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.

In my previous post, I gave an overview of what an optimal tax code would look like in theory.  Following are my thoughts on the current tax code and how it might be improved specifically.  I’m sure few people will agree with all my thoughts, but hopefully it will spur some thinking.  Here are my not so modest proposals for reform of the tax code:

1. Mortgage interest deductions should be eliminated. The current system of allowing mortgage interest to be deducted is confused for three reasons: 1) why should the government favor buying over renting?  This simply makes no sense, especially since renting is more advantageous for lower income people.  2) Since the mortgage interest is a deduction, the subsidy is greater for high income people.  Indeed, the subsidy is non-existent for people who don’t itemize (largely the poor, again).  3) The deduction is only available for those who incur debt.  Again, the tax code irrationally encourages leverage.  (Not to mention the ridiculous subsidization of second home ownership under the current tax code!)

2. Taxes on expatriates should be simplified. The U.S. is the only developed country that taxes its citizens on worldwide income even if they are not residing in the U.S.  This is done through a complicated system that forces people to plan so they don’t spend “too many” days in the U.S. in a particular year.  This should be replaced with a simple calculation:  (worldwide income for the year) x (# of days in the U.S. or its territories during the year) / 365 = U.S. taxable income.

3. All taxes should be paid directly by each individual so that each person is aware of his true tax burden. Tariffs, Value Added Taxes (VAT), corporate taxes, etc. all obfuscate the actual burden of the tax.  For example, when a corporation is taxed, there are only three possible sources for those funds:  a stockholder receives lower dividends, an employee receives lower wages, or a consumer pays higher prices.  Further, the current code encourages debt by making it tax deductible to corporations when dividends are not.  Eliminating corporate taxes removes this disparity in treatment.  A realistic change would be to tax all corporations like REITs.

4. Personal exemptions should be eliminated. Additional people are a drain on government resources and shouldn’t be subsidized.  Family size isn’t a proper area of concern for Congress to attempt to influence through the tax code, and child tax and adoption credits should be eliminated as well.  It is unfair to force the childless to subsidize those who choose to have children.

5. Deductions for state and local taxes (sales taxes, income taxes, property taxes, etc.) should be eliminated. Allowing deductions for these taxes effectively shifts those taxes to taxpayers in other (more frugal) states.

6. Social Security taxes should be eliminated. This would remove the fiction that people somehow have a pension in Social Security.  In reality, Social Security is a socially acceptable welfare system in which money is taken from people who are working and given to people who aren’t working.  Folding it into the regular tax system would clarify that.  To alleviate the concern that people would be unprepared for retirement, they could be required to save a certain portion of their income in a designated account and those accounts could be restricted to investing in treasury bonds.  This has the added advantage of funding the transition from traditional Social Security if older participants are kept in the old system.

7. Medicare taxes should be eliminated. Taxing earned income to fund Medicare gives those with unearned income a free ride and again complicates the tax code.  In addition, the “sharing” of Medicare (and Social Security) taxes with the employer leads to concealing the true cost.

8. Deductions, in general, should be eliminated in favor of tax credits. If a person in a 40% bracket wants to donate (net) $300 to what he considers a worthy cause, the charity can get $500.  (The individual donates $500 and gets 40% or $200 back on his taxes).  If a person in a 20% bracket wants to donate $300 (again net) to a charity, the charity would get $375.  (The individual donates $375 and gets 20% or $75 back on his taxes.)  Why should higher income individuals’ charitable choices get a larger subsidy than lower income individuals’ choices?  This holds true for other deductions as well.  Assuming the taxpayer has high enough medical expenses to claim them at all, each additional dollar of expense is more subsidized by the tax code for high income (tax bracket) people than it is for lower income (and tax bracket) people.

9. Almost everyone should have “skin in the game” and be paying something in taxes. Allowing approximately half the population to avoid all income taxes (though not FICA taxes) and yet still vote will eventually cause societal breakdown.  (As Frederic Bastiat said, “Government is the great fiction through which everybody endeavors to live at the expense of everybody else.”  Also Margaret Thatcher observed, “… eventually you run out of other people’s money.” )

10. Graduated tax rates cause inequities, and should be eliminated. Absent a flat tax or taxation of individuals instead of families, there is no way to arrange the tax code to not penalize some group for decisions about marriage.

11. Capital gains taxes at different rates from ordinary income cause gaming of the system and should be eliminated. A business owner can do three things with profit: 1) take it out in salary, 2) take it out in dividends, or 3) allow it to increase the value of the company and sell it later taking the profits out as a capital gain.  Having disparate tax treatments for those three items leads to incentives to structure things in different ways which, in turn, leads the IRS to try to combat that restructuring giving rise to costs and tax disputes.  Having the same rates for everything removes the incentives completely.  It then doesn’t matter how the individual is paid.  (This is another reason to remove the payroll taxes as mentioned above.)

12. Estate taxes should be eliminated, however recipients of large gifts or inheritances should have to include them on their income tax returns as ordinary taxable income if it is not a capital asset and have a basis set to zero if it is.

So, in keeping with the principles above, here is how the tax code might be overhauled.  It has the advantages of being simple, fair, transparent, etc.  Since this is more of a thought experiment than an actual proposal the percentages given below are what seem roughly appropriate to me.

1. Taxpayers (people, not entities) are taxed on “all income from whatever source derived” on a cash basis. (This is the definition we have now, but we have an enormous number of exceptions and special cases.)  In addition, there should be 100% expensing for capital investments and no limit on recognizing capital losses (which also may be carried forward if necessary).

2. Taxes are assessed on that net income at a flat 20% rate.

3. Non-refundable credits against that tax are given for a very few items:
   1. 50% credit for medical expenses paid (for anyone). This gets the government out of the healthcare business while helping those with legitimate needs.  This seems reasonable if we consider Rawl’s “veil of ignorance” approach (i.e. you don’t know whether you will be the unfortunate one with high medical expenses).
   2. 50% credit for charitable contributions made. This is to enable private charities to supplant the government assistance that exists now.  Charity would become directed by private individuals to what they perceive to be the real needs.
   3. 20% credit for education expenses paid (for anyone at any level). Education has societal benefits that “spill over” and is thus an externality that should be subsidized.  (A 20% credit combined with a flat tax rate of 20% is mathematically equivalent to education expenses being 100% deductible.)
   4. 20% credit for savings in accounts for retirement. However, these would be fully taxed upon withdrawal (essentially like the IRAs of today).  These accounts could also be used for medical expenses or education expenses, but those expenses would not get the additional credit mentioned above.

4. Unused credits may be carried back 5 years and forward indefinitely.

That’s it.  Simple and straightforward.  The definitions of medical expenses, charitable contributions, educational expenses, etc. would be the same as they are currently.  Many families at lower income levels still wouldn’t pay taxes and no one would pay more than 20%.  Education, healthcare, charity, and retirement savings are all privatized enabling the government to easily fulfill its proper functions with the remaining revenue.