Friday, February 25, 2005

The post that gave my blog its name...

(Part 5 of 5)

I’ve got a great idea. The government can borrow money really cheaply, right? It can issue bonds backed by the “full faith and credit of the US Government”. Rating agencies classify its bonds as “riskless”. The 14th amendment even makes it unconstitutional to question the validity of the public debt of the United States.

So, I propose that the government issue a bunch of bonds, about a trillion dollars or so, and dump that money into the stock market. There is a good spread between the yield on government bonds and the return of the stock market. This spread has historically been around 5%. This spread would result in a nice income of around $50 billion per year to the government. We couldn’t lose.

OK, so it might not be the best idea. The stock market might collapse, leaving the government owing its creditors a trillion dollars and not having the assets that were supposed to back that loan. Further, governments directly owning stocks – and thus businesses – is a bad idea; just ask the people who lived in the Soviet Union.

So, maybe it’s a bad idea for the government to borrow a trillion dollars and put it into the stock market. Too bad that the government has already done exactly that.

Look back at Ted up there, with his traditional IRA. By putting $1000 into it, he deferred $250 in taxes. That means that the government had to borrow an extra $250 that year. However, in return, the government got a claim on 25% of any profits that Ted makes in his IRA. If Ted waits until he’s 59.5 and then cashes out his IRA, then the government gets $250 * g. Across a hundred million taxpayers, g probably represents something pretty close to stock market growth. However, that $250 that the government borrowed had to be paid off at government-bond rates. By deferring $250 in taxes, the government got to borrow money at government-bond rates and invest it at stock-market-return rates.

As of 2005, IRAs, 401(k)s, and similar tax-deferred plans have about $5 trillion in them. That represents about $1.25 trillion in assets that the government has a claim on when they’re cashed out. If that $1.25 trillion is growing at 5% faster than the bonds that the government had to issue when the taxes were deferred, that represents $62.5 billion of appreciation every year. Even if Ted does manage to drop into the 15% tax bracket a few decades later, the spread will more than make up for the difference.

The government has managed to successfully borrow over a trillion dollars and invest it in over a hundred million little mutual funds, each of them managed by an ordinary citizen of the United States. Those citizens invest that money as if it was their own, and the government gets to keep the stock market rates-of-return that are generated, but without the bread lines, gulags, Great-Leaps-Forward, and similar things that usually happen when the government gets too directly involved in the economy.

Not only is it growing, it’s a cushion that the government has if it ever needs to collect some extra tax revenue. If it wanted to, the government could simply declare that all IRAs and 401(k)s are being converted into Roth IRAs, and that all of these rollovers will be taxed at 25%. This would result in a one-time windfall of about $1.25 trillion in revenue, though the effects on the stock market would be…interesting. Because most people know that they’ll wind up paying taxes on their withdrawals in the end anyway, an announcement like this would probably only result in a minor outcry. Drop the tax percentage to 20% and you would probably make people happy, and still pull in a trillion extra dollars. In early 2005, George W. Bush proposed a 2.5 trillion dollar budget. It would appear that the federal government is following the 6-months-of-savings rule that any financial advisor will tell you is a good idea.

So, what public-policy implications does all of this have? The government is investing in over a hundred million little mutual funds, each managed by an ordinary citizen of the United States. Some people will handle their money well, others poorly. To maximize the spread, we should try to get as much tax-deferred money into the accounts of people who are good at growing their own money, and discourage less-capable stock-pickers from having IRAs.

One possible way to do that is to increase your ceiling on 401(k) and IRA contribution limits by a factor that is related to the amount of capital gains you had that year. This would have the effect that people with lots of capital gains would accumulate larger IRAs. To the extent that past performance predicts future results, the return in IRAs would slowly creep up as the good investors were allowed to have larger balances. Growing the spread by .5% would earn the government an additional $6 billion per year.

If the IRA contribution limit were raised from $3000 to ($3000 + net capital gains), then that would result in people who had capital gains putting more money into their IRAs. Right now, capital gains are taxed at 15%, so every $1000 in capital gains I earn would results in me owing $150 in taxes. If I could turn around and put $1000 into my IRA and deduct it from my normal inncome, I would be able to defer $250 in regular income taxes. The government would actually have a net tax loss (this year) of $100, but would in return have $250 growing at stock market rates.

This looks suspiciously like a subsidy to the wealthy, so getting it through Congress might be challenging. The editorials pretty much write themselves: “The government is actually PAYING the wealthy to have capital gains! When the rich earn money on their stocks, not only do they not pay the taxes due on them, they get 10% of the gain back from the taxpayers!”

Another thing to do is to make sure that people who are already in a high tax bracket don’t contribute to IRAs. Deferring 35% taxes now in return for 15% taxes later requires decades of a healthy spread (almost 18 years at 5% just to break even) before it’s a good idea. This is already done with phase-out limits on IRAs, though the rationale (at least publicly) is more along the lines of “keep the rich from having too many tax breaks”. Combining this with the previous suggestion of allowing capital-gains-earners to put more money in their IRAs might also be challenging.

Finally, I believe that we should eliminate the Roth IRA. It's almost never the best choice for taxpayers. It sucks money out of the economy, and it deprives the government of future revenue, with no corresponding benefit to taxpayers or anyone else.


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