utility.

All of these effects will hit different people and items differently.  Here are a few of the main ones:

• Low-income workers – the income effect will probably dominate so raising taxes on the relatively poor or lower middle class is a very good way to raise revenue (I am not necessarily recommending it, I’m just sayin’…).  They can’t afford to work less, and have few options for avoiding the tax aside from taking cash jobs off-the-books.
• High-income workers – in theory the substitution effect should dominate, but it doesn’t appear to (with one exception I’ll get to next).  That may simply be that we haven’t had rates high enough to trigger it.  The rates necessary to make raising taxes unproductive (Laffer Curve maximum) might be as high as 60-70% though you still would create drag on the economy even below those rates.  In other words, if taxes are raised 10% and that causes a 5% reduction in hours worked for the group, tax revenue is increased but GDP will be lower so the economy isn’t doing as well overall.  High-income workers also have more flexibility to take income as perks or in different forms, delay recognition, move out of the country, etc. so the third item (inefficiency) from above is important here as well.
• High-income worker married to a low-income worker – the data does show that the lower paid spouse does tend to opt out of the paid labor force with higher taxes.  For example, a lower income spouse might stay home at higher rates.  That is bad for tax receipts, but also bad for lower-income workers if in staying home tasks are no longer outsourced.  In other words, he or she might cook more rather than the family eating out, clean more rather than hire a maid, mow the lawn more rather than hire a lawn service, wash and iron clothes more reducing the need for dry-cleaning services, and watch the kids more reducing the need for daycare.  Thus, by raising taxes on “the rich” it could reduce government revenue while simultaneously reducing the income of waitresses, cooks, maids, gardeners, drycleaners, childcare workers, etc. – none of whom are likely to be “rich.” For example, suppose the marginal tax rate on our taxpayer was 50% but it is raised to some higher amount while these other lower-income workers are in the 25% bracket the entire time.  The lower-paid spouse did make $40,000 which after tax was $20,000 which was all spent paying for these additional services.  The government got $20,000  plus $5,000 from the other folks.  By staying home and doing all these things “in house,” spendable income (on other things) is exactly the same – there is no loss of standard of living (though of course the stay-at-home spouse may disagree) – but the government is out $25,000, and low paid workers out $15,000.
• Recognition of capital gains taxes is frequently very discretionary and thus even modest increases in this rate probably triggers more of a Laffer Curve effect.  It is hard to see how there would be any income effect at all.

So what is the conclusion?  Assuming Congress is rational (so already this is silly conjecture) there should be a trend to:

• Raising taxes on lower incomes.
• Keep capital gains taxes low (and though I didn’t touch on it here, dividends as well because an unpaid dividend becomes a capital gain eventually, and we don’t need further incentives for debt in the capital structure of companies).
• Change the code to treat each person individually rather than as a household (i.e. you may be married, but each spouse still files an individual return).  This has the advantage of not treating unmarried couples differently and allows the lower-income spouse to have a low marginal rate and thus stay in the workforce.
• Raise taxes on higher incomes modestly.  There is probably room before the Laffer Curve maxes out – particularly if the previous bullet is implemented.

I read Different a few years ago and highly recommend it.  I thought about our business and how we are different from “wirehouse brokers” (i.e. large firms), and I made this list:

• We have no idea what the Dow did today, nor do we think it is important.
• We are bad at sales and good at expertise.
• We don’t have any proprietary products, principal transactions, commissions, sales contests, etc.
• We will give tax advice.
• We don’t call clients for permission to make a change in their accounts just to avoid fiduciary liability.
• We know what we don’t know – as far as I know. 🙂
• We don’t segment clients into gold, silver, lead categories and give different levels of service accordingly.  Every client we accept is a platinum client.
• We don’t “cross sell” mortgages, insurance, etc.
• We won’t sell clients what they want if we don’t think it is prudent.
• We aren’t pushing the “hot” product just because it has a great story (IPOs, growth stocks, commodities, gold, hedge funds, other alternative investments).
• We won’t let clients draw too much from their portfolios even though it will make them happy now (because they will be unhappy decades from now).
• We want to know the client’s entire financial situation and won’t take them as a client otherwise.
• We  won’t buy and sell in client portfolios just to look like we are doing something.
• We won’t provide clients our quarterly performance compared to a benchmark – it isn’t relevant.
• We are expensive for small clients and cheap for large ones.
• We frequently aren’t in the office, and when we are we aren’t watching CNBC or quote screens.
• We make our own decisions.
• We don’t have Class A office space (or expenses).
• We ignore “hot” managers and great track records.
• We don’t sell individual securities.
• We pay attention to taxes and costs.
• We won’t be going golfing with clients (but lunch is great!)
• We have clients all over the country rather than just near our office.

In the tax code owning your own home is favorable because you don’t show the rent you are really paying yourself.  Economists call it imputed rental income.  Essentially, you are on the one hand a landlord and on the other the tenant but you don’t report the income but you do take (some of) the expenses (interest deduction, property tax deduction, etc.)  On the other hand, when you own a rental you not only get the interest deduction and the property tax deduction, you also get depreciation expense, maintenance expenses, etc. and you get all of these above the line.  But on the third hand (?) you also report the rental income above the line, have to recapture the depreciation upon sale (maximum 25% rate) and don’t get the $500k (or $250k if single) section 121 exclusion when you sell.

Proposals are made periodically to eliminate the home mortgage interest deduction.  If that happened, I thought it might make sense for two people to each buy a house as a rental and rent to each other thus being able to get the interest deduction and foil the change to the code.  As is my wont, I dramatically overbuilt a spreadsheet model and have included most everything you can imagine.  It shows the difference between buying a home and buying a home and renting the same home to yourself.  (Which you could essentially do with the swap situation I mentioned.)

I actually think the mortgage interest deduction should be eliminated.  As a deduction it helps higher income people more (and those who make so little and spend so little they don’t even itemize not at all), and it is on up to two homes.  We are subsidizing second home ownership in the tax code?  On up to $1,000,000 (and another $100,000 if the taxpayer isn’t in AMT) of mortgage?  But only if you use leverage?  This seems like the opposite of a good idea.

As I usually do, all the yellow cells are the inputs.  The outputs are the IRRs for the Owner vs. the Landlord.  Interesting spreadsheet, I think.

There are three issues with deciding when to exercise the options:

• Taxes – obviously they should be minimized.
• Risk – given that most folks already have extensive exposure to their employers (through their human capital if nothing else) options should frequently be exercised quickly.
• Return – since the value of an option is comprised of both intrinsic value and time value, and the expirations of these options are frequently very long term, exercising early extinguishes all of the time value.

Let me dilate on that last point.  For a call option, the Black-Scholes option pricing model determines the value by looking at (among other things) the time until expiration and the volatility of the underlying security.  For a volatile stock with a long dated option, the time value can be significant.  The only time a call option should be exercised prior to maturity (to maximize return) is if it is deep in-the-money (little leverage vs. owning it outright) and the stock pays a dividend (which you don’t get on the option).  In that case, the optimal time to exercise would be immediately prior to the ex-dividend date.

To quantify this see this spreadsheet calculator I built.  For example, suppose an employee has just been issued an at-the-money option on a stock that pays no dividend.  The option has 10 years until expiration (he or she likely wouldn’t be vested in that yet of course).  Suppose the risk-free rate is 2% and the volatility of the underlying stock is 20%.  The value of the option as most people think of it is zero – it is at-the-money not in-the-money – but the actual value is about 33% of the value of owning the stock outright.  Suppose five years go by, and the stock is up 50%.  Most folks would be inclined to exercise, but the option is worth about 26% more than just the intrinsic value!  Exercising loses all of that 26%. Of course, the return considerations I mentioned are frequently trumped by the risk issues and influenced by the tax issues.  All three factors are important.

While inflation is currently quiescent, there is a great deal of concern that it may reappear with a vengeance in the future.  Currently the spread between nominal (“regular”) treasuries and TIPs (Treasury Inflation Protected Securities) indicates very moderate inflation expectations, but of course the situation could change.  Following are some of the main ways to hedge inflation risk.

Stocks.  As a claim on non-financial assets (land, equipment, brand name, etc.) stocks should maintain their purchasing power despite inflation.  Since companies are net debtors, they should even benefit from inflation.  Research indicates that people don’t analyze financial statements correctly in inflationary environments, and companies aren’t fully valued in that situation (i.e, they tend to discount real returns at nominal rates).  Of course, the mispricing should correct in the long run. “Common knowledge” regards inflation as bad for stocks, but it is probably the economic or political uncertainty rather than the inflation itself that is the issue.

International Investments.  U.S. inflation may be hedged by holding financial assets denominated in other currencies such as foreign stocks and bonds and not hedging the currency risk.

Fixed Income.  There are two ways to hedge, or at least mitigate, inflation ravaging a fixed-income portfolio.  First, hold TIPs rather than nominal bonds.  To the extent inflation manifests in the prices of consumer goods (rather than creating a bubble in some other asset), the bond-holder is fully hedged.  Second, in nominal bonds keep the duration (roughly the same as the maturity) relatively short.

Alternative Investments.  Equity REITs (Real Estate Investment Trusts) can be a good inflation hedge assuming the mortgages are less flexible (longer term and more fixed rates) than the rental agreements, which should normally be the case.  In addition, commodities in general should hedge inflation to some extent.  The historical change in commodities prices (spot prices, not futures) is slightly under the rate of inflation because technological developments mean constant improvement in our ability to grow, extract, refine, etc. commodities.

Real Estate.  For most people, their home is their largest investment.  Because purchasing a home can be considered pre-paying rent with today’s dollars, this is also an inflation hedge.  Alternatively, a home financed with a long-term fixed-rate mortgage is an outstanding inflation hedge as well since future payments will be made with cheaper dollars.