Borrowers, lenders, and others--beware trusting the government

Philip Brewer — Thu, 28 May 2009 15:10:27 +0000

Having a prosperous country (as opposed to having merely a prosperous elite) depends fundamentally on the rule of law. The system can work adequately well with various sets of rules, as long as they're known in advance and fairly applied. During hard times, though, there's a strong temptation to ignore the rules in a search for a less-bad result. Both borrowers and lenders need to watch out.

There has always been a fault line between creditors and debtors. There are usually many more debtors, which tends to give that side a certain amount of power--especially in a democracy. On the other hand, the creditors usually have a lot more money, which gives that side a kind of power as well. These divisions play out over time, changing the rules to favor one side or the other.

Changing and fudging

As I said, you can achieve prosperity under a broad range of different sets of rules. (Respect for private property is important, but you can be prosperous even with zoning, taxes, and eminent domain. Free markets are important, but it is probably better yet to have the government enforcing accurate weights and measures.) You can even change the rules, as long as the changes are done carefully, with a due respect for deals struck under the old rules. What really hurts prosperity is ignoring the rules--playing fast-and-loose with the rules so as to get an appealing outcome.

Right now we're definitely seeing the rules being changed--and possibly seeing them being fudged as well.

One example of rule changing is the new credit-card law. Generally, I think the changes are good changes. (The key test is: does the change bring the rules closer to what they should have already been? I think the restrictions on how banks can raise rates on already-existing debt fall solidly into that category, as do rules requiring that banks send bills well before they're due and apply payments promptly.) Of course, when the rules are being changed in your favor, it can be tempting to see only the upside.

Rule fudging, on the other hand, is almost always bad. Just now there's some possible fudging going on in the government-led efforts to reorganize Chrysler and GM.

Now, I'm not even sure that the rules are being fudged. The long-standing rules for chapter 11 bankruptcy already included a bias in favor of preserving the enterprise--even secured creditors could be made to accept equity instead of getting to grab their collateral, if the judge decided that keeping the company going could eventually provide as much total return to creditors. I'm not a lawyer, and I'm not knowledgeable enough about bankruptcy law to know if those rules are being followed or not. (Legally, the issue seems to have to do with whether the employee trust created to take over the costs of retiree health care amounts to a separate entity that should have to stand in line with other creditors, or if money owed to it should be treated like other employee compensation. I can certainly seem both sides of that issue.)

Be aware

But whether the rules are being fudged in that case or not, it's important to be aware of several things:

First, there's always more rule-fudging during hard times. During good times there's a tendency to just go with the flow, even when the results seem to drop an especially heavy load on one person or another. People can rationalize that, "Yeah, he got the short end of the stick, but he'll just have to pick himself up and carry on." During bad times, though--when maybe he can't just carry on--there's a greater temptation to bend the rules to produce a less cruel outcome.
Second, don't assume that the rule changes will all go one way. Both sides have political power and any particular rule change can have complex effects. As recently as 2005 the creditor class had enough power to push through punitive changes to the bankruptcy law. Now the debtor class has enough power to push through changes to the credit card law. (But not, so far, enough power to push through bankruptcy law changes that would allow a bankruptcy judge to reduce the amount owed on a mortgage.)
Third, although it's good when changing the rules produces better rules, just getting the rules changed in your favor is no cause for celebration. Rule changing does harm in several ways, one of which is that greater uncertainty makes everyone a little more cautious--which means that loans are harder to get and interest rates are higher. Everyone guessing what sorts of fudging are likely acts to change things even if the rule fudging doesn't even happen. (For example, because the action around the automakers favors unionized workers, the market seems to be pushing up the interest rates for broad swath of other companies with unionized workers, in anticipation that their workers and lenders might get similar treatment.)

Rule changes don't have to involve creditors and debtors. Anybody whose success depends on government policies is at risk. As just one example, a few years ago, when everyone was in a tizzy about a shortage of landfill space, Illinois created a package of tax breaks for people who built incinerators for solid waste. The political winds quickly changed, though, and solid waste incinerators began seeming like a bad idea. So the state repealed the tax break, leaving many companies with half-built incinerators in the lurch.

Diversification

Analyze how you would be affected if the government changed any rules that you depend on. If one or a few simple rule changes could cost you big bucks, the safe thing to do is to change your position so that you're not so dependent on those specific rules.

Note that this is not the same as the most profitable choice! If you align your finances to take maximum advantage of some special rules, you can often make a bunch of money--it's just that you're screwed if the rules change faster than you can adjust.

Sometimes, that's a risk worth taking. After all, you can often get a feel for whether the rule is vulnerable to change by looking at how many voters depend on it. But it's just plain safer to spread things around, so that any one rule change won't affect you too drastically.

For example, although it makes good sense to tax-shelter some of your income in 401(k)s and IRAs, I advise saving some money outside these plans as well. Yes, you're paying taxes that you could have deferred, but those big pots of tax-deferred money are a perpetual temptation for the government. (There has been more than one proposal for a "one-time" tax on retirement accounts to fund some spending priority or another.)

A little diversification--together with a healthy distrust of the government--will do a lot to keep you safe.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Investment Gains Taxes Increase - The Worst Tax Policy Ever?

Xin Lu — Fri, 20 Jun 2008 09:37:12 +0000

Yesterday Paul Michael wrote an article comparing the income tax policies of McCain and Obama and suggested that he would vote for Obama because Obama's tax policy would benefit everyone but the uber-rich. In the comments on the article there are many great comments about the candidates' tax policies and how it is not so simple to say that Obama's plan is better. One particular comment that stuck out to me is about Obama's stance on doubling capital gains taxes, and I think that is possibly the worst tax policy ever, and here is why.

Capital gains taxes are assessed on every sale of "capital" we conduct. The capital could be stocks, funds, or a business. Currently, the capital gains tax rate on investments held for more than a year is 15%, and for investments held for less than a year the tax rate is the same as a person's ordinary income. What Obama is proposing is to raise the long term capital gains tax rate back to 28%. He says that he wants to do this "for purposes of fairness" in a debate.

I have no idea why Senator Obama thinks this tax increase is fair in any way to all the individual investors like you and me who are by no means super rich. Actually, I think doubling the capital gains tax would discourage people from saving and investing and that is a horrible thing in my book. When we put our after tax savings in investment vehicles like stocks and mutual funds, all we are trying to do is to beat inflation and protect the wealth we have worked for. Capital gains taxes is already a double taxation on gains of money that has already been taxed. When this tax gets nearly doubled, it is a bigger slap in the face for honest hard working people who are trying to save for the future.

Additionally, many retirees who are liquidating their taxable investments will feel the pain of this tax increase. For most retirees, it is not enough to just live off of IRAs, 401ks, pensions, and Social Security so many people have normal taxable investment accounts. Suppose a retiree saved up a nest egg of $150,000 of which $100,000 is long term capital gains, then this particular retiree will lose $13000 if the capital gains taxes were raised from 15% to 28%. This is a significant amount of money and could be worth several months of living expenses. Is it fair to punish these people who built up their nest eggs honestly and responsibly by investing?

In addition to raising capital gains taxes, Obama wants to raise the taxes on dividends significantly. This will have a similar detrimental effect in dwindling investment gains all across the board for all investors big and small.

So does Obama's tax plan really benefit the people with low and middle income as much as Paul's article states? Well, personally I have always said to everyone I know that your wealth is not about how much income you make, but how much assets you have. It is possible for a family to have a nice plush portfolio without making so much income every year as long as they are good savers and wise investors and these families will be unjustly and severely penalized under Obama's proposal. So I believe in the long run Obama's tax policies punish all those who try to build wealth by investing, and that is not very wise.

This article is from Xin Lu of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: