How to fix the fiscal cliff: let go of the sacred cows!

Now that election week is behind us, Wall Street and markets around the world are focusing on the looming  US "fiscal cliff," which is dominating the talk in the financial media and which is in fact a very significant topic.

In case you are still a little hazy over the exact size and shape of the fiscal cliff towards which the US budget has been speeding since passing the "Budget Control Act" in 2011, this CNN Money article published in August of this year contains a fairly good rundown of the specific cuts to spending and the specific increases in taxation which will go into effect in January unless lawmakers and the president sign new legislation before the New Year.

This Wall Street Journal video also does a decent job of explaining the current budgetary mess, along with some cool "high-speed whiteboard drawing" footage and some footage of actual cliffs with sheer drops into yawning gorges coursing with icy mountain streams.

While the politicians are already posturing over which taxes will be raised or which programs deserve to be cut, we'd like to offer a solution which we believe should be welcomed by everyone, no matter what their political affiliation: let go of the sacred cows!

By "sacred cows" we are referring to the "loopholes" or tax exemptions granted to various business and investment activities, presumably as some kind of incentive for behavior that the government wants to encourage (in which case these tax breaks could also be labeled "social engineering").  In many cases, these tax exemptions benefit one industry at the expense of others, by making the purchase of that industry's products less costly than they would be otherwise -- thereby making some members of those industries wealthier than they would be otherwise (which is why these industries are often referred to as "special interests," especially when they pay for lobbying aimed at keeping or increasing the favorable tax treatment that their industry receives).  

We are fully aware that, as investment professionals and members of the "financial industry," we are part of an industry with more than its share of such tax shenanigans, but we are arguing that these should be eliminated, along with the rest of them.  By getting rid of these sacred cows that have heretofore been considered untouchable, we believe that the government would be able to enact lower, flatter tax rates on everybody.  That should make everyone happy.

Of course, if you think that it is better for the general public to pay higher taxes so that your special industry can sell a product that provides buyers with a tax loophole, then you might not like our list of sacred cows that should go away.  However, if you believe that these loopholes are unjust, then you might agree with us that these special interest loopholes should be thrown out, even if you (like us) are part of an industry that benefits from such loopholes.

We can start by naming a few products that the financial industry sells which are made more attractive by the special tax treatment they receive, such as IRAs and 529 college savings plans.  How many people would really put their money into 529 plans if those plans did not have special tax treatment?  The answer is, "next to nobody."  Those 529 plans are an example of a product (in fact, an entire sub-industry) that would not even exist without the current tax code.

Another member of this category is a much older species of sacred cow, the tax-free municipal bond.  For generations, investors have deployed capital to municipalities to which they would never have considered loaning their money if it were not for the tax-free status afforded to these bonds. 

Why should muni bonds get special treatment versus any other investment?  The reflexive answer is, "because municipalities need the money!"  That's probably the argument that was used to get the entire muni-bond racket started in the first place, and to get politicians to carve out a special tax exemption for muni bonds which other investments do not enjoy.  However, a moment of reflection will show that getting rid of the tax loophole for muni bonds would not mean that municipalities would not be able to borrow money -- it only means that municipalities would have to pay interest at market rates on the money that they borrow, rather than getting a special deal given to them by politicians, which other investments do not enjoy.  Imagine how much more fastidious government officials might be if they had to compete with every other borrower, on a level playing field, for the dollars they spend!

We believe that every potential investment should have to compete equally, on its own merits, rather than getting preferential treatment because politicians have decided that one investment is more "socially desirable" than another (or because one industry group is a bigger friend to those politicians than another industry group).

Into this same category, of course, we would put all the insurance products that receive special tax treatment, including annuities (another product which, like 529 plans, would be immensely less attractive to investors if they had not been given special tax treatment by the rules of our arbitrary and convoluted tax code).  For the record, we believe insurance policies are a very important part of wealth allocation planning, but that's exactly why we do not believe it requires any special tax laws to help "nudge" people into buying more of it than they might otherwise purchase.

While we're making some of our readers either dismayed or angry (there's enough loopholes here for us to anger or alienate everybody!), what about the tax deductions on real estate loan interest?  Why should home-buyers (both first and second home-buyers) be given tax incentives to take out home loans?  We also believe that tax laws that incentivize people to purchase new real estate with the proceeds of real estate sales without having to pay taxes on the gains (the "1031 exchange") should also go!  Unless, of course, you want to make ALL capital gains tax free...but we'll leave that for the details. 

We realize as we write this post that no politician of either party dares to address such "sacred cows" of the American tax code, but we believe that both sides of the aisle should really address the inherent unfairness (and actual injustice) that these special-interest loopholes represent, long before they go raising tax rates in other areas (such as on income or payroll).  Democrats are always talking about "change," and Republicans are always talking about "free markets" (we believe they should really say "free enterprise") --  what about getting rid of these sacred cows as a first step towards real change and real market pricing?

While members of the financial industry, insurance industry, and real estate industry might initially revolt at our recommendations, we believe that is the wrong way to look at it.  We actually believe that real estate and insurance offer value to those who choose to invest in them (we might even say the same thing about municipal bonds, if they ever get rid of their politically-engineered tax loophole).  In other words, we believe that members of the real estate industry and insurance industry (and financial industry) should be proud of the products that they sell, and should not feel that they need the government's help in selling them by way of tax exemptions (which only drive up the tax rates somewhere else).

In fact, it can be shown that historically the US government takes in taxes that are roughly equal to 20% of the GDP at any given time, regardless of the different ways that legislators fiddle with the various aspects of the tax code.  Given this fact, we believe they should be able to get to 20% without all the complexity and special-interest loopholes and deductions that only serve to favor one industry over another, shifting the tax burden onto those who aren't able to wiggle through all the available loopholes.  

We believe that the government could get to 20% of GDP with lower and flatter rates on everybody.  And that would make everybody happier.

Thus, as the "fiscal cliff" haggling proceeds in the US over the next several weeks, we'd like to see leaders emerge on both sides who are not afraid to tackle sacred cows such as muni bonds, insurance tax exemptions (grandfathered going forward, perhaps), and even real estate's favored tax status, as well as low, FLAT tax rates that are in line with what government collects as a percentage of GDP.  But, we're not going to hold our breath.