Thursday, September 29, 2011

America's Gasoline Excise Tax: A Mighty Temptation

Updated April 2013

As we are all aware, a portion of what we pay at the pump is in the form of an excise tax that is collected by the refiner and remitted to more than one level of government.  Excise taxes are basically sales taxes levied on specific goods as either a percentage of the value of the good or as a set dollar value per unit of the good as in the case of gasoline taxes (i.e. cents per gallon).  In the case of the United States, for the most part, these gasoline excise taxes are used to fund the construction and maintenance of our highways.  In this way, the excise tax does create jobs as the nation's highway transportation infrastructure is improved.  

Collecting excise taxes on gasoline in the United States began nearly a century ago.  The first state to enact gasoline excise tax legislation was Oregon in 1919; within just over a decade, every state in the Union had enacted its own state-level excise tax.  At that time, state gasoline taxes ranged from 2 to 7 cents per gallon.  The first federal government gasoline general revenue tax appeared in 1932, right during the height of the Great Depression, at the rate of 1 cent per gallon and became a permanent excise tax in 1941.

Gasoline taxes were raised from 4 cents per gallon to 9 cents per gallon under the Reagan Administration in 1983.  The purpose of the increase was to repair American highways and create jobs in an economy that was in the early phase of a recovery.  In 1990, under the Bush I Administration, gasoline taxes were raised by 5.1 to 14.1 cents per gallon, ostensibly to reduce the deficit.  Gasoline taxes were last increased in December of 1993 under the Clinton administration.  Use of the funds raised by that increase of 4.3 cents per gallon to the current level of 18.4 cents per gallon was once again restricted to deficit reduction.

Economists and politicians know that by increasing the level of the excise tax, consumers could be encouraged to increase their use of more fuel-efficient vehicles and may ultimately use more mass transit.  This would result in consumption of less oil and create less air pollution.  On the other hand, an increase in gasoline taxes would affect the pocketbooks of Americans who live in rural areas to a greater degree since they generally have to drive greater distances to access goods and services.  As well, governments have generally proven themselves to be rather poor stewards of tax revenue and the benefits to society by having the revenue in the hands of government may be outweighed by the benefits of leaving the revenue in the hands of the private consumer.

The demand for gasoline is generally considered to be very nearly completely inelastic, that is, a given increase in price results in almost no drop in demand or a drop that is far less than would normally be expected when compared to other goods.  This means that if the federal government decides to increase the excise tax, the revenue recovered from consumers will increase by more than the amount they might lose due to a relatively small drop in demand.  That said, inelasticity in demand can be overcome if price (tax) increases are high enough.  Eventually, gasoline prices will rise high enough that consumers will reach their personal gag point and simply cut back on their consumption.  If we look at historical price and demand data, between 2000 and 2007, gasoline demand rose by 9.6 percent even though the price of gasoline nearly doubled.  As 2007 turned into 2008, gasoline demand dropped as a result of the recession and gasoline prices that exceeded $4 per gallon.  Right now, gasoline demand in the United States is generally around 9 million barrels or 378 million gallons per day (2010 EIA data), down about 3 percent from 2007, largely because of a very weak economy.

At this point in time, the United States federal excise tax on gasoline stands at 18.4 cents per gallon (the equivalent of 4.86 cents per litre, substantially lower than Canada’s rate of 10 cents per litre).  This works out to approximately 5 percent of the average price per gallon (depending on the price at the pump).  Of the 18.4 cents, 18.3 cents is allocated to the Highway Trust Fund and the remaining 0.1 cents is allocated to the charmingly acronymed LUST Fund or Leaking Underground Storage Tank Trust Fund, a fund used to remediate the problems created by America's aging fleet of corroding underground gasoline storage tanks.  In the first three-quarters of fiscal 2011, gasoline excise taxes have generated over $22 billion for the Highway Trust Fund, not particularly a huge amount given the size of Washington’s overall budget.

States and local governments also get their pound of flesh from America's gasoline consumers as well.  These taxes plus the Federal excise tax add between 40 and 50 cents to a gallon of gasoline.  Here's a nifty little map from the American Petroleum Institute showing the total local, state and federal gasoline excise tax burden for all states in the Union:

Note that the average total gasoline excise tax for all states is 48.9 cents per gallon.  Connecticut has the highest gasoline excise tax burden at 68 cents per gallon and Alaska has the lowest at 26.4 cents per gallon.  That’s quite a spread.

Since, as mentioned previously, the price elasticity of demand for gasoline shows it to be extremely inelastic, it will take a very large increase in the level of taxation before consumers will cut their consumption level.  The current level of gasoline excise taxes form a relatively small portion of the price of gasoline.  With gasoline prices averaging around $3.50 per gallon, the federal portion of the excise tax adds only 5 percent to the price of a gallon of gasoline and total taxes add only 14 percent.  With current tax levels, it is very difficult for governments to use gasoline excise taxes to force consumers to switch to more environmentally friendly options.  The tax increases that would be required to change our behaviour would most likely be politically suicidal.

Now, let's take a look at how heavily gasoline consumers are taxed in other jurisdictions.  Here is a bar graph showing the level of fuel taxation for the month of April 2011 for a number of nations:

Note that the United States has by far the lowest fuel tax among all nations on the chart other than Mexico which subsidizes its consumers. Canada comes in second place at just under a dollar per gallon and the United Kingdom comes in fourth from the top at just under $4 per gallon.  Note that some of the EU nations have extremely high levels of fuel tax compared to just about everyone else in the world.

When one looks at the 378 million gallon per day gasoline consumption level and America's very low gasoline excise tax levels in conjunction with the $1 trillion plus deficit and $16.4 trillion debt, one can see where this story could well end up.  It has to be extremely tempting for governments at all levels to stick their hands into Main Street's wallets once again.  Should the Obama Administration make the extremely daring move of increasing gasoline excise taxes to $1 per gallon, that move alone would raise $138 billion annually.  A $2 per gallon excise tax would raise $276 billion and, despite the pain that would be inflicted, gasoline excise taxes would still be well below that of most OECD nations.  While this increased revenue would assure future funding for the Highway Trust Fund and should result in the creation of at least some jobs, it would most likely be political suicide.  As well, in this time of economic weakness, the transfer of funds from consuming taxpayers to Washington could well throw the economy further into a downward spiral.

Apparently, Washington is once again caught between a rock and a very hard and dark place.  Congress is going to be very tempted to raise gasoline excise taxes to achieve the fiscal balance they so badly need.


Tuesday, September 27, 2011

A Negative Federal Tax Rate - Only American Corporations Need Apply

With Washington trying desperately (well, they are at least pretending that they are trying desperately) to balance their revenues with their expenditures at the same time as they are trying to reduce joblessness, talk of changes to America's corporate tax rates appear in the mainstream media's business publications on a regular basis.  While posting about corporations who pay their CEO's more than they pay in taxes last week, I stumbled on the pre-release for this study released by the group Citizens for Tax Justice (CTJ), a public interest research and advocacy organization whose mission is " give ordinary people a greater voice in the development of tax laws.".  In their brief entitled "Twelve Corporations Pay Effective Tax Rate of Negative 1.5% on $171 Billion in Profits; Reap $62.4 Billion in Tax Subsidies", CTJ analyzes the pretax profits, federal tax paid and effective tax rates of 12 Fortune 500 companies for the years between 2008 and 2010.  Here are CTJ's findings as outlined in the pre-release.  Please note that the full study has not yet been released to the public but when it is, I will post on CTJ's final observations.

CTJ studied the pretax profits and taxes paid by American Electric Power, Boeing, Dupont, ExxonMobil, FedEx, General Electric, Honeywell International, IBM, United Technologies, Verizon Communications, Wells Fargo and Yahoo.  Their analysis shows that not a single one of these companies paid the much-touted and bemoaned 35 percent corporate tax rate.  Let's take a look at a few examples of which corporations paid or didn't pay among the twelve:

1.) The most heavily taxed as a percentage of U.S. profits:  The award for this honour goes to ExxonMobil which paid an effective tax rate of 14.2 percent, only only 40.6 percent of the headline 35 percent rate.  Over the three year period from 2008 to 2010, ExxonMobil paid only $2.783 billion in taxes on $19.655 billion in profits.  That is particularly juicy in this time of high oil prices.

2.) The most profitable corporation:  The award for this honour goes to Wells Fargo which made a massive profit of $49.370 billion over the three year period of the study.  On that profit, Wells Fargo actually received a $681 million tax benefit, resulting in an effective tax rate of negative 1.4 percent.  Must be nice if you can get it!  Oh to be a corporation!

3.) The corporation with the lowest Federal tax rate:  The award for this honour goes to General Electric (remember, the CEO of GE is President Obama's "job czar", one Jeffrey R. Immelt).  Over the three year period in question, GE's United States profit was $7.722 billion, hardly chump change.  However, the generosity of the current corporate tax system saw fit to reward GE with a $4.737 billion tax benefit.  This resulted in a three year effective Federal tax rate of negative 61.3 percent!  Note as well that General Electric also receives the honour for the largest Federal tax benefit as noted two sentences ago.  Congratulations!  Since Mr. Immelt heads a corporation that has achieved such illustrious awards under his tenure, I thought I'd throw in his photograph from the cover of Bloomberg Markets for the illumination of my readers:

Here's a chart showing the pre-tax profits, Federal income taxes paid (or not) and effective Federal tax rate for all 12 corporations:

Note that all of the companies but two (poor sad IBM and United Technologies) enjoyed at least one tax-free year during the period from 2008 to 2010.  In total, the 12 corporations made $171.021 billion in profits over the three year period and paid a grand total of, drum roll please, negative $2.5 billion in taxes for an effective overall Federal tax rate of minus 1.5 percent.  According to CTJ, had these 12 corporations paid the full 35 percent corporate tax rate that CEO's are prone to whinge about, they would have remitted $59.85 billion to the Federal coffers rather than collecting $2.5 billion in benefits.  That would have raised total corporate taxes collected by Washington by 12 percent for the three year period.

Let's put the amount of corporate taxes that Washington receives into perspective.  Here's a screen capture from the Congressional Budget Office's Monthly Budget Review for the first 11 months of fiscal 2011 released on September 8th, 2011 showing where the Federal government's revenue is sourced:

Despite a nicely profitable year, corporate taxes have not grown from fiscal 2010 to fiscal 2011 and, at $142 billion, are only 14.5 percent of the revenue sourced from individual income taxes, down from 17.95 percent in fiscal 2010.

Now, let's go back to the Monthly Budget Review from September 5th, 2008, just before the soft, glutinous material hit the rotating cooling device.  Here is a screen capture showing the data:

Notice that corporate income taxes for the first 11 months of 2008 were $251 billion, over 75 percent higher than what they were in 2010 and 2011, despite the fact that the economy was starting to circle the white porcelain bowl, particularly in comparison to 2010 and 2011.  At this point in fiscal 2008, corporate taxes were 24.75 percent of revenue sourced from individual income taxes, nearly twice as high as in fiscal 2011.

It is rather interesting to see how corporations seem to be quite adept at minimizing their tax burden.  Oh the juggling that must go on.  Perhaps their ability to purchase the services of tax lawyers and accountants allows them tax luxuries that the rest of us can only dream about.  Maybe it's time that Washington simplify the tax code to make it more transparent, eliminate some corporate tax loopholes and ensure that highly profitable American corporations pay their fair share.  The CTJ study shows us that this is not currently happening and given the current talk on the street, it is unlikely to happen anytime soon.

Friday, September 23, 2011

The Law of Unintended Consequences Part 2 - The Downside of Quantitative Easing and the "Twist"

You know how we never hear about the downside of the Federal Reserves quantitative easing programs from their architects?  We all know that QE1and QE2 really didn't work out that forcing the Fed to flash back to the 1960s to pull their next stunt out of their bag'o'tricks.  Not only did QE not have much of a positive impact on the American economy, it seems that its impact may well have been created at least part of the problem with the economy that it was intended to fix , contrary to what Mr. Bernanke and his Band of Merry Bankers would have us believe.  Remember how we were told initially that QE had resulted in lower unemployment, rising house prices, lower interest rates, a stock market that was on a seemingly never-ending tear upwards and that a cure for cancer had been found all because of the Fed's policies? (well, maybe not the last one)  Apparently, the suspicions that those of us who live on Main Street have had about QE have not been in error.  All is not well in America and we need look no further than Fed policies to see where things went off the track.

I found this interesting analysis of the impact of quantitative easing on America's economy at the website for the American Institute for Economic Research (AIER).  The paper, entitled "The Downside of Monetary Easing" by William F. Ford and Polina Vlasenko published by the American Institute for Economic Research dated July 4th, 2011, outlines the unintended consequences of the Fed's policy of "pumping and dumping" "money" (also known as a binary code that only computers can understand) into the system.

The Federal Reserve's quantitative easing programs QE1 and QE2 dumped about $2 trillion into the financial system after the near meltdown of 2008.  To keep interest rates from rising and further smothering the economy, the Fed flooded the financial markets with “paper” by purchasing larger than normal quantities of United States Treasuries and mortgage-backed securities in an attempt to get credit flowing.  In the minds of central bankers, there are three benefits to the economy that result from lower interest rates which I will outline in the following three paragraphs.

First, the low interest rates that result from QE are supposed to entice consumers to borrow and spend and to prod businesses into investing in plants, equipment and inventory.  These temptingly lower interest rates will lower the total cost of expenditure for both consumers and businesses and the resulting increase in economic activity will result in lower unemployment.  Whoppee!  We all win!  We get to buy all kinds of stuff on cheap credit and keep our jobs too!  Apparently, the bankers at the Fed seem to have forgotten that it was their policy of easy and cheap credit from the early part of the decade that helped consumers buy too much house and use their meagre home equity to borrow even more of a bad thing.

Secondly, another benefit of ultra low interest rates is related to the value of the American dollar.  When American interest rates are low compared to our trading partners, the value of the United States dollar is driven down since it is a less attractive currency.  This leads to an increase in exports of U.S.-made products since, when all else is equal, consumers et al outside the United States get more bang for their buck by purchasing American goodies.  As well, the low greenback makes imported products relatively more expensive, meaning that Americans are more likely to consume domestically produced goods.  Both increased exports and decreased imports should result in more jobs for Americans.  Once again, we all win!

Third, when the Fed buys up long bonds, their prices are pushed up, driving yield down.  As a consequence, yield-hungry investors that are looking for a reasonable return on their money are essentially forced to look to investments other than bonds.  In many cases, investors will turn to the stock market; their increased investment in stocks pushes prices up and creates a feeling of increased wealth.  This wealth factor results in investors/consumers prying open their wallets and spending more, further stimulating the domestic economy and creating employment.  Yet again, we all win!

Now for the downside.  The authors of the paper note that the prolonged period of ultra-low interest rates put in place by our friends at the Fed have had a very marked impact on the lives of both savers and particularly retirees who rely on interest-bearing investments as a key part of their portfolio.  This period of generationally low interest rates has made it almost impossible for most retirees to live off the returns from their interest-bearing savings, particularly if these investments took the form of bank issued CDs or GICs which generally mature in five years or less.  Right now, 5 year CD/GIC rates in the United States range from 1.5 percent to just over 2.0 percent annually.  Short-term rates are even worse as shown in this graph of 6 month CD rates for the past 10 years:

When you're getting a fraction of a percent on your investments, one wonders if money wouldn't be just as well off stuck between the mattress and box spring where it is out of the reach of the unstable banking industry.  In the low interest environment, investing strictly becomes capital preservation, less the impact of inflation.  Interestingly enough, if you look at all yields, they are extremely low right across the maturity curve with 30 year yields falling south of 3.4 percent, very close to an all time low as shown on this graph:

With an estimated $9.9 trillion in interest-sensitive assets held by United States households at the end of the second quarter of 2010, plus the investments made by life insurance companies and private pension plans, low Treasury yields are impacting the income levels from up to an estimated $18.8 trillion in assets.  Since pension plans and life insurers don't invest all of their funds in interest-bearing investments, the authors of this study assume a mid-point estimate of $14.35 trillion for the total American assets affected by the generationally low interest rate environment created by Ben Bernanke and his pals.

If you don't believe the observation that current interest rates are stunningly and comparatively low following the Great Contraction of 2008 - 2009, here's a table showing the average United States Treasury yields one year after the start of the last 9 recoveries compared to the current recovery and the difference between the two:

Current interest rates are dwelling in the basement by comparison to the average of the last 9 recoveries and are showing no signs of improvement any time soon.

Now, let's take the difference between the average post-contraction interest rate and the current post-contraction interest rate and utilize the mid-point $14.35 trillion in interest-sensitive investments as noted above.  Over the spectrum of maturities from 6 months to 30 years, the interest rate difference from the above chart is negative 4.93 percentage points (i.e. the interest rate after the Great Contraction was 4.93 percentage points lower than what it would normally be one year after the start of a recovery).  For the mid-point $14.35 trillion in interest-yielding investments, the authors estimate that the total loss in consumption as a result of our current abnormally low interest rates environment is $371 billion which equates to 2.53 percentage points of GDP or 3.5 million jobs.  This increase in the number of jobs could have lowered the unemployment rate from its current 9 percent to roughly 6.8 percent.  As well, the authors calculate that the additional GDP growth from additional spending by those who hold interest-sensitive investments would have brought GDP growth to 4.86 percent, close to the average for most recoveries in their second year.  Further to their analysis, the authors note that for every 1 percentage point decrease in yields, $75 billion of consumption or 0.51 percent of GDP or 715,000 jobs are lost using the midpoint $14.35 trillion asset figure.  We must also keep in mind that additional spending by those who receive interest income has a multiplier effect as it works its way through the American economy, multiplying the positive effects on economic growth that is not explained by simple one-time spending by consumers alone.

Once again, perhaps the Federal Reserve has fallen into the "law of unintended consequences" trap.  While low interest rates seem to be a partial panacea for the ills that affect the world's economy, they are a trap for more than one reason.  Lower interest rates do not necessarily cause savers to spend, rather, savers may take additional and ill-advised investment risks to boost their investment income, exposing themselves to a potentially calamitous loss of capital.  In addition, consumers that have not over-leveraged themselves may be tempted to take on additional consumer debt because, at current interest rates, the additional debt appears to be quite serviceable.  This is an issue that concerns at least one of the world's central bankers, the Bank of Canada's Mark Carney.  Even more importantly though, is the risk posed by governments that are being duped into thinking that they can continue to borrow and spend endlessly because interest on the accrued debt seems reasonably manageable at the current generational lows in interest rates.  Such will definitely not be the case when interest rates rise to their historic norms and we can all imagine who will suffer the greatest pain from their impact on sovereign debt interest costs.

If you recall my posting of September 29th, 2010 entitled "Quit griping and spend your!", you'll recall that a central banker, the rather aptly named Mr. Bean from the Bank of England, stated the following:

"Savers shouldn't necessarily expect to be able to live just off their income in times when interest rates are low. It may make sense for them to eat into their capital a bit."

"Very often older households have actually benefited from the fact that they've seen capital gains on their houses."

Mr. Bean's comments are most interesting in light of the findings of the AIER study.  Central bankers are interested in one thing only - economic growth at any cost and they want us to pay by increasing our consumption of consumer goods.  From what we have seen from the results of this study, it appears that the issues related to artificially low interest rates will only get worse as the Fed does the “Twist”.  Stand by for more bad economic news.

Wednesday, September 21, 2011

Will the Federal Reserve Policy Create A Lost Decade for America?

With the Federal Reserve pondering how they can unscrew themselves from the corner that their experiments have screwed them quite firmly into (i.e Operation Twist), I thought it was time to look at a paper by James Bullard, President and CEO of the Federal Reserve Bank of St. Louis.  This paper, entitled "Seven Faces of "The Peril" (a rather ominous sounding title, don't you think?) was released in late July 2010 and looks at the deflationary issues facing Japan's economy and how the actions taken by the Federal Reserve’s Federal Open Market Committee (FOMC) could help avoid this economic nightmare (for central bankers) with their program of quantitative easing or how they could mimic Japan’s problem by implementing a long period of near zero interest rates.  Let's delve more deeply than we ever have into the mind of a central banker.

Mr. Bullard opens with the rather frightening "...most worrisomely, current monetary policies in the U.S. (and possibly Europe as well) appear to be poised to head straight toward the problematic outcome described in the paper.".  The paper he refers to was written by three academic economists in 2001 and is entitled "The Perils of Taylor Rules".  For those of you who aren't aware of Taylor-type economic policy, it occurs when central bankers change nominal interest rates at a more than one-for-one ratio when inflation deviates from a given target.  Taylor Rules are basically a guideline for interest rate manipulation where changes in interest rates are used to both stabilize the economy in the short-term and maintain long-term growth.  Central banks will raise interest rates in times of high inflation and lower rates when inflation is low.  In general, Taylor Rules are followed by many of the world's central banks today on either a formal or informal basis.  As well, in the “Perils of Taylor” paper, the authors emphasize that a combination of Taylor Rules and a zero limit on interest rates will create a new outcome for a given economy that will result in very low interest rates and a deflationary environment.  One need look no further than Japan to see Taylor rules and deflation in action as we will see.

To open, and for your information, here are two graphs showing the benchmark interest rates for the United States and Japan since the very early 1970s:

Notice that while Japan’s benchmark rate has been low since the mid-1990s, the U.S. interest rate pattern is quite similar and could well replicate what has been experienced in Japan.

Now let's look at a graph from Mr. Bullard’s research showing both monthly short-term interest rates and inflation for Japan (round green data points) and the United States (square blue data points) from 2002 to 2010 with inflation on the horizontal axis (with the negative numbers showing deflation) and nominal interest rates on the vertical axis:

Please bear with me while I attempt to explain what this graph is telling us.  The red dashed line is called the Fisher relation or Fisher hypothesis.  In the Fisher hypothesis, the real interest rate is equal to the nominal interest rate (the rate you see posted at your local bank for example) minus the expected rate of inflation.  In this case, Mr. Bullard has taken the real component of the interest rate and fixed it at one-half percent or 50 basis points.  In Main Street speak, if nominal interest rates are 1 percent, then the Fisher relation will bring real interest rates up to 1.0 plus 0.5 or 1.5 percent.  Looking at the curved black line, we see the Taylor Rule in action.  This line describes what central bankers do as inflation rises, that is, they raise interest rates.  When inflation is above their preferred target, they raise interest rates at a more than one-for-one ratio.  When inflation is below their preferred target, central bankers raise interest rates at less than a one-for-one basis.  Notice on the graph that the straight red line (the Fisher line for lack of a better label) crosses the curved black line.  This is called the steady state where the central bank no longer wishes to raise or lower interest rates.  This is the point where central bankers have to raise interest rates at more than the rate of inflation, that is, where inflation is greater than 2.3 percent and nominal interest rates are greater than 2.8 percent, interest rate increases are greater than one-to-one.  Thus, the black line becomes steeper because it takes greater increases in interest rates to keep inflation within the central bank's target zone.

Now, if you look at the far left side of the graph, you'll notice that the red dashed line and black curved line intersect once again in amongst the green Japanese circles.  This second or unintended low interest rate steady state occurs where inflation (or in this case, deflation) is negative one-half percent (-50 basis points) and interest rates are nearly zero.  In this case, the policy rate cannot be lowered below zero but it is not really necessary (or possible for that matter) since inflation is non-existent.  That's most fortunate since the Bank of Japan has absolutely no "wiggle room" left.  Unfortunately, deflation is the stuff made of nightmares for central bankers and is exactly the outcome that they do not want from messing with interest rates.  Central bankers, particularly the Fed, are trying desperately to avoid ending up with the blue squares representing the U.S. experience with inflation and interest rates overlying the area on the graph covered with little green circles.

Note that the little solid coloured blue data point labeled "May 2010" lies very close to the horizontal axis of the graph along with a whole collection of other similar data points.  These data points are showing us that American interest rates are nearly zero but that there is still inflation within the system, unlike in the case of Japan.  The "May 2010" point does, however, show a potential slide toward the Japanese model discussed above.  With the Federal Reserve recently announcing that it was committing to a long-term policy of near zero rates, it would appear that they have boxed themselves into a corner.  The Fed wants and needs at least some level of inflation but, from the example of Japan's green data points, we can see that the ultimate outcome of extremely low interest rates could be the much dreaded negative inflation.  Here's a quote from Mr. Bullard's paper:

"Both policymakers (the world's central bankers) and private sector players continue to communicate in terms of interest rate adjustment as the main tool for the implementation of monetary policy. This is increasing the risk of a Japanese-style outcome for the U.S."

What he's saying is that the use of interest rates as a means to control the level of inflation (i.e. Taylor Rules) by central bankers around the world do not always work.  Deflation can and may well occur because of the Federal Reserve's long-term pledge to keep interest rates at a near zero level.

Through the remainder of the article, Mr. Bullard goes on to suggest that divisions among economists about his findings range from denial to tinkering with the minimum interest rate level that should be allowed.  He also discusses the policy of quantitative easing and how it is expected (hoped) to be inflationary.  Here's a quote:

"...The experience in the U.K. seems to suggest that appropriately state contingent purchases of Treasury securities are a good tool to use when inflation and inflation expectations are too low.  Not that one would want to overdo it, mind you, as such measures should only be undertaken in an effort to move inflation closer to target."  (my bold)

One question: how do central bankers know when they have overdone quantitative easing?  Is it possible that QE 3, if implemented, could be the straw that breaks the camel’s back?

Basically, those of us who live on Main Street are the subjects of a gigantic fiscal experiment by central bankers, most particularly the Federal Reserve.  They have no precedent which will allow them to predict the long-term outcome of their policy of ultra-low interest rates other than Japan and that is exactly the outcome they desperately need to avoid.  Interestingly enough, according to the Bank of England, in 314 years, interest rates never fell below 2.0 percent until recently.  That is most telling.

Here are Mr. Bullard's concluding remarks:

"The global economy continues to recover from the very sharp recession of 2008 and 2009. During the recovery, the U.S. economy is susceptible to negative shocks which may dampen inflation expectations. This could possibly push the economy into an unintended, low nominal interest rate steady state. Escape from such an outcome is problematic. Of course, we can hope that we do not encounter such shocks, and that further recovery turns out to be robust but hope is not a strategy. The U.S. is closer to a Japanese-style outcome today than at any time in recent history." (my bold)

The recent debt issues facing the Eurozone make it less and less likely that the world will return to a normal interest rate environment anytime soon.  Inflation, as shown on the graph at the beginning of this posting can move one of two ways.  Should it move toward the green circles, the United States could well experience Japan's "lost decade".

Remember this rule of thumb: economics is not a science, rather, it’s more akin to medieval alchemy.  The actions of today’s central bankers are all the proof that we need.

Monday, September 19, 2011

CEO Excess - How to make more money than your company pays in taxes

In light of the recent begging by Warren Buffett for higher taxes for the rich, I thought that I'd take a look at a recent report by the Institute for Policy Studies entitled Executive Excess 2011: The Massive CEO Rewards for Tax Dodging.  This is the Institute's 18th Annual Executive Compensation Survey and as always, it is both an interesting and maddening read.  This year, in particular, the study outlines just how CEOs are rewarded for minimizing taxes remitted to Washington, a most timely bit of research considering that Washington is relying more and more on taxation of individuals for revenue growth and consistently discussing the lowering of corporate taxes in the name of the creation of jobs.

Let's start off with this interesting fact: 25 major United States corporations actually paid their chief executives more than they paid in federal income taxes.  Sit and think about that for a minute before you read the next paragraph.  Then think about all of the Main Street Americans that you know or are related to that have suffered from long-term unemployment since the advent of the Great Recession nearly 3 years ago.

Now look at this graph:

This shows the ratio of CEO pay to worker pay for the last four years, just prior to and during the Great Recession.  Notice that CEO pay levels have risen to nearly their pre-Recessionary levels when compared to worker pay.  Notice that CEO pay has jumped from 263 times worker pay in 2009 to 325 times worker pay in 2010.  That's quite a nice pay jump if you happen to dwell in the top floor corner office and not so nice if you don't.

Let's now examine just how much America's corporate leadership stuffed into their mattresses in 2010.  It turns out that among the nation's S&P 500 corporations, CEO pay averaged a rather paltry $10,762,304, up a rather infinitesimally minute 27.8 percent on a year-over-year basis.  I, for one, cannot imagine how anyone could live on that kind of money!  How is one supposed to maintain that yacht, private jet, fleet of antique automobiles and 10,000 square foot house?  I also cannot imagine how anyone could get by with just a 27.8 percent annual raise.  On the other side of the spectrum, those of us who sweat while we work averaged $33,121 in 2010, up an extremely Scrooge-like 3.3 percent on a year-over-year basis.  No one can fault the folks in the corner offices for throwing little more that a few shiny baubles and mirrors down the corporate food chain, can they?  After all, they have to preserve both their jobs and corporate profitability and that's a full-time job.

For the purposes of this study, the folks at IPS researched the 100 United States corporations that paid out the most in CEO compensation in 2010.  They then looked at how much federal corporate income tax was paid by these same corporations.  In the case of 25 corporations, it was found that the pay and benefits package for the company's CEOs was greater than the amount of federal income tax remitted.  In fact, as a bonus, even inflated executive pay is a tax deduction through the use of stock-based compensation deductions!  In most cases, the low tax bills faced by these companies were not due to a lack of profitability, rather, they were due to tax avoidance.  Eighteen of the twenty-five firms actually have subsidiaries in offshore tax haven jurisdictions; in fact, among them, they had 556 tax haven subsidiaries in 2010.  These tax havens are estimated to cost the Federal government over $100 billion annually.  While that's chump change compared to the overall deficits Washington is running, it's certainly a start.

Just how do these tax havens work?  By opening a subsidiary in a jurisdiction with low corporate tax levels, American corporations transfer the intellectual rights to their products to these tax holiday resorts.  This is a favourite ploy of both technology and drug companies.  Once the intellectual rights for certain properties are transferred to the out-of-country subsidiary, the United States-based operations are charged inflated amounts for the use of these rights which, you guessed it, get deducted from United States earnings (and taxes).  On top of this insult to those of us that actually pay taxes, Corporate America once again has its hands out looking for another cut in taxes to a 5.25 percent rate on overseas profits should they be allowed to bring the money back to these hallowed shores.  As I mentioned, technology and drug companies are fond of these particular havens, however, a couple of companies that American taxpayers and mortgage holders are very familiar with, are loaded with tax haven bliss.  Citigroup has 427 tax haven subsidiaries and Bank of America has a rather paltry 115.  It's most reassuring to know that those TARP funds that everyone chipped into were used to support the most needy of America.

Now, let's get back to the subject of this posting; executive excess.  The IPS study details ten companies that pay their CEOs more than they pay the United States Treasury, but I'll select three that are particularly interesting.

Let's start with General Electric.  Why GE?  Because, GE's CEO Jeffery Immelt just happens to be President Obama's job czar.  Mr. Immelt earned $15.2 million in 2010, a rather handsome sum.  As background information, GE happens to be the 14th most profitable American corporation in 2010 with net earnings of $11.6 billion.  Not to worry, some of those profits are sheltered in one of the company's 14 tax havens including Bermuda, Singapore and Luxembourg.  Now to the bottom line.  What did GE pay in United States taxes in 2010?  The answer: a $3.3 billion refund despite making more than $5 billion in profits in the United States.  Oh, and by the way, GE has shuttered 31 plants in the United States since 2008 and laid off 19,000 workers over the past two years.

Now let's look at bank because who doesn't love banks!  The CEO of the Bank of New York Mellon, one Robert Kelly, took home $19.4 million in 2010.  The BNY Mellon availed themselves of $3 billion in TARP assistance but, fortunately for Mr. Kelly, the funds that American taxpayers loaned to BNY Mellon were repaid before restrictions on CEO pay were put into place.  This has allowed Mr. Kelly to earn over $10 million annually over each of the past 3 years, poor fellow that he is.  What has the BNY Mellon earned for its shareholders in 2010?  The bank earned $2.4 billion in United States pre-tax income in 2010 and paid a massive negative $670 million in taxes.  Yup, they got a tax refund too.

Lastly, let's look at the highest paid CEO in this sampling of ten corporations.  Stanley Black and Decker, manufacturers of the most manly of man toys, paid its CEO, John Lundgren, $32.6 million last year, a 253 percent pay increase from the previous year thanks to more than $25 million in stock.  Stanley Black and Decker actually got a $75 million federal tax refund, in part due to its 50 tax haven subsidiaries.  That's nice if you can get it.

Just to put these numbers into perspective, let's take a historical look at just how much of the United States Treasury's overall revenue comes from corporation taxation:

For the first 11 months of fiscal 2011, corporate taxes remitted to the Treasury totalled $142 billion, unchanged from the previous year.  In the same eleven months, individual income tax brought in $977 billion, up 23.5 percent on a year-over-year basis.

Apparently, Citizens for Tax Justice is in the process of completing a study on tax avoidance among the Fortune 500 corporations.  They have identified 12 corporations that paid an effective tax rate of negative 1.5 percent on profits of $171 billion.  That is a subject for another posting.  However, I'd suggest that you keep that number in mind when Washington tells those Americans who live on Main Street that we must lower corporate tax rates to remain competitive.  It's also worth remembering this posting when you hear executives whine about America's 35 percent corporate tax rate.

As an aside, and just in case you were interested, the 25 corporations highlighted in the IPS report spent more than $150 million in 2010 lobbying Congress and contributing to election campaigns.  Their near tax exempt status is simply an unfortunate coincidence.  Sad, isn't it?

Thursday, September 15, 2011

The Eurozone's Shrinking Economic Growth Predictions

With the debt issues facing a rather large handful of the Eurozone Member States hitting page one of many of the world's mainstream media newspapers, I thought that I'd take a look at the most recent economic forecast for Europe provided by the European Commission.  Their Interim Forecast for September 2011 suggests that all is not well in the Eurozone as far as projected economic growth is concerned for the second half of 2011.

The EC projects that economic growth is expected to come to a standstill in the second half of this year but is not expected to result in a double dip recession.  For the entire year, GDP growth is forecast to be 1.7 percent with third and fourth quarter growth falling to 0.2 percent, revised downward by 0.2 and 0.3 percentage points for the aforementioned quarters.  Here is a graph showing the quarter-over-quarter growth since 2007:

Notice that quarter-on-quarter growth for 2011 is well under the growth levels experienced in the Eurozone prior to the Great Contraction.  After quarter-over-quarter growth rates reached 0.8 percent in Q1 2011, it fell to a paltry 0.2 percent in Q2 2011 with a pronounced drop in exports which were down from 2.2 percent quarter-over-quarter growth in Q1 to 0.6 percent in Q2 because of weakening global trade.

Here is a graph showing the negative change in growth levels for several EU member states from the first half of 2011 to the second half of 2011:

Notice how widely the economic growth rates vary across the EU.  Notice as well that Italy is projected to have near zero growth for the second half of 2011, well below the EU average.  This should be of great concern since Italy has the world's third largest nominal sovereign debt and is being pressured to adopt austerity measures in order to prevent default.

Tension within the banking system is rising.  The three month LIBOR (London Interbank Offered Rate) OIS (Overnight Index Swap) has risen by 75 basis points and is at its highest level since the spring of 2009 when the merde really hit the fan.  Overnight deposits with the European Central Bank have risen to over 150 billion euros in early September, indicating that banks are not lending to each other.  This indicates that there is mistrust within the banking system similar to what was seen during the Great Recession.  This is NOT a good sign.

On the upside, the EC expects that consumer price inflation should drop very modestly over the second half of 2011 as energy prices moderate somewhat as shown in this graph:

In contrast, the United Kingdom is expected to have higher inflation that originally projected since increased energy prices are due in the second half of 2011.

Unemployment is expected to remain stable at about 9.5 percent in the EU and 10 percent in the euro area, only slightly lower than last year.  Once again, changes to unemployment levels are anticipated to vary widely across the EU with Germany showing the most improvement and Spain showing the least.  Employment prospects are not expected to improve over the second half of the year.  Here is a graph showing the changing unemployment levels for the EU, euro area and a smattering of Member States:

Let's take a brief look at the prognostications for two of the EU Member States that reside at opposite ends of the fiscal spectrum.

Germany experienced rapid quarterly growth in Q1 2011, with real GDP growth of 1.3 percent on a quarterly basis.  This dropped to 0.1 percent in Q2 2011, partially due to the impact of shuttering nuclear power plants.  Over the full year, German real GDP growth is expected to reach 2.9 percent.  Moderation in growth is expected for the second half of the year and consumer sentiment has dropped because of increasing uncertainty over Eurozone debt levels.

Italy noted very modest real GDP growth of only 0.1 percent in Q1 2011 followed by real growth of 0.3 percent in Q2.  Real GDP growth for the second half of 2011 is expected to be flat with year-over-year growth of only 0.7 percent, a downward revision of 0.3 percentage points.  Recent issues in the country's bond markets will increase costs for corporations looking to finance expansions and will likely affect their investment decisions.  Consumer sentiment has fallen markedly over the past few months as well, affecting private consumption levels.

When I look at prognostications involving economic growth, I always keep in mind that GDP growth numbers, in particular, are lagging indicators that are subject to frequent revisions.  In this past quarter, growth rates in many EU Member States, Canada and the United States have been surprisingly low, far below what economists predicted earlier this year.  My uninformed guess is that the growth numbers for the second quarter of 2011 will be revised downward and that we are most likely experiencing an economic contraction, if not now, by the second half of 2011.  This could well make the sovereign debt issues facing nations like the PIIGS members reach the critical point.

I find it most interesting to see the economic diversion among the founding nations within the EU umbrella.  Perhaps it really was a state experiment destined to failure.  Only time will tell and I suspect that we'll find out sooner rather than later whether the EU will remain a world economic force.

Tuesday, September 13, 2011

China's Plan for Gold and Fiat Currencies

Remember those WikiLeaks Department of State cables that grabbed the attention of the mainstream media back in late November 2010?  Seems like a lifetime ago, doesn't it?  It's just so "yesterday", isn't it?.

Well, apparently, WikiLeaks has just finished leaking Department of State cables and I happened to notice this unclassified gem from the Beijing Embassy dated April 28th, 2009 released on August 30th, 2011.  The title of the cable "MEDIA REACTION: U.S.-CHINA-JAPAN RELATIONS, U.S. POLICY, CHINA'S GOLD RESERVES" sounds rather innocuous, doesn't it.  Yet, reading through the last section of the Editorial Quotes, we come upon this interesting paragraph:

Apparently, according to China Radio International's newspaper World News Journal, China is accumulating gold in an attempt to lead other countries away from using either the euro or the United States dollar as their reserve currency.  It seems evident that China is well aware of the theory that the United States and Europe have conspired to suppress the price of gold to weaken it as a reserve asset, a favourite story from the conspiracy crowd.  I find it fascinating that China is discussing using gold as an alternative to the USD and euro with other nations.  Talk about hitting the rest of the world below the belt while they are down!

According to financial statistics released by the People's Bank of China for the first half of 2011, the PBC has gold reserves of 33.89 million ounces or 1054.1 metric tonnes (one metric ton of gold contains 32,150 troy ounces).  According to the World Gold Council, China has the sixth largest gold reserves in the world but, as a percentage of their total reserve assets, has a very small gold portfolio in relative terms.  Here is a list current to August 2011 showing the top ten country gold holdings and the percent of gold in their total reserves:

As background information, at the end of June 2011, China's foreign exchange reserves stood at $3.1975 trillion, an increase of 30.3 percent on a year-over year basis.  This gives China plenty of foreign currency to add to their gold reserves.

China is in the fortunate position of being the world's largest gold producing nation.  According to statistics from China's Ministry of Industry and Information Technology, China produced 73.412 tonnes of gold in the first quarter of 2011, up 4.63 percent from the previous year.  China has been the world's largest producer of gold for the past three years with increased production levels every year since 2004.  In 2010, China produced 340.88 tonnes of gold, up 8.6 percent from 2009.  China projects that gold production will rise an additional 10 percent in 2011.  Some analysts note that China's gold mining companies are in the fortunate position of finding more gold reserves than they are producing.

Not only has China's central bank prioritized investing in gold, China's citizens also have quite an appetite for the yellow metal.  According to the World Gold Council's Gold Demand Trends Q2 2011 report, China and India were responsible for 52 percent of global bar and coin investment and 55 percent of global jewellery demand in the second quarter of 2011.  On a year-over-year basis, total consumer demand for gold rose 25 percent in China, well above the world average demand growth rate of 7 percent.  Back in 2000, China was responsible for only 6 percent of the world's total gold demand; this climbed markedly to 18 percent in 2010.  As of the 2010 year end, total gold demand in China reached 706.7 tonnes.  In the second quarter of 2011, jewellery demand in China rose 16 percent on a year-over-year basis reaching 102.9 tonnes.  Chinese consumers prefer 24 carat gold products even at these elevated prices, indicating that there is an investment motive to their purchases.  To compare, United States demand for jewellery fell 8 percent on a year-over-year basis to 21.7 tonnes of mainly 10 and 14 carat items.  Chinese consumers were the second largest purchasers of gold coins and bars after India, consuming 53 tonnes of gold in coin and bar form.  The world's total gold supply in the second quarter of 2011 reached 1058.7 tonnes, down 4 percent from the previous year.  

With China's central bank sitting on over $3 trillion of foreign fiat currency including the beleaguered euro and United States dollars, it will be interesting to see if they resume their purchases of gold.  As stated in the Department of State cable, China's future moves in the gold market may well translate to additional gold purchases by other nations, weakening the position of both the euro or the USD as their reserve investment of choice.  Our current debt, weak leadership and weak economies make us most vulnerable…and my suspicion is that the People's Bank of China is well aware of their strengths and our weaknesses.