Experts Warn Debt May Threaten Economy

Assume that:

(1) You pay federal tax at a 30% rate.
(2) You buy a "taxable" $1MM bond with 20 years until maturity at an interest rate of 10%.
(3) You buy an equivalent "tax-exempt" bond with a 20 year maturity for $1MM. The interest rate is 7%.

No surprise here: At a 30% tax rate, 10% "pre-tax" is equivalent to 7% "tax-free"

Now assume that the federal tax rate is increased to 40%.

The after-tax annual income on your "taxable" bond is now decreased to $60,000 from $70,000. Your after-tax yield is decreased to 6%.

But your annual income from your "tax-exempt" bond continues to be $70,000.

Since your "tax-exempt" bond produces more positive cash flow than your "taxable" bond, your "tax-exempt" bond is MORE VALUABLE than your "taxable" bond.

How much more valuable?

Well, if you discount the cash flows of your "tax-exempt" bond at a 6% rate (the AT rate of your "taxable" bond), the net present value of your $1MM tax-exempt bond becomes $1,115,000.

Of course, to realize this $115,000 capital gain, you will have to sell your "tax-exempt" bond.

Of course, to realize this $115,000 capital gain, you will have to sell your "tax-exempt" bond.

And that's where accountants get trapped and forget about economics (finance)!

As I expected, you talked about unrealized gains. You surely will agree that one has no liability here.

Suppose that I do sell the bond, what will I do with the proceeds? I am now in an environment with a higher tax rate, and everything becomes more epxensive than before. That is, once you consider reinvestment in a new environment, this is a wash.

In other words, you create an artifical horizon for investment to make your consequence correct. One cannot unequivocally say that tax increase creates a liability. This is simply false.

You said,

"In other words, you create an artifical horizon for investment to make your consequence correct. One cannot unequivocally say that tax increase creates a liability. This is simply false."

I don't remember stating that a "...tax increase creates a liability...", but I DO think it should be obvious that ANY person with taxable income will pay more taxes (have a larger tax liability) if that income is taxed at a higher rate, rather than at a lower rate.

I also think it should be obvious that $70,000 is MORE than $60,000. Therefore, whether we use "accounting" or "finance" or simple "arithmetic", it should be obvious that the value of any number of annual payments, each at $70,000 is MORE than the value of that same number of annual payments, each at $60,000.

If you disagree with either of these points, then I think I "win by default".

The answer to the question of "how much MORE" depends on the measurement standard you chose to use. I used a discount rate of 6% in my example, to reflect the fact that the taxable bond market is much larger than the tax-exempt bond market. If I had used a 7% discount rate, then the tax-exempt bond would keep its value, while the taxable bond would lose value.

If a 6% discount rate is used, you could sell the taxable bond for $1MM and couild sell the tax-free bond for $1,115,000. By the standard of "cash-in-hand", the tax-free bond is worth MORE. $115,000 more.

Moreover, even if those two sales are not concluded, financial markets will give two different "market values" to those two different bonds. If those bonds were publicly traded, you could read those price differences in the daily investments sections of financial newspapers.

But let's say you want to ignore the "cash-in-hand" valuation and ignore the "market values" valuation and just hold both bonds until maturity.

In that case, the taxable bond from my example would return your $1MM of principal and pay you after-tax interest of $1.2MM ($60k times 20 years). Your total cash received would be $2.2MM.

Meanwhile you tax-free bond would return your $1MM of principal and pay after-tax interest of $1.4MM ($70k times 20 years). Your total cash received would be $2.4MM.

Simple arithmetic would indicate that the tax-exempt bond is worth $200,000 MORE than the taxable bond.

This analysis quite properly ignores the moot question of the "re-investment rate" to be earned on your money when it is returned to you.

That question is moot, because whatever investment opportunities exist for the payments from one bond are equally available for the payments from the other.

Hopefully, you NOW see that a tax-rate increase actually increases the value of tax-exempt bonds and hopefully you NOW agree that when folks, whose wealth is invested in tax-exempt bonds, call for "tax-rate increases", they are NOT necessarily being "altruistic".

I also think it should be obvious that $70,000 is MORE than $60,000. Therefore, whether we use "accounting" or "finance" or simple "arithmetic", it

Not at all; this is far from obvious. It is true that ONE particular instrument has become more valuable IF you sell it. But you will not if you consider the value of the PORTFOLIO --- and that is what precipitated the discussion. It is true that accounting stops at the point you indicated: IF you sell this appreciated instrument, then...

But in portfolio management (and that is what the RICH against whom you have a peeve are doing) the question of reinvestment is an integral part. You will not sell the appreciated instrument because you would have to reinvest into other similar assets that have become more expensive also. And, if you hold it to maturity, there will be absolutely no difference.

Now, you suggested that Kerry wanted to help himself and advocated a tax increase. That does not make any sense in portfolio management.

More importantly, your suggested cutoff at 1,000,000 indicates only that that is what you consider RICH. Well, a qualified nurse with experience can make $130,000/year and have that much by retirement. There are literally hundreds od secretaries that were made millionaires by Microsoft. A family of two engineers that also inherited a 400,000-house one one of the parents can have a million by retirement.

All these are working folks. And no, it's not an argument about the cutoff point: if you make it high enough, the revenue is hardly affected; and if you make it at any "reasonably" low level, you hurt work9ing folks. Which is why all those socialist measures of redistribution always hurt the middle class, although ostensibly directed at the "rich." You should know that you think like a socialist, whether deliberately or not.

Finally, as an accountant, you should know that top 1% of earners pays 17% of taxes in this country. When is it enough, Mr. Well-meaning-socialist?

I am disappointed and amazed that my efforts to "be clear" in my communications with you have been such a failure.

Here's one example:

Me: I also think it should be obvious that $70,000 is MORE than $60,000. Therefore, whether we use "accounting" or "finance" or simple "arithmetic", it...

You: Not at all; this is far from obvious. It is true that ONE particular instrument has become more valuable IF you sell it.

Perhaps I would have clearer if I had said that "it should be obvious that [an annual cash interest payment of] $70,000 is MORE than [an annual cash interest payment of] $60,000. This statement has nothing to do with the market value of "instruments", but you "thought" it did.

In my defense, I did not specify "...annual cash interest payment..." because I thought that everyone knew that, since most bonds are NOT "zero-coupon bonds", most bonds DO pay cash interest each and every year.

Hopefully, you do understand that now and also do understand that MORE annual cash interest received = MORE cash flow = MORE net preset value and MORE "total cash received over the life of the investment". I'm sorry you were confused on this point. Hopefully, you are now "on board".

Your point about portfolio management is interesting, albeit somewhat "quaint".

If, as you suggest, at any given point in time, an astute portfolio manager would not sell bonds because the yield at which he could sell a bond is identical to the yield at which he could buy a bond, then the NYSE must be nuts and all "astute" portfolio managers must be overpaid. Our financial markets are much more dynamic IN FACT than your theory suggests, and I'm siding with reality on this one.

Another example of misunderstanding:

I thought that my proposal for a "cap" of $1MM on non-taxed income (INCOME!) from tax-exempt bonds was simple and clear. This income (INCOME!) limitation would have the practical effect of limiting the value an individual would allocate to "tax-exempt bonds" to about $20MM, within his overall investment portfolio.

And yet, you attacked that proposal as if it were directed at ASSETS -- not annual INCOME. I don't know how to explain that misunderstanding.

Name-calling aside, I am one of the "1%" you mentioned, and I pay a LOT of taxes. And I AM "peeved" that some of my acquaintances, who enjoy the same life-style I do, pay NO taxes.

You are unquestionably correct in stating that some of what I wrote was imprecise, and I apologize for causing misunderstanding (I replied to you in both cases while working on a paper --- not a good idea if one wants to state his ideas clearly).

I wish we could have this conversation in person: this would allow us both to define the terms clearly and identify the points on which we agree. Thank you for taking time to clarify the points you've made: as a result of your detailed reply, I think I do understand better some of those points. I am sorry that I cannot respond in kind for the lack of time.

P.S. Perhaps, a flat tax and/or a VAT would ensure that people in the same bracket as you are do not have unfair advantages?

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