Property Tax

Thomas Piketty in an interview for a British think tank suggests property taxes should be assessed based on your equity in a property (value less debt) not on value:

But it is perfectly possible at the national level to transform our traditional forms of property taxation, which are typically proportional and which do not take into account financial assets and financial liabilities, because they were set up in the nineteenth century when most property was real estate property, so they do not take into account financial wealth and liabilities. This can be turned into a progressive tax on net wealth, which basically would be a way to reduce property tax –council tax in the UK – for the vast majority of the population. Typically, if you have a house that is worth £500,000, but you have a mortgage of £490,000, you are not rich – you have a net wealth of £10,000, so you should pay less than someone who has no mortgage or who paid off his or her mortgage many years ago. 

This makes little sense for US property taxes on owner occupied housing as I will explain.  Piketty is correct that someone with a mortgage on their house is less well off than someone who owns their house free and clear.  However this is already taken into account in the US tax code through the mortgage interest deduction in the federal income tax code.  Although this deduction is often cited as a loophole it has always made sense to me.  But I don't think it makes sense to provide a second reduction in your taxes for having a mortgage.  In fairness to Piketty many countries don't have a mortgage interest deduction in their income tax code in which case his equity argument above has more force.  But in those cases a simpler fix is to add a mortgage interest deduction.

I had previously though the real loophole regarding taxes and owner occupied housing was that the imputed rent on an owner occupied house is not included in income.  But while thinking about this it occurred to me that property tax is roughly equivalent to an income tax on imputed rent.  (This idea is not original to me but I had not encountered it before.)  So besides the practical problems in trying to assess and tax imputed rent as income there is a theoretical case for excluding it as well.  Of course if property taxes are a surrogate for income tax on imputed rental income they should ignore mortgage debt as this doesn't affect the imputed rental income you are receiving by living in your house.

A complication in thinking about tax breaks on owner occupied housing is that any benefits tend to be reflected in selling prices and hence make less difference to new buyers than might be expected.

FiveThirtyEight

Nate Silver launched a new version of his FiveThirtyEight website on ESPN a couple of months ago. I liked the previous versions (most recently associated with the New York Times) which mostly covered the horse race aspect of national politics but find the new site a disappointment. In my view the problem is the new site doesn't make enough predictions. Making (and explaining) predictions is useful because it encourages you to develop models that focus on what's important. And it has the commercial advantage of driving traffic as people check back to see how the predictions are changing. During the Presidential election campaign I would check the FiveThirtyEight website regularly to get the Silver's latest odds.

It would have been straightforward to extend FiveThirtyEights politics coverage model to sports. The four major US team sports (baseball, basketball, football and hockey) crown a champion every year. So each year you have the equivalent of a Presidential election campaign. And FiveThirtyEight could offer regularly updated estimates of the chances of each team advancing to each level on the way to the championship. Along with the predictions FiveThirtyEight could have posts explaining the models used to generate them. I would find this interesting just as I found the analogous politics coverage interesting. And from a commercial point of view more people care about sports than politics.

Extending the coverage model to areas other than sports is a bit harder as you don't have the same campaign analogs. And often the data isn't as good. Still there are plenty of things you could try to predict. How will stock prices, federal tax receipts, oil prices etc. evolve over time?  It should be possible to find a variety of things about which interesting predictions could be made.

But instead of systematically developing models and using them to attempt to predict things that people care about FiveThirtyEight has too many posts like this one on how Americans like their steaks cooked.  The internet is full of random data like this and it is unclear why we are expected to find it of particular interest. 

So to sum up, in my opinion the new FiveThrityEight has changed for the worse.

Target

Target's CEO, Gregg Steinhafel, recently resigned under pressure. Megan McArdle doesn't approve.  I find her arguments unconvincing.  First while Steinhafel was not directly responsible for the data breach as CEO he bears a general responsibility for everything that happens at Target.  It was his job to see that Target's data systems were staffed by competent people and that they were given sufficient resources to keep Target's systems secure.  Second the data breach is not Target's only problem.  Their expansion into Canada has not been successful to date hampered by what appear to be multiple failures to execute.  Again this is the general responsibility of the CEO even if some of his underlings were more directly responsible.  And there may be additional non-public issues.  For example the board may have lost confidence that Steinhafel was giving them accurate reports.  Naturally it is difficult for an outsider to evaluate Steinhafel's performance.  Perhaps he has just been unlucky.  But as a Target shareholder I am not going the second guess the board's apparent decision that a change at the top was needed.

Of course changing the CEO is a drastic move which shouldn't be undertaken lightly.  It suggests the board thinks Target is facing serious problems.  So it is not surprising the stock dropped on the news that Steinhafel was out.  As I noted back in January I had kind of lost faith in this stock pick.  I considered selling but didn't pull the trigger.  Perhaps I should have but at this point I think I will wait and see a bit.  Which is my natural inclination anyway. 

Annual Funding Notice

Last week I received the Annual Funding Notice for the IBM Personal Pension Plan (which is paying me a pension). Rather than require companies to adequately fund their pension plans Congress instead makes them send all participants annually a report on their plan's financial status. This is pretty pointless as most people won't get much from the disclosure. Pension accounting is inherently complicated and to make matters worse current rules are full of loopholes which can make a plan appear to be in better shape than it actually is. So the report is pretty opaque. And even if your plan is currently in good shape the weak regulations mean it may not stay in good shape. So I expect most people pay little attention to this notice and just hope for the best.

This year I actually tried to understand the report. Although the IBM plan is relatively easy to evaluate because it was frozen some years ago (which means participants are no longer accruing benefits) this proved rather difficult. Besides the notice for this year (2013) I looked at prior year notices, the 2013 IBM annual report and documents on the Department of Labor website for 2012 (the documents for 2013 aren't available yet). As best I can tell the only numbers in the notice worth paying attention to are in the "Fair Market Value of Assets" section. For IBM this says:

As of December 31, 2013, the fair market value of the Plan's assets was $53,953,692,333. On this same date, the Plan's liabilities were $47,920,350,174.

The key points here are that the valuation date is at year's end (as opposed  to 1/1/2013 or earlier elsewhere in the notice) so is relatively recent.  The assets are valued at fair market value which is fairly straightforward as opposed to elsewhere in the notice where a bogus accounting value can be used (although IBM does not do this)  based on what the assets would have been worth if the plan had achieved its expected rate of return.   Valuing the plan liabilities is a bit less straightforward as you have to figure the present value of future obligations which requires choosing a discount rate.  This should be determined by looking at the current yields of safe bonds which is not that complicated.  However elsewhere in the notice an artificially high discount rate is used which makes the plan liabilities look smaller than they really are.  This artificially high rate is a recent loophole created by Congress to allow companies to reduce their contributions to their pension plans while pretending they are adequately funded.  The notice for 2012 in the Fair Market Value section using a realistic (or at least more realistic) discount rate valued the plan liabilities at $52,939,309,074 (at 12/31/2012) while the artificially low discount rate used elsewhere in the 2013 notice gave a plan liability value of $40,044,112,196 (at 1/1/2013) which illustrates the magnitude of the loophole.  The actual discount rates used in the Fair Market Value section are not stated in the notice.  The IBM annual report lists discount rates of 4.5% and 3.6% for year end 2013 and 2012 respectively which may be the rates being used.  As best I can tell the present value of future plan administrative costs aren't included in plan liabilities which means they are understated a bit.  Still the IBM plan appears to be in reasonable shape.  And since it is frozen it less dependent on regular additional funding from IBM than active plans.

IBM assumes an 8% annual return on its US pension fund investments.  This is too high in the current environment but doesn't affect the above liability numbers as IBM (as a private company) is not allowed to discount plan liabilities using this rate.  In contrast public entity pension plans can and do discount their liabilities using their assumed rate of return (which is typically in the 7% to 8% range) thus grossly understating their actual liabilities.  IBM's assumed rate does affect IBM's reported earnings.

Utility Functions and the CAPM

A basic concept in classical economics is that given certain plausible assumptions it is possible to define utility functions which measure how desirable economic actors find possible states of the world.  Rational actors will then try to maximize the expected value of their utility function.  For example most people will have an utility function which gives an additional two million dollars less than twice the value of an additional one million dollars.  Hence they will prefer a sure million dollars to a 50% chance of two million dollars as this will maximize the expected value of their utility function.

The Capital Asset Pricing Model (CAPM) uses considerations of this sort to predict that risky assets will sell at a discount to their expected future value (as computed in dollars) and that the amount of the discount will increase as the amount of future uncertainty increases.  As without such discounts investors would prefer to buy only the safest assets.  It follows that risky investments will have greater expected return.  Note risk here is referring to non-diversifiable risk.  Risk particular to individual assets can be essentially eliminated by buying a diversified portfolio of such assets.  However some risks (such that the economy as a whole will do badly) are not particular to individual assets and cannot be eliminated by diversification. 

In the case of stocks it is reasonable to divide the risk (uncertainty in future returns) into two parts.  That due to idiosyncratic factors particular to individual companies and that due to uncertainly about the general future trend of stock prices (as stocks tend to move up and down together).  Stocks vary in how sensitive they are to general market movements.  Some might tend to move up and down twice as much as the market, others only half as much as the market.  The Greek letter beta is conventionally used to denote how sensitive the price of a particular individual stock is to a general change in the level of stock prices normalized so that a stock with a beta of x will tend to move up or down by x% when the general market moves up or down by 1%.  High beta stocks will have more non-diversifiable risk and are predicted by the CAPM to have greater expected returns.

The CAPM is quite elegant mathematically.  However that does not mean it is correct. Eric Falkenstein has extensively criticized it in books and his now dead blog, Falkenblog, which I mentioned earlier this month. Falkenstein's criticism (I don't know to what extent it is original, for the most part it is new to me) comes in two parts.

He claims that empirically high beta stocks have historically performed worse than low beta stocks which is a bit strange if their expected returns were actually higher.  A big part of this seems to be due to the highest beta stocks performing badly with returns otherwise pretty flat with respect to beta.

On the theoretical side he points out the usual utility function framework is inadequate as it neglects the fact that people care about how they are doing relative to others.  So they are going to prefer seeing their stocks go up 20% when the market is up 10% to seeing their stocks go up 20% when the market is up 30% although their personal return is the same in both cases.  To the extent that people care more about relative returns than absolute returns (or as Falkenstein puts it are driven more by envy than by greed) the predictions of the CAPM will be flawed.  For the so called risk free rate of return (often taken to be the interest rate paid on government bonds) is not actually risk free if people care (as they often will)about missing out on a big move upward by the stock market.  The risk free investment for such people will be an index fund which guarantees them the average market return.  Which means in effect that all risk is diversifiable and that there is no reason to anticipate greater expected returns when voluntarily assuming risk by deviating from the market average portfolio. 

Net Neutrality

Vox has an article blaming Congress rather than the FCC for the apparent demise of net neutrality regulations.  In my view this is wrongheaded, according to Vox's own coverage, Congress has given the FCC adequate authority to impose net neutrality regulations.  The FCC simply has to classify broadband internet provision as a "telecommunications service" rather than as an "information service".  This seems more logical and would allow the FCC to enact common carrier regulations.  Instead the FCC has tried to impose common carrier regulations while classifying internet provision as an "information service".  Since this is not allowed by the relevant law the Courts have rejected these attempts. 

Apparently the FCC is reluctant to classify broadband internet as a "telecommunications service" because they fear this would prompt a political backlash from industry groups.  But expecting Congress to be more willing to take political heat than a federal agency seems crazy to me.  The real reason net neutrality is dying is that its advocates haven't mustered enough political support to overcome industry opposition. 

As for my opinions on net neutrality itself, I don't think internet providers should be allowed to discriminate based on content but I am sympathetic to the view that they should be able to charge extra for high bandwidth usage and other behavior which stresses the network.

High Pay

Piketty's book is mostly about increasing inequality in the distribution of capital (and hence in income from capital).  However income from labor is also becoming less equal.  One aspect of this is the emergence of a group of extremely high earners.  Piketty's explanation for this is as follows.  This group largely consists of highly paid top corporate executives.  They are in positions where they can strongly influence their own pay.  This gives them some ability to overpay themselves and the reduction in top marginal income tax rates gives them more incentive to do so.  The natural result is very high rates of pay, well above economic value. 

I agree that top corporate executives in general are currently substantially overpaid.  Piketty's  account certainly seems plausible and is probably part of the explanation.  However it is not the entire story as there are lots of high earners who aren't negotiating their pay with themselves.  Krugman brings this up in his review:

 ... Also, I don’t think Capital in the Twenty-First Century adequately answers the most telling criticism of the executive power hypothesis: the concentration of very high incomes in finance, where performance actually can, after a fashion, be evaluated. I didn’t mention hedge fund managers idly: such people are paid based on their ability to attract clients and achieve investment returns. ...

However I think Krugman is also confused in that it isn't actually any easier to evaluate the performance of hedge fund managers than the performance of corporate executives.  In both cases you can look at how well they have appeared to do in the past but this won't predict their future performance very well.  This is because how well they do is highly dependent on luck and other factors outside their control.  But people tend not to adequately allow for this.

So I think another part of the explanation for unjustified high pay is that employers have a natural tendency to overestimate their ability to predict future performance.  So they are willing to pay more to attract their preferred candidates than is justified by actual differences in expected performance.  As a result it is quite plausible that top corporate executives would be overpaid even if their pay was negotiated with truly independent boards of directors.  Just as hedge fund managers as a group are obviously overpaid even though their clients could readily obtain better expected performance (after fees) in low cost index funds.