Reuters Money

Tax deductions are popular, but penalties may work better

When making tax policy, there’s a choice between carrots or sticks: Does the government give taxpayers credits or deductions for doing the right thing (buying their homes, giving money to charity, not emitting greenhouse cases) or penalize them for doing the wrong thing?

Brian Galle, who is on leave as an assistant professor at Boston College Law School and currently a fellow at the Urban Institute in Washington, DC, has been analyzing those choices, and come to a surprising conclusion: Expenditures may be politically expedient, but penalties would often be preferable for fiscal policy.

In his forthcoming paper in the Stanford Law Review, called “The Tragedy of the Carrots,” Galle argues that carrots are overproduced and often misguided, costing the Treasury funds that would be better spent elsewhere in an effort to nudge people towards the behavior it hopes to reward.

“The problem with tax expenditures is not that they are in the tax code, but that they are expenditures,” Galle explains in a recent telephone interview.

As Washington debates tax policy and budget cuts, Galle’s ideas are particularly relevant. Tax expenditures — those credits and deductions that favor some taxpayers over others — have grown dramatically over the years, and their cost to the Treasury is over $1 trillion dollars.

Last year, when the national deficit commission, co-chaired by Alan Simpson and Erskine Bowles, released its bold tax proposals, one of them called for eliminating all the expenditures and lowering marginal tax rates to 8 percent, 14 percent and 23 percent. The commission’s ideas went nowhere, and today the congressional supercommittee is hashing out its plan for budget cuts and tax reform.

Galle’s theory goes one step further in thinking about rewards versus penalties. Economists consider carrots and sticks pretty much indistinguishable. There’s not much difference, as Galle points out, between taxing someone a dollar for each cigarette smoked, versus giving someone a dollar for each cigarette thrown in the trash. Either way, smoking is penalized, and the cost to you (whether explicitly in the tax or implicitly in the foregone reward) is one buck.

Tax-saving ETF strategies to use before end of 2011

The final quarter marks the traditional time of year when kids dive into leaf piles, heating bills rise and investors with taxable accounts sell underwater stocks to help lower their tax bills.

They shouldn’t have too much trouble finding candidates this year. Despite a recent uptick, most major indexes remain in negative territory for 2011, and with market volatility in high gear more dips could be on the way.

Tax loss harvesting helps ease the pain of a down market by allowing investors to use the losses to offset gains and up to $3,000 of ordinary income on their tax returns. But you have to wait at least 30 days after the sale of a losing stock to buy back the same security. Otherwise, the IRS calls it a “wash sale” and you can’t deduct the loss.

While someone might use a similar stock as a placeholder in case the market bounces back, that option isn’t ideal because performance can vary significantly among stocks in the same industry. Mutual funds covering similar investment turf don’t always move in sync either.

Exchange-traded funds adapt to the strategy more easily. Since there are more than 1,300 of them, it’s fairly easy to find one that has the look, feel and performance of another security but is different enough to use as a substitute, either temporarily or for the long-term, without drawing IRS scrutiny.

“ETFs have made tax loss harvesting a lot simpler than it used to be,” says Charles Zhang of Zhang Financial in Kalamazoo, Michigan. “It’s not that hard to find one that’s a good stand-in.”

Zhang and some other advisers say using two ETFs or mutual funds based on the same index would probably violate the wash sale rule. To be sure, you might not want to sell iShares S&P 500 or a mutual fund based on the index, for example, and immediately replace it with SPDR S&P 500.

Margaret Atwood on debt and consequences

What might be most surprising about the myriad economic problems around the globe right now is how many major world economies seem to have been taken by surprise by the concept of debt. Maybe they should have been reading more Margaret Atwood.

Atwood isn’t only one of the world’s premier novelists, she’s also the author of the nonfiction “Payback: Debt and the Shadow Side of Wealth,” which hit the presses just as the financial crisis arrived in the fall of 2008 (timing that one review described as “freakishly prescient”).

Atwood is currently releasing her new essay collection about science fiction, “In Other Worlds,” and  sat down with Reuters Money for coffee in Manhattan. We chatted about how debt has been dominating the headlines – and, perhaps, reshaping our sense of self.

Reuters Money: How did the issue of money and debt come to interest you?

Margaret Atwood: I came to this subject through studying literature. Money is everywhere. Charles Dickens, for instance, is completely obsessed with debt. His father went bankrupt, and was thrown into debtor’s prison. As a child, Dickens had to go off and work in the factory, and he never forgot it.

You’ve said that the current debt crisis was entirely predictable. How so?

MA: I’m always sorry when I’m right. It really is true that you can go back through history and trace the influence of money on crises. If you look at conditions right before the French Revolution, you’ll see that they were having a lot of money problems. They kept firing finance ministers and coming up with one new scheme after another, but those at the top wanted to keep everything for themselves. Conditions were top-heavy, with a lot of debt, the price of food going up, and many out of work — which all sounds very familiar right now.

Steve Jobs and giving anonymously

For all that he achieved in his life in terms of his public image, Steve Jobs was famously not a public philanthropist, unlike his equally titanic tech rival, Microsoft’s former head Bill Gates.

Gates these days is almost as well known for the ongoing good work of the Gates Foundation as he is his private sector success. Jobs, by contrast, kept gates of secrecy around whatever philanthropic impulses he possessed. His giving track record remains shrouded after his passing from pancreatic cancer on Oct. 5, and while his will could shed some light on that, there’s yet no public knowledge of who has the will, when it will be disclosed, and whether charities will get anything.

Here’s what is certain: The death of Jobs has sparked conversation about the motivations and merits that surround anonymous giving. And for those who either eschew the spotlight or hold to a religious tradition that espouses anonymous donation, giving in secret sounds downright attractive.

“Giving is a very personal way of expressing one’s values,” says Kim Gerstman, associate director of development for the Population Council, an international, nonprofit that conducts biomedical, social science, and public health research. “Someone might donate to help fight a disease that impacts them personally — but they do not wish to publicly disclose that connection. And some wealthy individuals are concerned that recognition will translate into being flooded with requests.”

No doubt that highly public figures can do without any extra attention and entreaties from fundraising figures, or less-than-scrupulous people posing as such, says Jason Franklin, executive director of Bolder Giving, a website that shares stories of people pledging significant percentages of their assets to worthy causes.

Or it may involve a multitude of reasons that center around humility and privacy concerns — that “It’s not about me, it’s about the work,” Franklin says. “There’s also often an attractiveness to anonymity as an implied judgment against donors who seek significant recognition and attention for their giving — a feeling that “I’m better than person X because I don’t need my name on a building.”

In those cases, Franklin often asks givers to reconsider. “I try to point out that being public about your giving can be an act of service in and of itself,” he says. “When your name is attached to your gift, others will take notice — whether it be the world noticing a gift from Bill Gates, or, if you’re less famous, just your circle of friends and family taking notice. In being public, we lend whatever reputation and credibility we carry to the organizations we support, which can help raise their profile and inspire others to join us.”

What the Occupy Wall Street crowd should be saying

Are the thousands who have taken to the streets in the “Occupy Wall Street” (OWS) protests a bunch of anarchistic slackers or do they have a point?

If they’re protesting their personal financial situations or prospects for the American Dream, they have plenty to howl about, but the “99 percent” crowds could use some message management.

When I recently visited the Chicago OWS spin-off  in front of the Federal Reserve Bank, they were decrying everything from predator drones to corporations in general.  There were fewer than 100 people there, although their theme was similar to the New York demonstrations.

Instead of yelling at people ensconced behind financial district edifices, though, protesters could be making some more constructive demands. I’d like to humbly offer a few suggestions:

• Demand that big banks give ordinary citizens the same rates they receive from the Federal Reserve on loans. Borrowers can’t re-negotiate their college loans the way a big corporation or bank can, because they have access to interest rates that are nearly zero. Moreover, students can’t consolidate high-rate private loans with lower-rate federal borrowing, so the plums of high finance are out of their reach. Those who graduated from college may be staring down decades of paying off debt — an average of nearly $23,000 per student; those with professional degrees are wincing at six-figure burdens.
• Demand that Congress permit regular folks to discharge student debt in bankruptcy. It’s somewhat of a consolation that graduates can get lower payments based on sparse income or employment if they have federal loans, but they still have to repay those loans. If they file for bankruptcy, they can’t discharge those debts, which are like albatrosses. Not so with the megabanks, who not only received a multi-trillion-dollar bailout, but got the U.S. Treasury and Federal Reserve to buy their bad debt and toxic securities. There’s a solid reason why the delinquency rate for student loans is almost as high as credit cards.
• Demand that Congress pass a stimulus plan to create infrastructure, education, research and clean energy jobs instead of investing in two wars that three-quarters of the American electorate thinks are senseless. If the job market were robust, none of these protesters would have to worry. Like previous generations, they could work, pay off their debts and buy things like appliances, furniture and homes. They could afford to have children and provide them decent educations. That was the American Dream. The younger generation is not getting the job opportunities their parents or grandparents had. They are faced with average 15 percent unemployment. It’s much higher for minorities. Even if they can get a job, wages are depressed due to the recession and many are underemployed, working several jobs or are part-timers.
• Instead of targeting financial districts, focus on specific congressmen and senators blocking financial/bankruptcy reform and job creation.

Unless more people get in the face of politicians, one thing is certain: it will be continue to be a raw deal for the middle class. Now is the time for the protesters to take their demonstrations out of financial districts and into the offices of their elected representatives. All of this reminds me of when Ralph Waldo Emerson visited Henry David Thoreau in jail, who was imprisoned for not paying a poll tax. Emerson asked his friend why he was there. “Why are you not here?” Thoreau replied. Maybe we’re not quite on the streets today in spirit, but most of us were there some time ago in personal financial solidarity — whether we choose to admit it or not.

There will be tax breaks: Investing in oil and gas drilling

Seated in the conference room of his wealth management firm in San Ramon, Calif., Rich Arzaga breaks out a few tools to explain the investment advantages of oil and gas drilling programs. He’s got a fine-point pen and a sketch pad — but alas, no milkshake a la Daniel Day-Lewis in “There Will Be Blood.”

“This is not wildcatting,” says Arzaga, founder and CEO of Cornerstone Wealth Management and an adjunct professor in personal finance at the University of California at Berkeley. Lewis’ anti-hero in “Blood” swindles and snakes for oil wherever he can find it, whereas Arzaga (pictured) wants to discuss something much more civilized: qualified drilling programs that yield big tax savings for investors and, if you’re lucky, 10 or more years of financial returns.

Still, if that sounds a little bit Hollywood, Arzaga understands. “Insurance companies, wire houses and banks don’t offer this type of alternative investment,” he says. “It’s not their thing. You have to hang out with the independent advisers who do this.” You also need at least $25,000 to start, which explains why over the last five years, Arzaga has been limited to roughly a dozen clients in this realm.

Yet at a time when Wall Street sports the stability of a rickety roller coaster, and European turmoil dogs investors on North American shores, oil and gas drilling represents a niche so far outside the norm that it’s in many respects immune to common economic doldrums. And when oil prices soar, the prospects for this commodity look downright appealing— that is, up to a point. To be sure, once you give your cash over to the program, it stays there until the wells pan out, or don’t — making it much unlike a liquid mutual fund, for example. This explains in part why the program works best for those trying to avoid a major tax hit on an appreciated asset, where the burden might be 40 percent.

What’s more, “The number one risk is that there’s a certain amount of fraud out there,” says Grant Rawdin, president of Wescott Financial in Philadelphia. Yet once you find a drilling company with a solid reputation — Arzaga, like many in the game, uses Atlas Energy — you don’t just sit back and wait for the black gold to pour in.

“Then you have to do your homework,” Rawdin says. “You need to look at geological surveys, how other wells have done, what the drilling costs are going to be. And once that oil well goes dry, you’re done, so you have to amortize your investment over the life of the well.”

In the typical program, an investor immediately yields tax breaks as sanctioned by IRS codes, which are now more than three decades old. With a highly appreciated asset, you can put the money into oil and gas drilling and shelter it almost entirely from capital gains tax. If you invest $1 million and are in a 40 percent tax bracket, you will save about $350,000 right off the bat, Arzaga says. (The sheltering comes from how the program is structured; federal laws allow typically for 89-91 percent of the investment to be allocated to intangible drilling costs that can be written off entirely in year one.)

If you want lower property tax rates, you’ve got to ask

For years, the mantra of American homeownership was to count on home appreciation. Every year like clockwork the value went up and houses were a  growing source of wealth.

Now, more than three years after the housing market imploded, the tune is different. It may make sense for you to prove that your home’s value has dropped so you can file for reduced property taxes.

This is the time of the year when local assessors send out notices of your home’s assessed value. Note, however, that this is not your real market value. It’s a base value that’s used to calculate your property taxes. If you want to reduce your real estate taxes, start with paring your assessed value.

You have a reasonably good chance of winning a challenge to your assessed valuation. It’s estimated that some 60 percent of residential properties are over-assessed, although only a handful of home owners appeal, according to the National Taxpayers Union.

As someone who’s volunteered with a local non-profit in Northeastern Illinois on property tax issues, I know it’s worth fighting assessments every year. Sometimes I win, sometimes I lose. If you feel that your assessment is too high, there are many ways to challenge it, but it takes some homework and diligence.

You can always start by checking the property record of your home, which is on file with the assessor. Does it have the correct number of bathrooms and bedrooms? Is the total living space correct? Does it list a finished basement in error? You can fix any incorrect data by either allowing the assessor to inspect your home or by submitting an approved builder’s drawing or survey.

Although you can dispute the assessed market value of your home with your assessor, it’s not an easy task since you may need at least three comparable homes in your neighborhood with lower values.

Charitable remainder trusts: How the wealthy give it away and get it back

Though he first attended the Hollywood Bowl more than 30 years ago, Ron Moormeister remembers well those Los Angeles Philharmonic concerts. His voice waxes rhapsodic as he recalls the lineup: Mandy Patinkin, Julie Andrews, a Tchaikovsky Spectacular complete with the bombastic 1812 Overture.

So when he hit it big in 1995 — selling his insurance brokerage firm at age 49 — he decided to help the orchestra and to get a tax benefit too. He used a  charitable remainder trust, or CRT, a creative strategy that allowed him to give away his money, yet still derive funds from it based on a mix of tax deductions and investment.

He started the trust with about $350,000. “I had to get used to the idea a little bit,” says Moormeister, 64. “I thought, ‘Gosh, do I want to give away this money?’ But I wasn’t just giving it away. It was going to work well for me, for others and for my family.” He also wanted to protect his assets from the claims of creditors or lawsuits, equally important factors in his decision to implement a CRT.

So far, all has worked out well. Moormeister set up his CRT with the help of Simon Singer, principal and founder of TheAdvisor Consulting Group in Encino, California (pictured). Under the trust guidelines, Ron guarantees that 25 percent of funds go to the Los Angeles Philharmonic. Yet in setting up the trust, Ron estimates that he’s saved at least $250,000 in tax deductions over time. His initial investment was sheltered from federal and state taxes, and trust money that’s invested grows tax free, much as it does in a retirement account.

This means Moormeister can make money off the CRT without expensive tax consequences. “I could use an investment counselor, but I control the investments myself,” he says, “and I can invest in virtually anything.”

Simply defined, a charitable remainder trust allows you to transfer cash or assets to the trust — from which you may receive income for life or, if you prefer, a fixed term not to exceed 20 years. The income can be paid over your life, your spouse’s life and even the lives of your children and grandchildren. (The guidelines are outlined in IRS code section 664.) In essence, the trust takes advantage of the tax-exempt status of the nonprofit it benefits.

The rich respond to Obama’s “Buffett Rule”

Once the debt ceiling rancor faded, financial gurus and observers had little reason to think debate on taxing the wealthy would ignite again before Nov. 23. That’s when the 12-member congressional super committee issues its recommendations on finding at least $1.2 trillion in deficit reduction.

Then came President Obama’s announcement on Monday of the “Buffett Rule,” a plan to raise taxes on American households making more than $1 million annually. Suddenly, the millionaires who support such a plan — like Warren Buffett himself — had cause for hope after many months of anti-tax furor and tax hike inaction.

“It’s an excellent policy proposal,” says Wealth for the Common Good co-founder Chuck Collins. “The defenders of wealth and power are going to crazy over this proposal, but our job is to help balance the story. We’re already putting out calls; our members will call their legislators; they’ll organize their peers; they’ll write letters to editors.”

Yet it was also as though the Buffett Rule came with an unspoken corollary: Where proposals to tax the rich come, rhetoric and strong words on both sides of the issue will surely follow.

“The President’s speech today drew a clear line in the sand between patriotic Americans and people who just use the United States as a place to park their planes on the way to St. Bart’s,” says Agenda Project founder Erica Payne, who has worked closely with Wealth for the Common Good. “This issue is not complicated. It is not nuanced. If you care about your country, you pay taxes. If your country is in trouble, you pay more taxes.”

Under the President’s proposal — spelled out in a 67-page report issued by the Office of Management and Budget — the Buffett Rule (named for billionaire Warren Buffett) would mean that “No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. As Warren Buffett has pointed out, his effective tax rate is lower than his secretary’s. No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay. This rule will be achieved as part of an overall reform that increases the progressivity of the tax code.”

Indeed, the 2,500 folks of high net worth who make up Patriotic Millionaires for Fiscal Strength would definitely agree — though not all of them find the President’s latest proposal exciting, let alone revolutionary, even though it’s sure to meet stiff opposition from anti-tax Republican lawmakers.

Would Obama’s payroll tax cut hurt Social Security?

The Congressional Super Committee hasn’t even started cutting Social Security, but advocates are already expressing concern on a different front: the payroll tax cut extension proposed last night by President Obama as part of his jobs plan. Those payroll taxes fund the Social Security program.

The President asked for a $175 billion one-year extension and expansion of the employee payroll tax holiday now in place, halving the tax rate to 3.1 percent in 2012. He also proposed halving employer payroll taxes to 3.1 percent for the first $5 million of payrolls in 2012. The president also wants a complete payroll tax holiday that would apply when companies grew their payrolls by up to $50 million in a year by hiring  new workers or raising the salaries of existing workers.

These cuts in the Federal Insurance Contributions Act tax (FICA) may be one of the best available stimulus options in the current political climate, and they will have a positive economic impact. An analysis by The Center for Budget and Policy Priorities notes that the cuts already in place make a substantial difference in the spending power of middle class families, and that allowing them to expire at this time would be very negative for growth:

Failure by Congress to extend the temporary payroll tax cut enacted last December would reduce all paychecks starting on January 1, withdrawing needed support from the still-weak economy. The measure, part of the tax cut-unemployment insurance deal between President Obama and Republican leaders, reduces the employee share of the Social Security payroll tax, boosting workers’ take-home pay by an estimated $120 billion in 2011. The tax cut is worth $934 to the average worker.

And Moody’s Analytics estimates that allowing the payroll tax cuts to expire would reduce GDP growth by one percentage point in 2012, translating into one million fewer jobs by the end of next year.

But Social Security advocates worry that these temporary payroll tax cuts will never be restored. “The problem is, it is very easy in our current political climate to cut revenue and very hard to increase it,” says Nancy Altman, co-director of the Strengthen Social Security coalition and author of The Battle for Social Security, an excellent history of the program and its politics.

“Look at the controversy over ending the Bush tax cuts, which would only affect a small portion of taxpayers,” Altman says. “In this case, if you propose restoring the payroll tax down the road, you’d have to double the rates on workers making minimum wage. This is being sold as temporary, but it’s not likely to work out that way.”