Thursday, 19 March 2009

Lies, Damned Lies, and Bernie Madoff

Forget the NCAA Tournament and March Madness - for me nothing can beat the Opera Bouffe that following the financials presents. I came across this little nugget today at Yahoo Finance:

The piece was written by a man called James Stewart, which is itself rather a bit of an inside-joke, given that James Stewart the actor often starred in films that glorified the little guy in his fight against the plutocrat. This incarnation would seem to favour Lionel Barrymore.

Mr Stewart - the writer, not the actor - raises what I am sure he thinks is something of a defence of the so-called rich, and deploys as his foot-soldiers various numerical arguments. The fulcrums (fulcra?) on which this rests are the suppositions that the "rich" are not necessarily so rich, have suffered more than the general population in the current economic downturn, shoulder a larger tax burden, and are largely not criminals.

Now, most people who have more than the intellectual discipline of a housefly understand that the final point is a straw-man. Of course most of the rich are law-abiding, his plaintive comment: "Yet, as hard as it may be to believe, the overwhelming majority of people earning six-figure incomes aren’t criminals or spendthrifts" notwithstanding. Mr Madoff is a criminal, but the guys over at AIG who approved "retention" bonuses are only criminally stupid, which itself is not yet illegal. We are still waiting on the California Supreme Court to rule on that one.

But looking through the rest of Mr Stewart's opus, there are three essential points.

One, those who are high earners (six figures) have suffered greater losses than the typical man on the street.

The Federal Reserve released statistics last week that showed Americans collectively lost $5.1 trillion of their net worth during the last three months of 2008 and $11.2 trillion for the full year. The numbers don’t break that down by income level, but I think it's fair to say that much of the drop came from the steep decline in stock prices, and stocks are owned disproportionately by high-income people. Indeed, stock ownership is so skewed to upper-income households that the percentage declines are probably much steeper for them, more likely in the 30% to 40% range.

That means anyone who was a millionaire at the beginning of 2008, and had a million dollars invested in stocks, has lost about $300,000 to $400,000, which is in line with what I’ve been hearing anecdotally. And the losses have only multiplied this year as the market continues its descent.

Now, the first problem with this argument is practical. There are not actual data to show exactly how the losses have skewed; Mr Stewart instead says "it's fair to say" that because the decline is largely driven by stock losses, that stock ownership skews to the wealthy, and therefore, losses are "steeper" for them.

I'd like to see the numbers before I agree what is fair, and more important, what is accurate.

It's true that the average guy is less likely to own stock, but he likely does have a pension and/or 401-k, which is intrinsically linked to stock performance. I know my own 401-k is off by about 35 per cent, and my son's college fund has lost about 40 per cent.

Second, he fails to make the distinction between "a millionaire" and those who have "a million dollars invested in stocks." Americans to a large degree are disgracefully innumerate, and do not understand the differences along a scale of someone whose net worth is $100,000; $1 million, and $10 million. The differences are, to say the least, enormous. And when he conflates someone with an income between $200,000 and $300,000 (which comes later) with the jet-set who have a million dollars worth of stock, he is directly playing on this ignorance.

And this ignores the existential issue that the "losses" in this case are largely paper losses. If your stock portfolio drops 30 per cent, you only "lose" that money IF YOU SELL when it is down. So while it is true that Warren Buffet's net worth has declined, he in actuality has not "lost" anything in this regard. In fact, to use Mr Stewart's own implied argument, "I think it's fair to say" that, given the current low stock prices, many of the super wealthy are quietly acquiring stocks at bargain prices that their other assets allow them to acquire, and when the market turns up, they will have grabbed an even larger share of the wealth pie than they had before. To extend the Stewart/Barrymore metaphor, as George Bailey said of Mr Potter, he's not selling, he's buying. In five years, we'll see the endgame of the current situation.

Second, Mr Stewart raises the issue that the rich are taxed at disproportionately higher rates:

This group also pays a disproportionate share of income taxes, even before Obama's proposed tax increases. The top 1% of earners are expected to pay 25% of all personal income taxes this year, and the top 5% to pay 40%, according to Tax Policy Center's latest figures. It's no wonder that the people I know who earn $200,000 to $300,000 are incredulous to be branded as “rich.” They certainly don’t feel that way.


By contrast, let’s take a look at the top 400 earners, who in 2006 (the most recent year for which data are available) earned an average of $263.3 million. Now that’s what I call rich. These 400 people paid on average $45.2 million each, and collectively paid a remarkable 1.77% of all personal income taxes that year, the highest percentage since the IRS has been keeping records. They also paid an average rate of just 17%, the lowest ever, largely because of their massive capital gains, which are taxed at a low rate. Presumably those gains will seem a distant memory by the time the 2008 data are compiled. But imagine if they were paying at the top rate of 35%. That would roughly double their taxes paid in 2006, to $90 million each, or a total of roughly $36 billion. And that’s only 400 people

What a fair distribution of the *income* tax burden ought to be is subjective - I am certainly no communist who thinks that the tax burden ought to be borne exclusively by the wealthy, and think that the Obama plan (like the "fix" passed last month in Sacramento) represents if not socialism galloping at full speed, is at least of the creeping sort.

But let's get real here.

This argument obscures the truth in two ways. First, it focuses exclusively on income tax, ignoring sales, property, and other taxes that all essentially pay. Rich or poor, if you go to purchase a shirt, you pay the same sales tax. And second (and more important), the author focuses on income, not wealth. In this point, the top one per cent of earners are said to pay 25 per cent of all income taxes. Well, what share of the national wealth does this one per cent control?

Third, there is the argument that the wealthy are not, in fact, rich as they are portrayed. Mr Stewart opens with comments about resorts, private jets, and luxury condos, and ends up talking about people earning "six figures" and/or the theoretical target of the Obama "rich guy" tax ladder ($300,000 per annum in income).

The two (three) groups are not the same. A private jet of the sort that Steve Jobs flies around in is tens of millions of dollars. I would suggest that virtually no one earning $250,000 flies frequently in a private jet, or goes to the sort of resort that Jobs or Dick Fuld is able to frequent. To this point, there is a huge problem in homogenising "six figure" incomes - itself an enormous range of 100,000 to 999,9999 - someone earning $300,000, and multi-millionaires.

Mr Stewart again is using the fact that Americans simply do not understand the enormous gulf between 100,000, one million, and ten million as a blunt club.

He turns to a hypothetical individual with an annual income of $200,000, living in Manhattan:

In New York City, for example, $200,000 in income yields roughly $100,000 after all taxes (including the unincorporated business tax, which applies to anyone who’s self-employed). If you're following the prudent rule of thumb that you should spend no more than one-third of your after-tax income on housing, that means $33,000, or less than $3,000 a month, can go toward housing — barely enough for rent on a one-bedroom apartment in Manhattan. As for buying, the collapse in stock prices has wiped out much of what many people invested toward a down payment. New York may be atypically expensive, but many people who earn $200,000 and up have little choice but to live in a high-tax, high-cost location.

Now, it might be pointed out that the guy at $200,000 is, as of now, NOT going to be affected by the Obama tax rise, but that's somewhat akin to Titanic passengers complaining that their food was too cold.

What truly plagues this example are that, a) it is *not* the case that the person must live in Manhattan, and b) the 1/3 rule for after tax really does not scale up linearly.

For (a), the choice to live in Manhattan in the tiny one bedroom apartment is a choice. There is plenty of housing, along train lines, at much lower cost available in Brooklyn or Queens or Northern New Jersey. There are plenty of people who work at much lower salaries than $200,000 for whom Manhattan is simply not even a choice.

For (b), if one thinks about the application of the 1/3 rule for a second, the fallacy arises pretty quickly. Someone with an income of $75,000 who thus has an after-tax income of about $36,000 would have about $3,000 per month - $1000 for housing. THAT is a crunch, and leaves a total of 24,000 for all other expenses ($2000 per month) The guy in the example would similarly have 33,000 for housing, but $67,000 for other expenses, which is 5500 per month. I don't know about you, but 5 grand per month is a *lot* of money for discretionary spending. What he can buy with the difference in discretionary income over the person with the $75,000 income (more than three thousand dollars PER MONTH) is what makes him relatively "rich."

But more to the point, using this same model, someone who is right in the middle of the "six figure" income, $500,000, would pull down about $250,000 after taxes. If we apply the 1/3 rule to this, that's $83,000 for housing, or $6900 per month, leaving $167,000 for discretionary spend, or more than $13,000 per month. He has more than eleven thousand dollars every single month than the guy making $75k to spend on whatever he wants.

That's an awful lot of downloads from iTunes, isn't it?

To be fair to Mr Stewart, the person making $500,000 per year may not "feel rich," to be sure. But my guess is it's because he is looking from his apartment in Greenwich Village at people in his company who live on the upper East Side, or in Westchester County, and not the bridge and tunnel person who works for him.

So all things considered, the rhetorical question asked by Mr Stewart: "Considering taxes, who wants to be a millionaire," I suggest he look at the famous Pink Floyd song for an answer:

But if you ask for a rise, it's no surprise that they're giving none away.