May 8, 2012

Chained-CPI is not an accurate deflation gauge

Posted in Ben Bernanke, Economy, Federal Reserve, Finance, government, Housing Market, IRS, medicare/medicaid, social security tagged , , , , , , , , , at 5:09 PM by Robert Barone

Circulating around the Beltway is a concept called Chained-Consumer Price Index (Chained-CPI). It is being billed as a new and “more accurate” way to measure the rate of inflation.In an April 25th article, the editors of Bloomberg View stated that the Chained-CPI “is a more accurate gauge of U.S. inflation that would yield immediate savings … The fix to this has already been endorsed by lawmakers in both parties, the Obama administration, many economists, and a series of bipartisan deficit-reduction panels.”According to Bloomberg View, the Chained-CPI is “a more exact measure that accounts for the substitutions consumers make when a product’s price goes up.” Remember this substitution concept, for, as you will see, it is the problem not the solution.
 
Currently, the most popular measure of inflation is the Consumer Price Index. The Bureau of Labor Statistics (BLS) produces several CPI measures monthly, but the one that makes the headlines is called CPI-U. In theory, CPI-U represents the buying patterns of all urban consumers.

This CPI measure is the “benchmark” that determines cost-of-living adjustments (COLAs) for a wide range of government programs, including Social Security, Medicare and government pensions. It is also widely used by the IRS in the tax code, in union contracts and in most long-term rental agreements.

The reality is that, like much of what comes out of Washington, the “Chained-CPI” concept is neither new nor more accurate. This chain-weighted concept is just another step in a series of steps that began in 1980 aimed at changing the CPI concept from one that measures the cost of maintaining “a constant standard of living” to measuring, really, not much at all, as I will explain later. The real purpose of altering the methodology is twofold: 1. To reduce the reported increase in inflation for political reasons; and 2. To lower future federal budget costs of Social Security, Medicare and government pensions by lowering the COLA adjustments without having to haveCongress vote for those or the administration sign it into law. Just note, however, what class bears the biggest burden of this – seniors and retirees.

The CPI rate of inflation reported for the year 2011 was approximately 3 percent. That was higher than what appears to be “tolerable” for America’s political class. But, we have a fairly recent concept called “core” CPI, which is the CPI-U excluding food and energy.

Both Fed chief Bernanke and Treasury Secretary Geithner believe that this is a better measure of “underlying” inflation. Apparently, they don’t believe that Americans are much impacted by the cost of petroleum products or food. I promise, however, that when the “core” CPI is higher than the CPI itself, “core” will be ignored!

If the methodology for computing the CPI-U were the same formula that was used in 1980, then the 3 percent rate of inflation reported for 2011 would have been closer to 11 percent, according to John Williams of Shadowstats.com, who follows this indicator in detail.  In 1980, the CPI measured a “standard of living,” with the price index telling us how many dollars more it would take to buy the exact same basket of items we bought in a prior period, say, last year. Below is a simple example using two goods: T-bone steaks and hamburger.

 

Weight (W)

Price (P)

W x P

T-Bone

50%

$10.00

$5.00

Hamburger

50%

$3.00

$1.50

   Index

 

 

$6.50

The table shows that the consumer has chosen, at current prices, to spend 50 percent of his/her budget on each item. The weighted index is $6.50. Now, assume that the price of T-bone steak rises to $12 while hamburger rises to $3.25. The table below shows that the weighted index would be $7.625.

 

Weight (W)

Price (P)

W x P

T-Bone

50%

$12.00

$6.000

Hamburger

50%

$3.25

$1.625

   Index

 

 

$7.625

That is, it now takes $7.625 to purchase what $6.50 used to purchase. What that says is that to maintain the “standard of living” that $6.50 used to buy now takes $7.625. So, prices have risen (i.e. inflation) by 17.3 percent [(7.625-6.5)/6.5].

We all know that when prices change, and especially if incomes are not rising as fast as prices, consumers substitute lower cost goods that usually are of lower quality. When that happens, the “standard of living” is clearly falling. The following is an example of how the Chained-CPI would significantly lower the reported inflation rate.

The table shows the same two goods, but because incomes have not risen, consumers have cut back T-bone steak to 40 percent of their budget and increased hamburger to 60 percent. As shown in the following table, the weighted index is $6.75 and the resulting reported rate of inflation is 3.8 percent [(6.75-6.50)/6.50)] rather than the 17.3 percent rate associated with maintaining a defined “standard of living” (i.e. 50 percent T-bone and 50 percent hamburger).

 

Weight (W)

Price (P)

W x P

T-Bone

40%

$12.00

$4.80

Hamburger

60%

$3.25

$1.95

   Index

 

 

$6.75

U.S. consumers already know that their living standard is being eroded, and that the reported rate of inflation understates reality. This has been the explanation of why. And, clearly, the “Chained-CPI” is not a “more accurate” gauge of inflation.

If you think about it, the two weighted average costs using different weights are not really comparable at all. What would you say if consumers had to substitute canned dog food for hamburger? Would you think the measure of inflation meant anything? The 3.8 percent is a math result, the product of numbers in a formula. But the numbers being used in the calculation measure different things and are not comparable. The result is that the Chained-CPI doesn’t really measure anything.

Nevertheless, the coming use of the Chained-CPI will allow reporting of much lower rates of inflation than is the reality, reducing Social Security, Medicare and government pension COLAs, all without any action on the part of Congress or the administration.

It also will distort to the upside the reporting of other economic activity where nominal” (i.e. current dollar) indicators, such as GDP, are translated into “real” terms by deflating them with an artificially low measure of inflation.

As I’ve said in many past blogs, much of the recession is being carried on the backs of those living on fixed incomes, savers, those living off of accumulated assets and retirees. Not only do they now get near 0 percent on their savings, but now they will be further cheated out of part of the COLA adjustments that would keep them at their current living standard via their Social Security, Medicare and, if a government retiree, pension. Isn’t it wonderful how government works?

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April 9, 2012

Financial armageddon: Should you worry?

Posted in Armageddon, Banking, crises, debt, Economic Growth, Economy, Finance, government, Housing Market, investment advisor, investment banking, investments, IRS, medicare/medicaid, Nevada, payroll tax reductions, recession, social security, taxes tagged , , , , , , , , , , , , , , , , , at 8:37 PM by Robert Barone

You’ve probably seen them in your email, or even on TV — I’m talking about the “approaching financial armageddon” forecasts. People must be responding to them, because they keep on appearing in my email — several per week, and others I know get them too. Should you be concerned?To answer this, we examine data from the six largest categories of Federal expenditures in 2000, 2012, projections for 2016, and their associated compounded annual growth rates (CAGR). Much of this data comes from USdebtclock.org. Caution, the website is not for the faint of heart.Six expense categories (Medicare/Medicaid, social security, income security, federal pensions, interest on debt and defense) account for nearly $3.1 trillion of spending in 2012, represent more than 86 percent of total federal spending and account for 137 percent of taxes collected. These six spending categories are critical when trying to understand the nature and extent of the structural deficit.Growth rates in CAGR show Medicare/Medicaid spending growing to $1,050 billion per year in 2016. The demographics of the U.S. population don’t show us getting younger and baby boomers are just beginning retirement. Social Security will also advance much more quickly than its 5.4 percent growth rate of the past 12 years. All in all, the projection of expenses I’ve shown in the table for 2016 ($3,692 versus $2,265 in 2012) appear quite optimistic. But, let’s go with it.Americans, in general, will tell you they oppose bigger government, at least in the abstract. But in poll after poll, when asked where Congress should make significant cost cuts, almost no specific program eliminations are favored by a majority of Americans. Given this predilection among Americans and assuming that these six categories again account for 86 percent of Federal spending in 2016, then, total Federal spending will be approximately $4.3 trillion.

Some analysts fret about the “fiscal cliff” on Jan. 1, 2013 when the Bush tax cuts are scheduled to expire along with the 2 percent payroll tax reduction for individual social security contributions.

Those analysts put the impact of these at a 3 to 4 percent GDP reduction. When the Bush tax cuts expire, the Federal government theoretically could collect about $300 billion more in taxes if economic activity were otherwise unchanged (a heroic assumption). In addition, the reinstatement of the 2 percent social security tax on individuals will add about $160 billion to tax revenues (again, assuming no decline). The breakout with this story is an estimate of what the deficit would be and its relationship to 2016 GDP. It assumes the Bush tax cuts have been eliminated, the payroll taxes are reinstated, and economic activity is not negatively impacted, so it is likely to understate the deficit. The tax revenue growth rates (left hand column) begin in 2013, after the “fiscal cliff.”

As you can see from the table, reinstatement of the Bush tax cuts and the payroll tax reductions alone do little to solve the issue, as the deficit remains at $1.54 trillion if no further tax increases occur.

 

OUR ‘FISCAL CLIFF’

If Tax CAGR is: Deficit/GDP will be: Deficit will be ($trills):
0% 9.1% $1.54
5% 6.6% $1.12
7% 5.5% $0.93
8% 4.9% $0.83
10% 3.7% $0.63
16% 0.0% $0.00
 
Such a tax regime will clearly keep the economy in a no growth or recessionary mode. If America resists the tax increases, then deficits will balloon, interest rates will rise as the world spurns the dollar, the Fed will continue to print money and purchase the debt that can’t be placed externally, a nasty inflation will likely set in (it has already begun — look at food and energy prices), and we will find ourselves in a Greek type tragedy. The only way out is to significantly cut the growth of Medicare/Medicaid, Social Security, Income Security and Federal Pensions. Which Congress and president will do that?So, should you be concerned about an approaching financial armageddon? Yes.
  

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah
Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.

 Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

 

February 16, 2012

Debunking the Warren Buffett Tax Deception

Posted in Economy, Finance, government, investment advisor, investment banking, investments, IRS, local banks, taxes tagged , , , , , , , , , , , , , , , , , , , , , at 10:10 PM by Robert Barone

It is an election year, so the media makes a big deal out of Warren Buffett’s assertion that the tax system unfairly taxes his supposedly “working class” secretary at 33% (we’ve also seen 34% and 35.8%), while he only pays 13.7% (we’ve also seen 17.4%) on the millions that he makes.

The political implication is that he, and others like him, such as GOP hopeful Mitt Romney, somehow aren’t paying their “fair share” of taxes.

But instead of doing even superficial analysis, the media carries the story at face value. That is naive. Even a slight amount of digging will turn this story upside down.

Let’s start with Buffett’s secretary, Debbie Bosanek. In order to pay a marginal tax rate of 33% (or 34% or 35.8%), she would have to be in Occupy Wall Street’s 1%, not the 99%. Using the 2011 tax tables for individuals, if she were single making a $250,000 adjusted gross income (that’s after deductions!), she would be in the 33% marginal tax bracket and would have a 27% effective tax rate. To get to the 35% marginal tax bracket, her adjusted gross income would have to be more than $379,000. Isn’t a $250,000 income the magic line that [President Barack] Obama has drawn that demarcates those who he is targeting as “rich” and should be paying more taxes? So, let’s not be deluded into thinking that his woman somehow represents America’s working class.

But the bigger deception is Buffett’s claim that he pays a much lower tax rate than he supposedly should. A quick review of business taxation in the US today will show that Buffett pays in excess of 30% of his income in taxes.

Most small-business owners choose the Subchapter-S or LLC format for their businesses. Any profit from their business flows directly to their personal taxes (form 1040). Assume two similar businesses, one owned by X and the other by Y. Both businesses make $450,000 in pretax income. Owner X has chosen the LLC format. Owner X’s company pays no taxes to the IRS, but sends Owner X a K-1 requiring X to declare $450,000 on his form 1040. His marginal tax bracket is 35%.

Owner Y has chosen the C-Corp format. Y’s company also had a pretax income of $450,000, which is taxed at the corporate 35% tax rate. Y has chosen to declare a $50,000 dividend to himself which shows up on his 1040 and is taxed at 15%. Looking only at his 1040, you would think that Y doesn’t pay much in taxes. In fact, Y pays more taxes than X because the dividend is double taxed – that is why most small businesses choose the LLC or Sub-S format.

Now let’s talk about Buffett. He is famous for buying large stakes or even controlling interests in large C-Corps. He is the equivalent to Owner Y.   So, the taxes that Buffett pays go well beyond what is shown on his 1040. Like Owner Y, the 13.7% rate on Buffett’s 1040 shows only the taxes he pays on the dividends and therefore is only part of the story. I looked up Buffett’s 13F SEC filing dated January 30, 2011. That filing shows nine major holdings.

Using the share price of each holding and the number of shares shown on the 13F, I estimated the value of each of those holdings. Then, using the C-Corp’s reported effective tax rate, the pretax income per share, and the dividends per share (taxed at 15%), I calculated Buffett’s effective tax rate on each holding. Finally, using the market value of each holding to form a weighted average, I then calculated that Buffett’s effective tax rate on these nine holdings was more than 32%.

Buffett Holdings from September 30, 2011 13F
Click to enlarge

This should debunk the myth that America’s investor class does not pay its “fair share” and that we should put a minimum of 30% on their 1040 filings.

Finally, some advice for Romney. Should you become the GOP candidate, I would advise that you do an analysis on your income similar to what I did for Buffett in the table above. If you are the GOP candidate, you can take the issue of paying your “fair share” of taxes off of the table.