Taxes, Individual Decisions and
Investment Alternatives
Presentation to the President’s Advisory Panel on
Federal Tax Reform
March 16, 2005
Brian S. Wesbury
Chief Investment Strategist
Claymore Securities, Inc.
People Pay Taxes, But The Tax System Really
Impacts People’s Chosen Activities
 From an economic perspective, it is the impact of taxes on incentives
and behavior that matters.
 Taxes influence decisions about how individuals allocate their scarce
time, talent and resources.
 Investors contrast potential after-tax rewards and risk.
 Now the Israelites had been saying, “Do you see how this man
[Goliath] keeps coming out? He comes out to defy Israel. The King
[Saul] will give great wealth to the man who kills him. He will also
give him his daughter in marriage and will exempt his father’s family
from taxes in Israel.” – I Samuel 17:25
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Different Investment, Different Taxes
Bonds
 Corporate Bonds – Corporations deduct interest from income. Interest
payments, however, are taxed at individual or corporate marginal income tax
rate.
 Treasury Bonds – Interest income taxable at marginal tax rate.
 Municipal Bonds – Most interest exempt from income tax for individuals.
Banks, however, are limited to the type of tax-free bonds they can buy, and
also face TEFRA haircuts and AMT.
 Original Issue Discount (OID) Bonds – Can create a tax liability even if no
interest is earned (example, zero-coupon bonds).
 Treasury Inflation Protected Securities (TIPS) – Increase the principal of the
bond by the rate of inflation. Tax is then due on this increase in principal as if
it were actual interest income.
Loans
 Mortgage Interest – Deductible for borrower, taxable for lender.
 Investment Interest – Interest paid on loans to fund investment, such as
margin loans, is deductible to the individual.
 Other Interest – Interest paid on car loans or credit card debt is not deductible.
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Different Investment, Different Taxes
 Corporate Dividends – Prior to 2003 tax cut, dividends were taxed at
individual marginal income tax rate. Today, recipient is taxed at 15%
on “qualified dividends.”
 If corporation earns $100, and pays 35% tax rate, or $35 in
corporate tax, then $65 remains to be paid as dividend. Recipient
is then taxed at 15%, which leaves $55.25. Tax rate = 44.75%.
 Capital Gains on Stock – After holding stock for one year or more,
taxed at 15%. Less than one year, taxed at individual marginal income
tax rate. Stock option compensation plans are very complicated.
 Capital Gains on Housing – Tax-free up to $500,000 for a couple who
has used home as primary residence for at least two years. Gains over
$500,000 taxed as income.
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Further Complication: Tax-Deferred Vehicles
 Different tax treatment for investments are further complicated by the
existence of tax-preferenced vehicles such as IRAs, Roth IRAs,
Keoghs, 401(k)s, 529s, life insurance policies, pension plans, deferred
compensation plans, and others.
 Alter after-tax returns on investments.
 For example, no one should buy municipal bonds in an IRA.
 The existence of these vehicles makes investment decisions even more
complex.
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Differential Tax Rates Change Behavior
 Prior to 2003 tax cut, the long-term capital gains tax rate was 20%, but
dividends were taxed at marginal income tax rates.
 As a result, corporations issued debt, bought back stock and paid
fewer dividends.
 This reduced the combined corporate and shareholder tax liability.
 2003 dividend tax cut to 15% encouraged dividend payments.
 Homeowners can deduct mortgage interest from income and interest
paid on home-equity lines.
 As a result, many use home-equity lines to make large purchases of
furniture, vehicles or home appliances.
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Differential Tax Rates Change Behavior
 Does the tax code boost the trade deficit?
 This panel has already heard testimony about how the U.S. tax
code is biased against saving (see 2/16/05 transcripts).
 Future consumption is relatively more expensive because
investment dollars are taxed more than once. As a result, current
consumption is encouraged, which increases imports.
 At the same time, foreign central banks and many other foreign
investors do not pay taxes on interest earned from US bonds. As a
result, interest earnings from owning US debt are higher for
foreigners than for US citizens who must pay taxes on interest.
 The tax code boosts domestic consumption and encourages foreign
investment. The result could be a larger trade deficit than would
otherwise exist.
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Interest Rates are Higher, Investment Lower
 Because interest income is taxable and interest payments are
deductible, investors demand a higher interest rate.
 This is why corporate and Treasury bond yields are higher than
municipal bond yields. Most municipal bond interest is tax-free to
investors. As a result, investors are willing to accept a lower rate.
 If interest income were tax-free, interest rates would be lower across
the board.
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Tax Cuts and Investment
 2001 recession was an investment depression.
 Even with dramatic Fed rate cuts in 2001, business fixed
investment fell for nine consecutive quarters, between Q1-2001
and Q1-2003.
 Employment growth was slow and the economy struggled. During
the first five quarters of recovery (which began in November
2001), real GDP growth averaged just 2.1%.
 Investment grew after the May 2003 tax cuts, which cut capital gains
and dividend tax rates and provided for accelerated depreciation.
 Business investment has grown for 7 consecutive quarters, and real
GDP has since grown at a 4.5% annualized rate.
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Lower Taxes and Investment
Nonresidential FIxed Investment
Quar ter ly Annualized Per cent Changes
22. 5
22. 5
15. 0
15. 0
7. 5
7. 5
0. 0
0. 0
- 7. 5
- 7. 5
- 15. 0
- 15. 0
00
01
02
03
04
Sour ce: Bur eau of Economic Analysis /Haver Analytics
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The Housing Market
 Housing is the least taxed investment in the US and it is clearly
booming.
 Tax cuts in 1997 exempted $500,000 of capital gains from sale of home
for couples who live in home for 2 years.
 Strong Growth.
 Housing starts and sales grew through the recession.
 Since 1997, residential construction jobs have increased by 36% and
real estate jobs jumped 17.6%, while retail employment rose just
5.8%, and manufacturing jobs fell 17%.
 Housing prices are up dramatically.
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Summary: Leveling the Playing Field
 Different tax treatment of different investment vehicles distorts the
financial market playing field.
 Interest rates are higher than they would otherwise be, corporations
make decisions based on the tax code, individuals are encouraged to
save less.
 A consumption-based tax system would level the playing field for all
types of investment.
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