Topic: Finance, Banking & Monetary Policy

Reply to Robert Gordon & James Kvaal’s WSJ letter

In a letter to the Wall Street Journal (Nov. 5), Robert Gordon and James Kvaal responded to my critique of their estimate that McCain’s tax plan would cut big oil’s taxes by $3.8 billion. They claim that “corporations as profitable as ExxonMobil pay a 35% rate on more than 99% of their profits.” Yet they also say, “Our code is riddled with special interest deductions, credits and exemptions that shield corporate profits from tax.” Well, which is it?

If big oil companies actually “pay a 35% rate on more than 99% of their profits,” then Gordon and Kvaal might be justified in ignoring McCain’s bold plan to end the oil companies’ “deductions, credits and exemptions.”

As the Committee for a Responsible Federal Budget noted, “Senator McCain … would repeal special expensing rules for oil and gas companies, eliminate the foreign tax credit for oil companies, disallow expensing of exploration and development costs, encourage an increase in royalty rates for drilling on public land, subject working interests in oil and gas to the passive loss rules, eliminate 15 percent tax credit for enhanced oil recovery costs for tertiary wells, and eliminate special depreciable lifetimes for certain assets used by oil companies.”

CFARB estimated that McCain’s plan to tighten up deductions and credits would raise oil company taxes by $6 billion in 2013. That would certainly be offset to some extent, of course, by lower tax rates—30% in 2010-11 and 28% in 2012-2013 (Gordon and Kvaal wrongly assumed the rate would drop to 25% in 2009).

If big oil really pays 35% tax on virtually all their profits, however, then such loophole-closing would simply be a waste of time.

If big oil does not surrender 35% of profits to the IRS, however, then Gordon and Kvaal’s estimates (which assume that statutory tax rates are the same as effective tax rates) are worthless.

Their estimates are based on earnings reported to the SEC — earnings as defined by Financial Accounting Standard Board (FASB) accounting rules, not by IRS reporting rules. Gordon and Kvaal acknowledge that “The figures reported on tax returns … may differ because corporations employ different methodologies for calculating income for accounting and tax purposes.”

If any corporation reported SEC/FASB earnings to the IRS, they would be in very big trouble with the IRS. If they reported IRS earnings to the SEC, they would be in very big trouble with the SEC.

FASB, for example, insists that the “fair value” of nonqualified stock options be estimated when the options are granted, regardless of their ultimate worth. The IRS, by contrast, is not about to let firms deduct the estimated cost of anything. The IRS insists that companies deduct the labor cost of stock options only if and when they exercised and therefore taxed as individual income.

Using a matched sample of financial statements with tax returns, George Plesko of the University of Connecticut business school found that “financial reporting information does not allow a user to infer important information about a firm’s tax attributes.”

Ignoring Plesko’s well-known point, Gordon and Kvaal report that ExxonMobil paid $4.3 billion in federal income tax in 2007, which they assume was 35% of their domestic profits as shown on SEC financial reports.

Their estimates then “present each corporation’s estimated savings from reducing the corporate tax from 35 percent to 25 percent.”

Since a 25% tax rate is 28.57% smaller than a 35% tax rate, they figured that ExxonMobil would have saved 28.57% of $4.3 billion, or $1.2 billion. They repeated such naïve arithmetic for the entire Fortune 200.

ExxonMobil’s accounting profits were almost $41. billion, worldwide, but 68% of their revenue came from overseas according to Forbes (Apr 21). If profits are roughly proportionate to gross revenue, then U.S. earnings would have been $13 billion (32% of the total), and a tax of $4.3 billion happens to be 33% of $13 billion.

At first glance, that might appear consistent with Gordon and Kvaal’s claim that companies as profitable as ExxonMobil really do pay 35% of profits to Uncle Sam. But that would contradict their other claim that “deductions, credits and exemptions … shield corporate profits from tax.”

If we repeat that same exercise for the least international oil companies on the Gordon-Kvaal list, it looks as if Valero paid 40% of domestic profits in federal tax and Conoco Phillips paid 47.6%. As economist and accountants understand, the reason accounting earnings generate such unbelievably high tax rates is that it is just not possible to infer effective corporate tax rates from accounting earnings as Gordon and Kvaal attempted to do.

As I wrote, “That is not economics; it is not even competent bookkeeping.”

Messrs. Gordon and Kvaal thought I was criticizing them for being lawyers rather than economists or competent bookkeepers. On the contrary, I was criticizing President-elect Obama for using estimates from John Podesta’s Center for American Progress Action Fund —a 501c4 political lobby with a rather obvious bias. Unlike any think tank, such political action funds are free to engage in lobbying and campaign activity. Indeed, Gordon and Kvaal boast that “our results have been featured in millions of dollars worth of advertising.” Well, that certainly adds credibility doesn’t it?

A Tale of Two Auto Industry Business Plans

As Detroit’s lobbyists rack up the expenses trying to paint the Big Three and the UAW as innocent victims of the credit crunch, American workers cheer the groundbreaking of an American automobile plant in the American heartland by Honda, which has been producing vehicles in Marysville, Ohio for more than a quarter century now.

Let’s not forget that it’s these companies – the one’s capable of making the investments in manufacturing, the one’s who are leading the way in terms of producing fuel-efficient, comfortable, stylish vehicles that Americans have been inclined to purchase – that are implicitly taxed and burdened when their competition is subsidized.

A “bailout” costs taxpayers/consumers in many more ways than one.

Everything Is a Security Issue

Anyone who sells to the Pentagon can claim that theirs is a strategic industry. In a war, enemies could cut off shipments from foreign producers, subsidy seekers say. Government then needs to protect American steel makers, shippers, shipbuilding, and so on. Those making these arguments avoid discussing the long odds that foreign supply will be interdicted or that the United States will fight a war that lasts long enough for it to matter.

Consider Wesley Clark’s op-ed in Monday’s New York Times. Clark notes that the Army buys a lot of vehicles from US automobile companies. Therefore, he says, bailing out the big three is a security issue. But letting US automakers go bankrupt does not mean they will stop making trucks. Even if they did, there are still foreign automakers that manufacture in the United States and would be happy to sell to Uncle Sam. And even if domestic automobile production disappeared entirely, we could still import. No imaginable enemy could close the sea-lanes that we use to bring in vehicles from Europe and Japan. Clark doesn’t address any of these holes in his argument. Nor does he let his lack of experience in the automobile business stop him from telling Detroit how to run its business.

In Sunday’s Washington Post, Joby Warrick offers similarly shaky analysis about the financial crises’ effect on US security.  Economic difficulty impacts every security issue, so you can always find an expert to tell you how the downturn heightens the odds of some particular nightmare.

Warrick suggests that lowered federal revenue could require cuts in defense spending, leaving us more vulnerable. Maybe, but the doubling of non-war defense spending since 2001 has bought us plenty of security to spare, by this logic. Warrick cites specialists who say increased global poverty will cause instability, which will cause terrorism. But there is no clear link between instability and terrorism. 

Warrick says “many government and private terrorism experts say the financial crisis has given al-Qaeda an opening,” which they may use to “probe for weakening border protections and new gaps in defenses.” Does anyone know what that means? The article never explains what defenses we’re talking about, let alone what gaps a downturn will open in them. It does not tell us why we should we view Al Qaeda as a carefully reckoning organization that probes and times its attack to US events, rather than groups of guys who attack when they can. The article cites analysts who say that the downturn could speed the day where China overtakes us economically. But China is not immune from economic distress. Nor it is clear that China’s rise is bad for US security.

The article could be turned on its head: “Global Downturn likely to slow China’s rise, undermine terrorist fund-raising, and eliminate wasteful defense spending, experts say.”

Gridlock Puts Brakes on Big 3 Bailout (for Now)

The Associated Press is reporting today that “Stalemate dims prospects for $25B auto bailout.”

Here’s the lead:

WASHINGTON (AP) - Prospects dimmed Monday for enactment of a $25 billion bailout for the faltering auto industry before year’s end, as congressional Democrats and the Bush administration seemed headed for a stalemate. Help for Detroit’s Big Three, which have been battered by the economic meltdown that has choked their sales and frozen their credit, is falling victim to a partisan fight over where the money should come from. Senate Democrats said they would press ahead with their plan to carve out a portion of the $700 billion Wall Street bailout to pay for the loans, but aides in both parties and lobbyists tracking the plan acknowledged they did not currently have the votes to do so. The White House and congressional Republicans insist that the automaker bailout money instead come from redirecting a separate $25 billion loan program approved by Congress to help the industry develop more fuel-efficient vehicles.

The story is already making me nostalgic for partisan gridlock and divided government, which will officially end on January 20, 2009.

My trade center teammate Dan Ikenson has been ably making the case in recent days that the bailout is a bad idea. What appears to be saving our country from wasting this huge amount of money is the much-bemoaned gridlock.

A key word in the story is “currently.” The plan does not “currently” have the votes to pass, but all that will change in 64 days.

Would an Auto Bailout Lead to National Greatness?

There have been plenty of criticisms here of neoconservatism and “national greatness conservatism,” but two of the occasional targets, Charles Krauthammer and David Brooks, have just published devastating critiques of the auto industry bailout. Here’s Krauthammer in the Washington Post:

First, the arbitrariness. Where do you stop? Once you’ve gone beyond the financial sector, every struggling industry will make a claim on the federal treasury. What are the grounds for saying yes or no?

The criteria will inevitably be arbitrary and political. The money will flow preferentially to industries with lines to Capitol Hill and the White House. To the companies heavily concentrated in the districts of committee chairmen. To clout. Is this not precisely the kind of lobby-driven policymaking that Obama ran against?

Second is the sheer inefficiency. Saving Detroit means saving it from bankruptcy. As we have seen with the airlines, bankruptcy can allow operations to continue while helping to shed fatally unsupportable obligations. For Detroit, this means release from ruinous wage deals with their astronomical benefits (the hourly cost of a Big Three worker: $73; of an American worker for Toyota: $48), massive pension obligations and unworkable work rules such as “job banks,” a euphemism for paying vast numbers of employees not to work.

The point of the Democratic bailout is to protect the unions by preventing this kind of restructuring. Which will guarantee the continued failure of these companies, but now they will burn tens of billions of taxpayer dollars. It’s the ultimate in lemon socialism.

Democrats are suggesting, however, an even more ambitious reason to nationalize. Once the government owns Detroit, it can remake it. The euphemism here is “retool” Detroit to make cars for the coming green economy.

Liberals have always wanted the auto companies to produce the kind of cars they insist everyone should drive: small, light, green and cute. Now they will have the power to do it.

And David Brooks in the New York Times:

This is a different sort of endeavor than the $750 billion bailout of Wall Street. That money was used to save the financial system itself. It was used to save the capital markets on which the process of creative destruction depends.

Granting immortality to Detroit’s Big Three does not enhance creative destruction. It retards it. It crosses a line, a bright line. It is not about saving a system; there will still be cars made and sold in America. It is about saving politically powerful corporations. A Detroit bailout would set a precedent for every single politically connected corporation in America. There already is a long line of lobbyists bidding for federal money. If Detroit gets money, then everyone would have a case. After all, are the employees of Circuit City or the newspaper industry inferior to the employees of Chrysler?

It is all a reminder that the biggest threat to a healthy economy is not the socialists of campaign lore. It’s C.E.O.’s. It’s politically powerful crony capitalists who use their influence to create a stagnant corporate welfare state.

Hear, hear. The intellectual case for the bailout–if there was one–surely can’t survive these two clear and analytical critiques in the nation’s most influential newspapers. But then, protectionism couldn’t survive the analytical critique of Adam Smith in 1776, and yet it persists. So we can’t assume that members of Congress will read Brooks and Krauthammer and sheepishly drop the idea of handing a big pile of taxpayers’ money to corporate managers, stockholders, and unions who have dug themselves into a deep hole.

Krauthammer and Brooks both make a careful distinction between the financial bailout and the proposed auto industry bailout. Krauthammer posits the Wall Street intervention as “an emergency measure to save the financial sector on the grounds that finance is a utility. No government would let the electric companies go under and leave the country without power. By the same token, government must save the financial sector lest credit dry up and strangle the rest of the economy.” But bailing out Detroit is put forth as a scheme to save jobs, and where does that process stop? Krauthammer warns that the “drift toward massive industrial policy threatens to grow into the guaranteed inefficiencies of command-economy maximalism.”

For those of us who opposed all the taxpayer bailouts, starting back with Bear Stearns―or with Chrysler in 1979―all these bad ideas may seem to run together. Bear Stearns, AIG, the general financial industry, the auto industry―it’s all government intervening with taxpayers’ money to favor some businesses or industries that made mistakes. Perhaps because they weren’t so critical of the measures to deal with the financial crisis, Krauthammer and Brooks find it easier to see what’s very different about the Detroit bailout. And they both make crucial points: the dangers of political allocation of resources, the benefits of bankruptcy and restructuring, the industry’s partially self-inflicted wounds, the desire of some Democrats for political power over corporate decisionmaking, the dangers of corporate capitalism. Let’s hope members of Congress read and underline both columns.