Fundamental tax reform appears probable soon so I thought it would be worthwhile to share some thoughts on it.  Ideally, taxes should exist solely to raise revenue to fund appropriate functions of government.  When the code is used to reward or penalize particular behavior or groups, it becomes the tangled mess we have today.  I am sure others, much smarter than I, have come up with approaches to how the code should be structured, but I have been thinking about this and thought you might find my thoughts useful.

Adam Smith in the Wealth of Nations gave four principles for taxation (emphasis mine):

1. The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person. Where it is otherwise, every person subject to the tax is put more or less in the power of the tax-gathered, who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some present or perquisite to himself. The uncertainty of taxation encourages the insolence and favours the corruption of an order of men who are naturally unpopular, even where they are neither insolent nor corrupt. The certainty of what each individual ought to pay is, in taxation, a matter of so great importance that a very considerable degree of inequality, it appears, I believe, from the experience of all nations, is not near so great an evil as a very small degree of uncertainty.

2. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state. The expense of government to the individuals of a great nation is like the expense of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. In the observation or neglect of this maxim consists what is called the equality or inequality of taxation. Every tax, it must be observed once for all, which falls finally upon one only of the three sorts of revenue above mentioned, is necessarily unequal in so far as it does not affect the other two. In the following examination of different taxes I shall seldom take much further notice of this sort of inequality, but shall, in most cases, confine my observations to that inequality which is occasioned by a particular tax falling unequally even upon that particular sort of private revenue which is affected by it.

3. Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it. A tax upon the rent of land or of houses, payable at the same term at which such rents are usually paid, is levied at the time when it is most likely to be convenient for the contributor to pay; or, when he is most likely to have wherewithal to pay. Taxes upon such consumable goods as are articles of luxury are all finally paid by the consumer, and generally in a manner that is very convenient for him. He pays them by little and little, as he has occasion to buy the goods. As he is at liberty, too, either to buy, or not to buy, as he pleases, it must be his own fault if he ever suffers any considerable inconveniency from such taxes.

4. Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state. A tax may either take out or keep out of the pockets of the people a great deal more than it brings into the public treasury, in the four following ways. First, the levying of it may require a great number of officers, whose salaries may eat up the greater part of the produce of the tax, and whose perquisites may impose another additional tax upon the people. Secondly, it may obstruct the industry the people, and discourage them from applying to certain branches of business which might give maintenance and unemployment to great multitudes. While it obliges the people to pay, it may thus diminish, or perhaps destroy, some of the funds which might enable them more easily to do so. Thirdly, by the forfeitures and other penalties which those unfortunate individuals incur who attempt unsuccessfully to evade the tax, it may frequently ruin them, and thereby put an end to the benefit which the community might have received from the employment of their capitals. An injudicious tax offers a great temptation to smuggling. But the penalties of smuggling must rise in proportion to the temptation. The law, contrary to all the ordinary principles of justice, first creates the temptation, and then punishes those who yield to it; and it commonly enhances the punishment, too, in proportion to the very circumstance which ought certainly to alleviate it, the temptation to commit the crime. Fourthly, by subjecting the people to the frequent visits and the odious examination of the tax-gatherers, it may expose them to much unnecessary trouble, vexation, and oppression; and though vexation is not, strictly speaking, expense, it is certainly equivalent to the expense at which every man would be willing to redeem himself from it. It is in some one or other of these four different ways that taxes are frequently so much more burdensome to the people than they are beneficial to the sovereign.

Similarly, the American Society of CPAs has promulgated ten guiding principles of good tax policy:

Equity and fairness. Similarly situated taxpayers should be taxed similarly. This includes horizontal equity (taxpayers with equal ability to pay should pay the same amount of taxes) and vertical equity (taxpayers with a greater ability to pay should pay more taxes).

Certainty. Tax rules should clearly specify when and how a tax is to be paid and how the amount will be determined. Certainty may be viewed as the level of confidence a person has that a tax is being calculated correctly.

Convenience of payment. A tax should be due at a time or in a manner most likely to be convenient to the taxpayer. Convenience helps ensure compliance. The appropriate payment mechanism depends on the amount of the liability, and how easy (or difficult) it is to collect. Those applying this principle should focus on whether to collect the tax from a manufacturer, wholesaler, retailer or customer.

Economy of calculation. The costs to collect a tax should be kept to a minimum for both the government and the taxpayer.

Simplicity. Taxpayers should be able to understand the rules and comply with them correctly and in a cost-efficient manner. A simple tax system better enables taxpayers to understand the tax consequences of their actual and planned transactions, reduces errors and increases respect for that system.

Neutrality. The tax law’s effect on a taxpayer’s decision whether or how to carry out a particular transaction should be kept to a minimum. A tax system’s primary purpose is to raise revenue, not change behavior.

Economic growth and efficiency. A tax system should not impede productivity but should be aligned with the taxing jurisdiction’s economic goals. The system should not favor one industry or type of investment at the expense of others.

Transparency and visibility. Taxpayers should know that a tax exists, and how and when it is imposed on them and others. Taxpayers should be able to easily determine the true cost of transactions and when a tax is being assessed or paid, and on whom.

Minimum tax gap. A tax should be structured to minimize noncompliance. The tax gap is the amount of tax owed less the amount collected. To gain an acceptable level of compliance, rules are needed. However, a balance must be struck between the desired level of compliance and the tax system’s costs of enforcement and level of intrusiveness.

Appropriate government revenues. A tax system should enable the government to determine how much tax revenue it likely will collect and when—that is, the system should have some level of predictability and reliability.

Obviously our current tax code bears little resemblance to one that would be ideal, but in some respects it has gotten better.  A lower tax rate on a broader base (i.e. few “loopholes”) is a better tax system and we have been doing that to some extent over time.

In my next post I will share my thoughts on what I believe would be some useful reforms.  It’s guaranteed to be contentious!

There has been a great deal of discussion since 2008 about the stock market exhibiting “fat tails” where the 2008 downturn was considered to be an outlier.  I thought it might be useful to investigate just how “normal” (or not) the market really is.  Normal means the distribution of returns matches the standard bell curve.

Some Statistics.  To describe a distribution, first we need to know where it is centered.  In statistics this is called the first moment (because the formula that computes it only has terms raised to the first power, i.e. nothing is raised to anything, it is just a simple arithmetic mean).  The second moment (because the formula contains squared terms) is the standard deviation or sigma (σ).  This is a measure of how spread out the data is; and it is the square root of the variance.  Those two statistics are relatively familiar, but the normality of the data is dependent on what are called the higher moments.

The third moment is skewness, a measure of whether the distribution is symmetrical or not.  If not, it has skew.  (The formula, as you have no doubt realized by now, has cubed terms.)  In a normal distribution, the mean and median (and mode for that matter) are identical.  In a skewed distribution they are not.  Positively skewed distributions have a tail going out further on the right, with the mean being higher than the median.  A negatively skewed distribution has a longer tail on the left with the mean being lower than the median.

An example of positive skew would be a graph of the distribution of wealth for a random group of people that happened to include Bill Gates; on average they are all very wealthy.  Life expectancies, on the other hand, exhibit negative skew – it is much easier to die 50 years before your life expectancy than it is 50 years after.  In investing negative skew is unfortunate because the investor receives more extreme negative results than extreme positive results.  In theory, investment returns should have a slight positive skew due to compounding, and (again in theory) would follow what is known as a log-normal distribution, which simply means the logarithms of the returns follow a normal distribution.

The fourth moment is kurtosis, and this is a measure of the “peakedness” of the distribution.  A distribution with a high middle but more weight in the tails can have the same average dispersion (standard deviation) as a distribution with the opposite.  When you hear the term “fat tails” or “black swan,” usually what the person really means is positive kurtosis.  A normal curve is said to be mesokurtic; while one with fat tails and a higher peak is leptokurtic; and one with skinny tails (or no tails) and a lower peak is platykurtic.  It is nice to know if your investments will have more extreme events than you would expect (i.e. is leptokurtic), particularly if they are negatively skewed as well.  The remainder of this post is devoted to examining empirically what the distribution of returns actually is.

Daily Data.  The length of the period we are measuring is important.  There is no question that at time frames as short as one day the market is not even close to normal.  For example, if, on October 18^th, 1987 (the day before the famous collapse) you had computed the statistics on the S&P 500 since 1950, you would have found that the odds of a decline as big as the one that actually took place the following day were astronomically (actually bigger than astronomically, but I can’t think of an appropriate adverb) against it.  It was a 26 standard deviation event.

Some context about how often daily moves in the stock market of various sizes should be expected (if they were normally distributed) is helpful here:

Standard Deviation	Expected Occurance
One	every three days or so
Two	every month or so
Three	every 1½ years or so
Four	every 63 years or so
Five	every 7 millennia or so
Six	every 2 million years or so
Seven	every 1½ billion years or so
Eight	every 236 times the age of the universe
Nine and higher	the numbers are too big to quantify

 

 

 

Keep in mind the 1987 crash was a 26 standard deviation event.  So markets on a daily basis clearly are not normally distributed and have extreme outliers, and extreme daily down moves are bigger than daily up moves (but there are slightly more up overall) as well.  So we can unequivocally state that short term market moves (daily or less) are negatively skewed and leptokurtic (and extremely so on both counts).

Monthly Data.  Monthly stock market moves are closer to normal.  The stock data used here is the total U.S. stock market (CRSP 1-10) from 1926 through 2015.  The real (inflation adjusted) and log-normal figures are similar.  Here is the distribution of nominal monthly returns over the 1,080 months in our sample:

Threshold	Predicted	Actual	Difference
>+3 σ	1	5	4
>+2 σ	25	18	-7
>+1 σ	171	103	-68
Above Avg.	540	576	36
Below Avg.	540	504	-36
<-1 σ	171	128	-43
<-2 σ	25	30	5
<-3 σ	1	10	9
Within 1σ	737	838	101
Within 2σ	1031	1021	-10
Within 3σ	1077	1054	-23

Rolling 12-month Data.  This is even more normal:

Threshold	Predicted	Actual	Difference
>+3 σ	1	4	3
>+2 σ	24	18	-6
>+1 σ	170	136	-34
Above Avg.	535	529	-6
Below Avg.	535	480	-55
<-1 σ	170	157	-13
<-2 σ	24	35	11
<-3 σ	1	4	3
Within 1σ	730	776	46
Within 2σ	1020	1016	-4
Within 3σ	1066	1061	-5

In other words, out of the 1,069 rolling 12-month periods from 1926 through 2015, if U.S. stock returns were normally distributed, a return greater than 3σ (75.6%) should have occurred once.  We have had it happen four times:

• 123.33% in the trailing twelve months through May 1933
• 154.60% in the trailing twelve months through June 1933
• 100.79% in the trailing twelve months through February 1934
• 95.05% in the trailing twelve months through March 1934

Out of the 1,069 rolling 12-month periods from 1926 through 2015, if U.S. stock returns were normally distributed, a return less than 3σ (-51.5%) should have occurred once.  We have had it happen four times:

• -52.47% in the trailing twelve months through March 1932
• -56.84% in the trailing twelve months through April 1932
• -60.35% in the trailing twelve months through May 1932
• -65.42% in the trailing twelve months through June 1932

So, what are our conclusions?  There are three:

1. Daily stock market returns have extraordinary outliers compared to a normal distribution.
2. Monthly stock market returns have a number of outliers also.
3. Rolling 12-month returns, aside from the early 1930’s, are pretty normal.

 

Vanguard has Alpha.  Morningstar has Gamma.  Envestnet has Sigma.  Apparently describing the value a high-quality advisor brings to a client’s financial planning and investment management without using a Greek letter is prohibited!  But those papers have a point, and I also believe a high-quality advisor adds significant value.  Here’s how:

1. Constructing an appropriate portfolio (I conservatively estimate the value add to be 100 bps annually from this)
   1. Proper asset allocation, factor tilts, diversification, etc.
   2. Low-cost implementation
   3. Intelligent rebalancing

2. Tax savings (I conservatively estimate the value add to be 100 bps annually from this if the client has funds in multiple tax buckets and are in a high bracket, etc. but much lower otherwise)
   1. Proper asset location strategy
   2. Proper accumulation strategy (maximizing tax-advantaged vehicles)
   3. Proper decumulation strategy (spending order)
   4. Strategic use of conversions, step-up in basis, loss-harvesting, munis, etc.
   5. Optimal transfers for children’s education, other funds to descendants and charities, etc.

3. Behavior modification (the value added is mostly unquantifiable, not as high as the methodologically-flawed Dalbar studies claim, but I would estimate 100-300 bps annually on average – but  it occurs sporadically)
   1. Maintaining an appropriate strategic allocation at market extremes
   2. Appropriate levels of saving (pre-retirement) and spending (post-retirement)

4. Other financial planning (the value added is primarily either peace of mind or only shows up in a tiny fraction of cases, for example premature death with insurance, so the average improvement to performance frequently isn’t high, but in those cases it is absolutely crucial)
   1. Risk management including appropriate insurance and asset protection
   2. Selecting optimal pension options (including Social Security)
   3. Liability management (optimal debt)
   4. Estate and end-of-life planning (not primarily tax-related)

So, for a client with pretty good behavior (though not perfect), who is in a lower tax bracket or has no investments outside of deferred accounts, the value added might be just 200 bps (100 each from 1 & 3 above) annually.  For clients with more emotional behavior, who is in a high marginal bracket, and has savings in various types of tax buckets (IRA, Roth, taxable, etc.) the value added is probably around 500 bps (100 from #1, 100 from #2, and 300 from #3).  Thus, advisory fees are typically covered 2-5x.

One of the ways a high-quality advisor adds value is by paying attention to asset location.  Low-quality advisors tend to ignore it. There are three reasons they may do so:

1. They don’t care.  The advisor may have the cynical view that clients only focus on pre-tax returns so don’t worry about it.  If the primary objective is sales rather than actually doing the best possible job, this makes sense.
2. It’s too hard.  It adds operational complexity.  Particularly for advisors with a high number of small accounts, it is easier to just “mirror” all the accounts exactly the same way.
3. They don’t know.  They either don’t know about the strategy at all, or don’t know how to implement it.

Taxes should not determine asset allocation (though it may influence it slightly at the margin), but once the proper allocation is determined, location is important.  Optimal asset location is simply locating the least tax-efficient assets inside of tax-advantaged (i.e. retirement) accounts and the most tax-efficient in taxable (i.e. non-retirement) accounts.  A combination of three factors are multiplied together determine tax efficiency:

1. Investment return. An investment with a rate of return of 0% (e.g. cash) is perfectly tax-efficient.  The higher the return the lower the efficiency.
2. Tax rate. An investment with a tax rate of 0% (e.g. munis) is perfectly tax-efficient.  The higher the rate (e.g. ordinary income vs. long-term capital gains) the lower the efficiency.
3. Turnover.  If an investment is never sold, under current tax law there is a full “step-up” in basis at death and thus is perfectly tax-efficient.  Keep in mind that yield (dividends and interest) are a form of turnover.  The higher the turnover the lower the efficiency (basically, there can be “good” turnover where losses are being harvested).  In the case of a mutual fund, use the higher of the expected fund turnover or the inverse of the investor’s expected holding period in years but not more than 100%.

In addition to the three factors above, there are two more things to keep in mind:

1. Volatility.  An investment with high volatility is more valuable in taxable account because of the possibility of being able to tax-loss harvest in an early year.  Of course, more volatile investments also tend to have higher expected returns which I noted above are better held in tax-advantaged accounts.  In general, I would say the expected return dominates the volatility, but it is something to keep in mind.
2. Foreign source income. Foreign investments (e.g. foreign stock funds) are better held in taxable accounts so as to be able to take a credit or a deduction (the credit is usually better) for foreign taxes paid.  The effect is partially offset by the fact that the yields on foreign stocks tend to be higher than those on domestic stocks which I noted above would indicate holding the higher-yielding investments in the deferred account.  In general, I would say it is just slightly better to have the foreign stocks located in the taxable account.

There are two types of tax-advantaged accounts, tax-deferred (e.g. traditional IRAs, 401(k) plans, etc.), and tax-free (e.g. Coverdell and 529 accounts if used for education, Roth IRAs, etc.).  Between those two, because (under the current tax code) the Roth does not have RMDs (Required Minimum Distributions), it is better to have higher returning assets located in the tax-free accounts.  Most people think that the reason is because it is tax-free, but this is not so.  There is no difference between a Roth and an IRA except the investor owns 100% of the Roth while (assuming a 25% tax rate) she owns only 75% of the IRA (the government is a 25% partner) but both are completely tax-free once you make that initial adjustment.

Again, the most tax-efficient assets are optimally held in the taxable account and the least tax-efficient in the tax-advantaged accounts.  But suppose relatively large amounts of inefficient holdings are end up in the taxable account anyway (either because the size of the tax-advantaged accounts is small or the holdings are large, or a combination).  For example, suppose the least tax-efficient holding in the taxable account is a total bond market bond fund (all ordinary income).  Particularly if interest rates are higher (say 6% rather than the current 2.3%), there are five things to consider doing to improve the tax efficiency:

1. Buy a municipal bond fund instead. This is particularly appropriate for high-tax-bracket investors.
2. Make non-deductible IRA contributions. While I would not make non-deductible contributions if the marginal holding is eligible for capital gain treatment and might receive a step-up on death, in a case where it is already ordinary income this probably makes sense.  The downside is the loss of liquidity if the investor is younger than 59½.
3. Use a variable annuity wrapper. This is exactly like the previous recommendation of the non-deductible IRA from a tax perspective, but has additional cost.  Despite the additional cost, if it is cheap enough (and I have in mind a plain-vanilla annuity with no riders at 25-30 basis points) and the time horizon long enough, this can make sense (not today, but in a higher interest rate environment).  I have discussed this option here.
4. Buy permanent life insurance. I am not a fan of permanent life insurance in general, but as I have noted before there are rare cases where it is recommended.  Ordinary-income holdings like bonds in the taxable account is one of the factors.
5. Pay down your mortgage instead. There are many other aspects to this decision also which I have covered here.