Tuesday, November 11, 2008

My Economic Agenda for President-Elect Obama

The other day someone asked me, half jokingly, what I would do to fix the economy. I blurted something incoherent because I'm not very good on my feet and went back to work. Then I started thinking a little bit more and decided I would share my conclusions with the ten people that read my blog. I've given it a good day's worth of pondering, so, clearly, my opinions are very broad. Here are three thoughts, in no particular order.

1. Create a principles-based rather than rules-based economy. This is no surprise to accountants. Most of them have had long philosophical discussions late into the night regarding the benefits and drawbacks of principles-based accounting (remember I spent a summer with a bunch of them). I'll share an example from the accounting world that will help illustrate my point. International accounting standards have a principles-based rule for the accounting of leases while the U.S. standards (according to GAAP) favor a rules-based standard. According to international accounting, leases must be booked as capital leases (nevermind the terminology here, that's not the point) "if it transfers substantially all the risks and rewards incident to ownership." However, U.S. accounting standards lay out four different criteria for differentiating the different types of leases. If the lease meets one of the four criteria, it must be classified as a capital lease. The international standard is based on a principle, while the U.S. standard is based on several rules. There are obvious advantages and disadvantages to both. We generally like rules because they're easier to communicate and understand. They also create standardization. Conversely, while rules are better for communicating, we generally see that principles are better for compliance and forces one to use judgment. Broad principles avoid the pitfall of creating specific requirements that allow contracts to manipulate their intent. It's emphasizing form over substance. I'm not arguing we shouldn't have any rules, just that it currently seems a bit excessive and most savvy individuals and firms are quite good at finding ways around the rules.

2. Lower Corporate Tax Rates. Currently the U.S. has the second highest corporate tax-rate (behind Japan) for developed nations. The tax rate, combined with the increasingly onerous regulatory environment (i.e. Sarbanes-Oxley) decreases the relative attraction of establishing businesses in the U.S. It also de-incentivizes companies currently headquartered in the U.S. to maintain operations, or a public listing. So this repels business investment, and creates both un- and under-employment. But there is yet another disadvantage of high corporate tax rates. Interest from debt is tax-deductible. The higher the tax rate, the greater the savings from the interest write-off (which eventually increases your firm's value, and, thus, share price). Therefore, elevated tax rates create an economic incentive to obtain leverage. This will come as no surprise to anyone in finance familiar with the "optimal capital structure." At it's core is a theorem which basically states in a world with no taxes, the amount of debt you have is irrelevant (from the standpoint of the value of your business and shareholder wealth, although it does increase risk) but as rates increase, so does the corresponding incentive to obtain debt since the tax savings from the interest write-off will be greater than the cost of the debt. The theorem states that there is an optimal amount of debt a company should have where it maximizes the risk adjusted return to shareholders. So decreasing tax rates will correspondingly decrease the economic incentive to lever a business. As a nation I think it's fair to say we are over-levered.

3. Boost Government Spending in Infrastructure, Health Care, and Education. It may be good to introduce how GDP is calculated. GDP = C + I + (G-T) + X where GDP equals the sum of consumer spending C, Private Sector Investment (corporate spending) I, fiscal stimulus (netting government spending G minus what they bring in taxes T) and net exports X.

How can GDP increase when consumer spending is down C, businesses are investing less I, and exports are decreasing because of the global recession X? That leaves fiscal stimulus. And, according to our equation above, if GDP is to remain constant, the fiscal stimulus (G-T) must be great enough to offset the losses in the other three categories. So we focus on G and T. Certainly decreasing taxes, both consumer and business, or creating tax credits will increase aggregate consumption in both (C and I). But many overlook the importance of government spending. Whatever the government spends will obviously increase the overall deficit. But the deficit will be a smaller problem if the money is spent on infrastructure rather than fettered away into adult film consumption (which, by the way, is very resilient in a recession). Instead of sending out more stimulus checks to Joe the Plumber (I'm referring here to the average American, not the actual guy that's been identified) the government should think longer term and invest to decrease the cost of education, increase access to Health Care, and update our ailing 30-year old infrastructure (highways, roads, and utilities). If my children are going to be responsible for the deficit the government creates, then I want them to benefit.

As I said at the onset, I haven't given this a great deal of thought, but enough to perhaps elucidate where I think our economy should look over the next ten to fifteen years. I'm sure I've left some vital piece of information out, but blogs are obviously imperfect (afterall, you get what you pay for). I think some of these changes will create a more intelligent, agile, and sustainable economy. And one last suggestion, I don't think Obama should run for re-election. He needs to be able to make decisions without the subconscious desire to please potential supporters in 2012 .


James said...

Some good ideas here. I would add to your #3 that our emphasis in infrastructure should be green. Not just because it "helps the planet." While that's nice, green technology it is one of the lowest hanging fruits in terms of innovation and entrepreneurship. A major growth industry internationally, at least from my point of view.

Speaking of entrepreneurship, I thought you'd get a kick out of what Mark Cuban had to say about the impact of tax rates on corporate tax rates.


Nate said...

I disagree with this statement in your #1:

"Broad principles avoid the pitfall of creating specific requirements that allow contracts to manipulate their intent."

Take the broad principal that you outline: "leases must be booked as capital leases if it transfers substantially all the risks and rewards incident to ownership."

Any attorney worth their salt can go to town on that statement to manipulate the intent -- plenty of the words are squishy, especially "substantially all" but also "transfer" and "incident to."

I'm not disagreeing with the overall statement, just your characterization of its potential benefit.

Jenga said...

I believe we're making the same point. You're suggesting principles contain soft language and that such language will not stop corporations from acting opportunistically because it can't be enforced. Clearly businesses will try and stretch the limits. The argument becomes one of degrees. Will they do so any less with more principles? If the system is designed around ambiguous language, as you suggest, then I don't expect executives to behave altruistically and I would submit such a system is doomed to failure. But you're simply arguing against the other extreme. Either way, what we're both arguing for (me directly, you indirectly)is a system designed around a more optimal mix of principles combined with rules.

In reality, the example you use from my post would not be the only comment holding up the standard. But here's my point (using the same example); the international standards further clarify accounting of leases in 6 pronouncements and one interpretation. The U.S., on the other hand (remember they've already laid out four rules) has decided to clarify the matter through 20 statements, 9 interpretations, 10 technical bulletins, and 39 abstracts (I looked it up). That's excessive.

In this case, its the department accountants that will/should (or the CFO) dictate the proper accounting treatment, not attorneys, and they will want to keep it out of court due to certain costs as well as headline/reputation risk. If it does go to court because the company gets sued, then I agree with you, the words are soft. But if it gets to that point, the company has already lost, in my eyes.

I believe you've correctly identified the major disadvantage of principle-based systems. The other one is the issue with comparing apples to oranges. How is an investor supposed to know the difference when one company chooses a different accounting treatment than a competitor may use? Again, there need to be rules, but I think we have to many under our current system. And although I can't prove it, I'm going to guess we are not extracting any proportional benefit (which I would express in terms of lawsuits per some relative denominator) from such rules compared to other developed nations.

Nate said...

You are a gentleman and a scholar.