tag:blogger.com,1999:blog-582368152716771238.post1902663060797529940..comments2024-03-29T07:18:14.271-05:00Comments on The Grumpy Economist: Debt MaturityJohn H. Cochranehttp://www.blogger.com/profile/04842601651429471525noreply@blogger.comBlogger65125tag:blogger.com,1999:blog-582368152716771238.post-47111445198018151152014-01-22T03:07:39.302-06:002014-01-22T03:07:39.302-06:00Can I use the theories from corporate finance to a...Can I use the theories from corporate finance to analyze the maturity structure of sovereign debt? I would like to analyze the signallig theory, taxes theory, agency theory in the sovereign market using proxies for those theories. Would it have any sense?Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-63065562477525687242012-12-11T19:08:57.274-06:002012-12-11T19:08:57.274-06:00DOB,
"Alright so we're back to something...DOB,<br /><br />"Alright so we're back to something roughly equivalent to my initial proposal: some independent body of the government looks after the taxpayer equity (public assets - public liabilities)."<br /><br />You got it.<br /><br />"Whether equity-like instruments are used for funding or not is optional, you need the watchdog either way."<br /><br />Yes it is optional and yes you need an apolitical watchdog. However, there are reasons other than funding expenditures for the federal government to sell equity claims on its revenue. It comes down to a limitation of monetary policy. The central bank (Fed) buys and sells government debt to set a nominal cost of money (interest rate). But real interest rates can move independently of central bank operations depending on the productivity of a nation. During the Great Depression real interest rates rose to north of 15% while nominal interest rates were in the 3% to 4% range (severe deflation). If a government wants to embrace that productivity, they sell equity that reduces the after tax cost of money.FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-16508270060314219182012-12-11T07:24:24.696-06:002012-12-11T07:24:24.696-06:00Frank,
Alright so we're back to something rou...Frank,<br /><br />Alright so we're back to something roughly equivalent to my initial proposal: some independent body of the government looks after the taxpayer equity (public assets - public liabilities).<br /><br />Whether equity-like instruments are used for funding or not is optional, you need the watchdog either way..DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-55677689998663164352012-12-10T16:59:41.317-06:002012-12-10T16:59:41.317-06:00DOB,
"Moreover, you're assuming taxation...DOB,<br /><br />"Moreover, you're assuming taxation is kept proportional to income. To use your example above, I'm expecting $100k taxed at 30%, leaving me with $70k of after tax income. Imagine the government changes the tax structure to exempt the first $50k, but now the marginal tax rate is 60% after that. My tax burden is still $30k. But depending on the income distribution at that time, the return on my shares has either skyrocketed or plummeted. This just doesn't work as a tax hedge."<br /><br />Fair enough. I was primarily concerned with tax burden of original owner. Yes changes in marginal tax rates and income distribution will affect the pool of buyers and sellers of equity and can thus affect the market value of the equity. If as you say, the first $50,000 of income is excluded from taxation and the distribution of U. S. income is skewed so that a lot of people pay no taxes (incomes below $50,000) then suddenly a lot of potential equity buyers disappear.<br /><br />"You also haven't specified under which conditions the government chooses to not pay return to the preferred shares."<br /><br />It is not a question of the government refusing to pay the return on investment. The risk lies with the buyer not the seller (different than corporate equity). It is a question of the government equity buyer having a taxable revenue stream (and thus tax burden) to realize the rate of return against. There is no logical reason that I can think of why the federal government would sell equity and then refuse to accept it back as payment on a tax burden.<br /><br />"Finally, you're missing the spending side of the equation: without taxes changing at all, if spending increases, my shares aren't worth much, yet my taxes are still there."<br /><br />It took me this long just to explain the finance side :-)<br /><br />Increased government spending can create an inflationary pressure (demand for goods increases without increasing supply). And so you would want a "Federal Reserve" type of independent body to set the initial rate of return that is offered when the government sells equity. In essence you want your return on investment to be positive on a inflation adjusted basis.<br /><br />The logical choice for this would be the U. S. Treasury department. But for such a system to work and work well, Congress would have to cede some power to the Executive branch in exercising tax policy (Treasury department falls under Executive Branch of government). And second you would need a Treasury Secretary that is politically neutral - which is very atypical.FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-55731236347196401172012-12-10T14:55:07.750-06:002012-12-10T14:55:07.750-06:00Frank,
Alright, thanks for clarifying. The instru...Frank,<br /><br />Alright, thanks for clarifying. The instrument you describe might be junior to bonds, but it has fixed return and a fixed maturity so it doesn't feel or smell like equities. Maybe a preferred stock. So the taxpayer/citizen is still the ultimate implicit equity owner.<br /><br />Moreover, you're assuming taxation is kept proportional to income. To use your example above, I'm expecting $100k taxed at 30%, leaving me with $70k of after tax income. Imagine the government changes the tax structure to exempt the first $50k, but now the marginal tax rate is 60% after that. My tax burden is still $30k. But depending on the income distribution at that time, the return on my shares has either skyrocketed or plummeted. This just doesn't work as a tax hedge.<br /><br />You also haven't specified under which conditions the government chooses to not pay return to the preferred shares..<br /><br />Finally, you're missing the spending side of the equation: without taxes changing at all, if spending increases, my shares aren't worth much, yet my taxes are still there. The present value of all government expenditure probably isn't any smaller than that of taxes.DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-46253370327187439362012-12-10T13:35:03.862-06:002012-12-10T13:35:03.862-06:00DOB,
Let me try again.
"The richest X% of t...DOB,<br /><br />Let me try again.<br /><br />"The richest X% of the population owns Y% of such or such asset, with X small and Y large is true for virtually every asset class. That's just the natural order of things and it would be the case regardless of any legislation on market access or lack thereof."<br /><br />And that is only problematic for fixed resources. The present value of all tax revenue the federal government is ever going to collect is - infinite - at any tax rate other than 0% and 100%. Government equity is a claim against that infinite source. <br /><br />"Are you assuming these shares aren't fungible, i.e. they're attached to the name of a certain person and depend on what taxes he's paying somehow?"<br /><br />The realized rate of return on the investment is dependent on the tax rate that the person is paying - yes. I am not assuming that the equity is attached to the name of some person. I am assuming that the only person who can realize the rate of return on the equity is someone who has a tax liability when the equity reaches maturity (that may or may not be the original owner).<br /><br />What I am saying is that the owner of the equity is responsible for generating the return on that equity. And so government equity would not be making dividend payments.<br /><br />Let me give an example:<br /><br />Government sells you 30 year government equity with a fixed 8% annualized return on investment. You are anticipating a taxable income of $100,000.00 30 years from now and an after tax income of $70,000 30 years from now (30% tax rate). You buy $2,980 of 30 year equity. After 30 years that $2,980 of initial investment will cover $30,000 of tax liability.<br /><br />20 years from your purchase, some populist politician decides to lower your tax rate to 20%. Suddenly your return on investment can shrink unless your pretax income is larger than you anticipated. FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-13519982643693268412012-12-10T05:21:18.690-06:002012-12-10T05:21:18.690-06:00Frank,
Sorry, but I still have no idea what you&#...Frank,<br /><br />Sorry, but I still have no idea what you're talking about.<br /><br />"And so a politician (populist or non-populist) can only "screw" a person by first selling him equity AND then lowering that same person's tax rate."<br /><br />Are you assuming these shares aren't fungible, i.e. they're attached to the name of a certain person and depend on what taxes he's paying somehow?DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-61079468187073693742012-12-09T21:54:57.480-06:002012-12-09T21:54:57.480-06:00DOB,
"The richest X% of the population owns ...DOB,<br /><br />"The richest X% of the population owns Y% of such or such asset, with X small and Y large is true for virtually every asset class. That's just the natural order of things and it would be the case regardless of any legislation on market access or lack thereof."<br /><br />"Assuming this happens, what's to prevent a populist politician to screw the holders of the stock in favor of everyone else?"<br /><br />Maybe your definition of populist differs from mine. You view a populist politician as a politician that tries to equalize outcomes, my definition is a politician that tries to equalize opportunities.<br /><br />And so you say a populist politician would try to "screw the holders of government equity" by giving a tax break to the poor rather than paying a dividend.<br /><br />Let me step back and try to explain what I mean by government equity. Equity in an accounting sense is a residual claim on a cash flow after debt claims have been paid. In that strict definition, it is a junior claim to a bond's senior claim. A financial asset is not equity because it pays a dividend. It is equity because the rate of return on the asset is not afforded the same legal protection that bonds are. For government bonds, that protection comes from the 14th amendment to the Constitution of the United States - payments to bondholders in the form of interest supercede all other government expenditures.<br /><br />Now let me answer your question. The ONLY way for an owner of government equity to realize the rate of return on that equity is to have a tax burden at a future date that is equal to or greater than the value of that equity at a future date. The equity that I imagine does NOT make cash payments in the form of dividends.<br /><br />And so a politician (populist or non-populist) can only "screw" a person by first selling him equity AND then lowering that same person's tax rate. Imagine you bought government equity to offset an anticipated tax rate of 35% of your income. Then a "populist politician" comes along and lowers your tax rate to 20% of your income. That politician just screwed you.<br /><br />Like I said, it has nothing to do with rich or poor. If a politician sold a lot of government equity to rich guys and then another politician cut the tax rate faced by those rich guys, those rich guys just bought a bunch of equity that would become a lot less valuable (they would lose money on the investment). <br /><br /><br />FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-9546007922625318692012-12-08T09:57:54.816-06:002012-12-08T09:57:54.816-06:00Sorry but you're not answering any of my quest...Sorry but you're not answering any of my questions..<br /><br />The richest X% of the population owns Y% of such or such asset, with X small and Y large is true for virtually every asset class. That's just the natural order of things and it would be the case regardless of any legislation on market access or lack thereof.<br /><br />Assuming this happens, what's to prevent a populist politician to screw the holders of the stock in favor of everyone else?<br /><br />In the case of a regular company, it's obvious: the stockholder control the activity of the company either directly or through the board when they're too large in number.<br /><br />Here, the control is democratic and unrelated to ownership, so what gives?DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-33560130880408157682012-12-06T10:47:47.743-06:002012-12-06T10:47:47.743-06:00DOB,
"How do you prevent that situation from...DOB,<br /><br />"How do you prevent that situation from occurring? What's the incentive for a government to pay dividends given that its electoral base is very different from the stock holder base?"<br /><br />The only way for a government's electoral base to become very different from it's stockholder base is when the government places limitations on who can buy it's equity and who can't.<br /><br />"A rich minority holds most of the equity of the govt. Screw them, let's give a tax break to the poor rather than pay any dividend"<br /><br />The only way for a minority to hold most of the equity of the government is for the government to discriminate who is permitted to buy it's equity and who is not permitted.<br /><br />Rich or poor has very little to do with it. Even if the very rich buy a lot of government equity, then can still lose money on the investment.<br /><br /><br />FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-54827877404715789922012-12-06T03:42:55.045-06:002012-12-06T03:42:55.045-06:00DOB,
"How do you prevent that situation from...DOB,<br /><br />"How do you prevent that situation from occurring? What's the incentive for a government to pay dividends given that its electoral base is very different from the stock holder base?"<br /><br />The incentive is for the federal government to allow equal market access to purchasing its equity and to resist the temptation of equity grants. In short, the federal government must practice egalitarianism instead of cronyism. Difficult for politicians? Yes - they can't see beyond the next election.<br /><br />"A rich minority holds most of the equity of the govt. Screw them, let's give a tax break to the poor rather than pay any dividend"<br /><br />Problems don't arise when the rich minority hold most of the equity of the government. Problems arise when the rich minority are the only people permitted to buy the equity of the government. It is a market access problem, not an ownership problem.FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-59765462661371773042012-12-05T17:56:25.810-06:002012-12-05T17:56:25.810-06:00This comment has been removed by the author.FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-2668154334633331382012-12-02T06:37:35.154-06:002012-12-02T06:37:35.154-06:00Frank,
I think I'm starting to understand wha...Frank,<br /><br />I think I'm starting to understand what you're trying to say.<br /><br />Sounds like you rely a lot on the repeated game aspect of equity issuance. For instance: assume the equity program has grown and the government has issued a meaningful amount of equity to fund itself. Then some political party comes in power and decides something along the lines of:<br /><br />"A rich minority holds most of the equity of the govt. Screw them, let's give a tax break to the poor rather than pay any dividend"<br /><br />Yes, the price of the shares should drop to zero and yes, the govt will never be able to issue any equity after that. But assuming the "market cap" (which is the PV of the expected dividend stream) was high, that's a huge windfall for the taxpayer, who is still the ultimate equity holder in your system. In that sense your system works more like a preferred stock than actual equity, since it gives no control to the securities holders.<br /><br />How do you prevent that situation from occurring? What's the incentive for a government to pay dividends given that its electoral base is very different from the stock holder base?<br /><br />"I am not sure what you mean by the book value of the federal government. You do realize that its liabilities (bonds) are not claims on physical assets - yes?" -><br /><br />Just because the bankruptcy process works differently for sovereigns doesn't mean the economics are so different. The transmission works this way:<br />- If the assets of the govt aren't worth much, then the govt can't justify taxing its citizen that much for their use<br />- If it does attempt to tax anyway, the citizens will either suck it up and enjoy a lower standard of living, or flee to countries where they get better public service for their money<br /><br />That's why we must keep the assets in line with the level of liabilities. This way those who come and go don't benefit at the expense of those who remain. Yes, it's not exactly well defined how to value the assets; that's just one more reason to keep government small.DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-72961077786193287732012-11-29T15:40:13.484-06:002012-11-29T15:40:13.484-06:00Absalon,
One other thing:
"The principal of...Absalon,<br /><br />One other thing:<br /><br />"The principal of a loan is not tax deductible but if the money is invested in buildings or equipment the depreciation of the capital cost is deductible over time."<br /><br />Incorrect. Depreciation is treated by the tax code as the result of normal wear and tear on an asset. A building or piece of equipment has an anticipated useable life of 5, 10, 15, 30 years and so the tax code allows you to deduct the loss of usable life from an asset.<br /><br />On the other hand, capital losses / capital gains of long lived assets (like buildings) are only realized when those assets are bought and sold.<br /><br />Greg Mankiw bemoans Warren Buffets "tax avoidance" scheme of being a long term investor:<br /><br />http://gregmankiw.blogspot.com/<br /><br />But the only other alternative is for the federal government to tax unrealized gains and refund unrealized losses. That creates a perverse incentive to always report losses. Because those losses are anticipated rather than realized, they are based on a guess of what the market value of assets at sale is.<br /><br />What the tax code does not address however is the possibility that competition (from a foreign country for instance) reduces the utilitarian value of an asset below its cost of purchase. Meaning that a new piece of equipment loses value both because it is getting older and because it is not being used to its potential.<br /><br />See output gap:<br /><br />http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=GDPPOT_GDPCA&transformation=lin_lin&scale=Left&range=Custom&cosd=1960-01-01&coed=2022-10-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-11-29_2012-11-29&revision_date=2012-11-29_2012-11-29&mma=0&nd=_&ost=&oet=&fml=%28a-b%29%2Fa&fq=Annual&fam=avg&fgst=linFRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-29883261725621367522012-11-27T15:57:21.769-06:002012-11-27T15:57:21.769-06:00DOB,
"The equity idea is an interesting one....DOB,<br /><br />"The equity idea is an interesting one. As of now, all citizens (taxpayers?) are implicitly holders of a share. When you're born a citizen (or is it when you enter the tax residency?), or naturalized, you get a share. When you die, or give up citizenship, you lose a share."<br /><br />Correct, but with implicit ownership you are at the mercy of political machinations that changes every 2 to 4 years. With explicit ownership (government equity) your sensitivity to changes in poltical guardianship of the economy drop. <br /><br />"You want these shares to trade in the markets I assume?"<br />They could trade on the markets but that is not a requirement. Ultimately I want the federal government to realize that contracts work better than discretion (from a long term growth perspective) and nonguaranteed contracts work better than guaranteed contracts (from a productivity perspective).<br /><br />"What kind of voting rights would these shareholders have?"<br />Obviously, tax rates still play a part. If the federal government sets all tax rates to 0% or 100% then there is no way it can sell equity claims against zero future revenue and there is no way to sell equity claims when no one has any money to buy them. The voting rights come from the ability to vote and shape what tax rates should be.<br /><br />"If none, then what's the incentive for non-shareholding citizens to not undertax?"<br />I am not sure what you mean by undertax. If the federal government sets all tax rates to 0% then there is no way for any equity buyer to realize a rate of return.<br /><br />"If much, then does that mean it's no longer a democracy? What's to prevent the shareholders "overtax" the citizens for profit?"<br />Again I am not sure what you mean by overtax. If the federal government sets all tax rates to 100% then no one would have any money to buy government equity.<br /><br />"I personally think it's simpler to pass some kind of golden rule (#4 in my list of proposals) whereby the book value of the government is kept near zero at all times so that people can enter/exit the citizenry/taxbase freely without having a wealth impact on themselves or others."<br /><br />I am not sure what you mean by the book value of the federal government. You do realize that its liabilities (bonds) are not claims on physical assets - yes? FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-85120673329882819842012-11-26T05:03:20.892-06:002012-11-26T05:03:20.892-06:00Frank,
"First I said the federal government&...Frank,<br /><br />"First I said the federal government's ability to "collect" tax revenue is unencumbered by the price level. The federal government's ability to "maximize" tax revenue does indeed depend on other factors." -><br /><br />Fair enough. If you're statement was simply that the activity (not amount) of tax collection isn't affected by the price-level, then I guess I mostly buy that.<br /><br />"You wouldn't have the "temptation" of inflating to get out of debt problems if someone would realize that the capital markets allow for both debt AND equity."<br /><br />The equity idea is an interesting one. As of now, all citizens (taxpayers?) are implicitly holders of a share. When you're born a citizen (or is it when you enter the tax residency?), or naturalized, you get a share. When you die, or give up citizenship, you lose a share.<br /><br />You want these shares to trade in the markets I assume? What kind of "voting rights" would these shareholders have? If none, then what's the incentive for non-shareholding citizens to not undertax? If much, then does that mean it's no longer a democracy? What's to prevent the shareholders "overtax" the citizens for profit?<br /><br />I personally think it's simpler to pass some kind of golden rule (#4 in <a href="http://catalystofgrowth.com/proposals/" rel="nofollow">my list of proposals</a>) whereby the book value of the government is kept near zero at all times so that people can enter/exit the citizenry/taxbase freely without having a wealth impact on themselves or others. I understand book value isn't stock price, but this is a good enough proxy for keeping thinks in check.<br /><br />Negative market yields in TIPs just mean it's cheap for the government to issue. When it's cheap in TIPs, it's also cheap in nominals. TIPs vs nominals have the same expected returns, it's the sensitivities that change. If the govt issued 100% of its debt in TIPs, nudging the Fed to target a higher inflation rate would not help the government get relief on the liability side.DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-30464409845770687442012-11-25T11:58:41.584-06:002012-11-25T11:58:41.584-06:00DOB,
"Wow. Go tell that to Spain. The bigges...DOB,<br /><br />"Wow. Go tell that to Spain. The biggest determinant to tax revenues/govt expenses, for a given tax structure, is nominal GDP (real output * price level). And trying to increase taxes when NGDP drops due to low growth generally pushes NGDP down and gives a lower than hoped increase of in tax revenues."<br /><br />First I said the federal government's ability to "collect" tax revenue is unencumbered by the price level. The federal government's ability to "maximize" tax revenue does indeed depend on other factors. So what should I tell Spain? <br /><br />"I think nominal bonds are fine if the central bank is targeting the level of NGDP. But with a vague inflation/unemployment mandate, TIPs can indeed tame the temptation of "inflating" to get out of debt problems."<br /><br />You wouldn't have the "temptation" of inflating to get out of debt problems if someone would realize that the capital markets allow for both debt AND equity. And please tell me how negative market yields on TIPs eliminate the temptation of inflating?FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-49315007137223034052012-11-23T18:45:59.298-06:002012-11-23T18:45:59.298-06:00"Anyone who understands even basic economics ..."Anyone who understands even basic economics realizes that the federal government services its debt through tax revenues and the federal government's ability to collect tax revenue is unencumbered by the price level" -><br /><br />Wow. Go tell that to Spain. The biggest determinant to tax revenues/govt expenses, for a given tax structure, is nominal GDP (real output * price level). And trying to increase taxes when NGDP drops due to low growth generally pushes NGDP down and gives a lower than hoped increase of in tax revenues.<br /><br />If the price level drops due to an increase in productivity in a healthy economy that's growing, not much of a problem with taxes, but that's not what we're seeing now.<br /><br />I think nominal bonds are fine if the central bank is targeting the level of NGDP. But with a vague inflation/unemployment mandate, TIPs can indeed tame the temptation of "inflating" to get out of debt problems.<br /><br /><br />DOBhttp://catalystofgrowth.com/noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-71473404065477699792012-11-20T20:31:53.019-06:002012-11-20T20:31:53.019-06:00Absalon,
"If companies can borrow at 5% ther...Absalon,<br /><br />"If companies can borrow at 5% there is no reason to think that the government of the United States would have to offer 10%."<br /><br />This is not a question of the government of the United States having to do anything. It is a question of is it in the best interests of the people of the United States for the federal government to do something like this.<br /><br />"If I could lock in a 5% borrowing cost and a 10% investment return I would be leveraged to the hilt."<br /><br />I doubt it. The 10% investment return is not guaranteed and so there is no way you could lock it in. That was the point. To realize that 10% investment return you would need to factor in what your anticipated tax liability would be when the government equity that you own matures. In essence you are buying government equity on the anticipation that you will have a tax liability 30 years (10 years, 2 years, whatever) down the road equal to or greater than the future value of the government equity that you bought.<br /><br />You would be buying a risk asset, but you yourself would be responsible for realizing the return (as opposed to relying on 500 separate companies in the US).FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-56049272146097636312012-11-20T19:30:15.230-06:002012-11-20T19:30:15.230-06:00Frank
The principal of a loan is not tax deductib...Frank<br /><br />The principal of a loan is not tax deductible but if the money is invested in buildings or equipment the depreciation of the capital cost is deductible over time.<br /><br />You example says: assume companies can borrow at 5%; assume that the government is offering a 10% return on a prepayment of taxes. If companies can borrow at 5% there is no reason to think that the government of the United States would have to offer 10%. If I could lock in a 5% borrowing cost and a 10% investment return I would be leveraged to the hilt. In the real world, I sold off some equities and paid off my margin loan in August 2011.Absalonhttps://www.blogger.com/profile/09131268683451462949noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-23182539836960052772012-11-20T18:17:37.329-06:002012-11-20T18:17:37.329-06:00Absalon,
The interest expense on debt financing i...Absalon,<br /><br />The interest expense on debt financing is tax deductible, not the principle.<br /><br />A business will have some available funds, but not enough to fund an investment which is typically the case. And so picture this as a for instance:<br /><br />Company A has $1 million in free cash flow but it wants to invest in a new production facility that costs $5 million to build. It anticipates a lifespan of 30 years for the facility and so it decides to borrow at the going rate of 5%. Suppose that the federal government is selling 30 year equity that has a 10% return.<br /><br />Should the company borrow $4 million at 5% using the free cash flow to reduce the amount borrowed OR should it borrow $5 million at 5% and use the free cash flow to buy $1 million in 30 year federal equity?<br /><br />If you run the numbers it should be obvious that while buying the $1 million in 30 year federal equity is riskier, it reduces that after tax cost of servicing the debt significantly.<br /><br />FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-23942456808887668072012-11-20T16:26:54.728-06:002012-11-20T16:26:54.728-06:00Frank
I really do not understand your reasoning. ...Frank<br /><br />I really do not understand your reasoning. The cost of debt financing for a business is deductible in calculating taxable income. If a business does not have financing: where does the money come from to buy the "equity" from the government. <br /><br />I am giving up trying to understand your proposal.Absalonhttps://www.blogger.com/profile/09131268683451462949noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-13187493227898357702012-11-20T09:38:18.242-06:002012-11-20T09:38:18.242-06:00"Given the risks and discounts involved I see..."Given the risks and discounts involved I see no advantage to the government in such a plan."<br /><br />First, the government exists to serve the interests of the voting public. Second, what risks to the government? Obviously there is a cash flow issue that occurs when government sells liabilies that offer a rate of return. That rate of return can be coupon type (regular fixed interval payments) or lump sum accrual type (return on investment is realized at maturity).<br /><br />With accrual securities, the federal government can escape any short term cash flow problems by simply extending the average maturity of the liabilities that it sells. In addition, because government equity would be non-guaranteed it incentivizes productive effort to realize the return on investment.<br /><br />If a buyer is unable to realize the return in any one year he / she simply rolls over an existing investment to another year. The incentive still exists but in this case the buyer of the security has opted to extend the maturity of the government's liabilities.<br /><br />"If you want to set aside money to pay your taxes five years from now, you are perfectly free to buy a five year Treasury and use the proceeds in five years to pay your taxes. As a bonus, if your income falls you do not forfeit any part of the money you invested in the Treasury."<br /><br />If you are a producer looking to lower your cost of production you look at three things - capital, labor, and materials. If you do not have equity financing available (typical for most small businesses) your financing is limited to debt. As a producer your cost of debt service is realized on an after tax basis. And so the federal government by selling you equity (instead of playing give away / take away with rates) can lower your after tax cost of debt capital below 0%. <br /><br />In which case, why would you "need" higher inflation - ever?<br /><br /> <br />FRestlyhttps://www.blogger.com/profile/09440916887619001941noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-10269309561737954142012-11-19T19:17:18.633-06:002012-11-19T19:17:18.633-06:00Frank For the record: in my last post I was agree...Frank For the record: in my last post I was agreeing with Professor Cochrane's comment at 4:33, not your subsequent comment.<br /><br />I went back and re-read your comments. What you are calling a sale of equity, I see as a non-refundable prepayment of taxes (with interest accruing on the prepayment). Given the risks and discounts involved I see no advantage to the government in such a plan. <br /><br />If you want to set aside money to pay your taxes five years from now, you are perfectly free to buy a five year Treasury and use the proceeds in five years to pay your taxes. As a bonus, if your income falls you do not forfeit any part of the money you invested in the Treasury. Absalonhttps://www.blogger.com/profile/09131268683451462949noreply@blogger.comtag:blogger.com,1999:blog-582368152716771238.post-48149339759790135362012-11-19T14:41:51.591-06:002012-11-19T14:41:51.591-06:00Absalon,
First -- it actually is possible to redu...Absalon,<br /><br />First -- it actually is possible to reduce risk via finacial engineering up to a limit. e.g. a diversified fund has less risk than any of its holdings.<br /><br />Risk tranferrence is okay, so long as the person buying the risk is capable of withstaining the losses. In 2008, people had more at risk that they could afford to lose. Furthermore, there was a lot of risk that was tranferred only cosmetically. i.e. the banks sold the high risk bonds from the CDO and held overcollateralized "high quality" bonds on thier ballance sheets. It turned out that there was not nearly enouhg OC on the high quality bonds.<br /><br />But this is a little bit beside the point. When the Treasury runs a 4 year average maturity, while forecasting deficits well beyond 4 years, they are engaging in a little financial engineering of thier own, leaving the taxpayer holding this risk. Longer maturity bonds pass the more risk to investors and leave the Treasury with a less risky liablity profile.<br />Anonymousnoreply@blogger.com