Cap and Trade: Path to Glory?

One of the most controversial pieces of the new Obama budget is an emissions trading program which hopes to generate revenue for the government in addition to limiting the amount of greenhouse gases that America releases into the atmosphere every year.

While the details of the program have not yet been fully fleshed out, the proposal itself has created a torrent of criticism, from likely places with an unlikely argument. Regardless of the political controversy, an argument worth having is whether or not this particular system is the most efficient way to curtail greenhouse gas emission.

America's historical experience with emissions trading dates back to the 1990 Clean Air Act, which sought to limit acid rain by curtailing sulfure dioxide emissions. If measured on results, this particular program was incredibly successful. From 1990 to 2002, sulfur dioxide emissions dropped from 16M tons to 10M tons achieving 80% of the goal eight years before the target date. The EPA estimates that the program costs roughly $1 to $2 billion per year, which is relatively inexpensive on a per capita basis. This annual cost is actually only one-fourth of what was predicted when the bill was enacted.

There are several criticisms of the cap and trade borne out of the experience with the sulfur dioxide trading regime, which are highlighted in this particular post by, ironically, Larry Summers.

He lists the following problems:
1. Difficicult to implement.
2. Pollution credits in Europe are very cheap, indicating an ineffective permitting regime.
3. Incentives are created for companies to engage in economic rent-collecting behaviors.
4. Pollution credits are allocated rather than auctioned, creating marketplace inefficiency, and robbing the government of additional revenue.

Picking up on a theme? Most of his difficulties come from his view that any centralized scheme is doomed to failure because of either or both of implementation difficulty or sheer incompetency.

Another perspective comes from the Environmental Defense Fund:
1. Mandatory emissions cap, with a very positive market clearing price for credits.
2. Fixed allowances for each polluting entity.
3. Creation of robust banking and trading of credits.
4. Clear performance criteria.
5. Flexibility for polluters.

Again, the EDF lists many of the design factors in a trading program that need to be optimized, but does not really have any good ideas for how to do it. As such, it would seem that at a cursory level the devil is certainly in the details.

Therefore, it would seem we can only know how effective and efficient the program will be once the EPA actually creates the trading framework. By then, the debate will be over and oversight over the most crucial phase of implementation will be, unfortunately, lax.

A tax by any other name

President Obama has faced little difficulty in selling the biggest component of his tax policy- the expiration of the Bush tax cuts. Given the massive amount of spending we’ve seen in the last two months, the fact that Democrats control the entire federal government, and the not-to-be-underappreciated fact that Obama campaigned on killing the tax cuts, everyone knew this was coming. Republicans are gamely fighting it, but one suspects they secretly welcome a fiscal debate that offers this much clarity. The lapsing of the Bush tax cuts represents a straightforward, old-fashioned tax increase. It is something the public can understand and clearly support/oppose, something they couldn’t do during the expedition into fiscal androgyny known as TARP or the drunken scrum known as the stimulus package.

Given rising concerns over federal debt levels and the redistributive spirit that always seems to accompany economic recessions, the public largely supports phasing out the Bush tax cuts. At the same time, Obama is finding out how hard it is to camouflage tax increases the public doesn’t support. His proposal to decrease tax deductions for charitable contributions was lambasted by non-profits and ridiculed by Congress. His attempt to fast-track carbon taxation through the Senate ran into a brick wall of moderate democrats, and the surprisingly sophisticated public has worked backwards through the math and realized that the home mortgage bailout plan will inevitably push credit costs higher for everyone else, while creating another federal deficit stream that will need to be funded by increased taxation.

In summary: 1) Americans don’t feel they shouldn’t be taxed for money that they give away to others 2) they don’t like being taxed to change their energy consumption behavior when they're in the middle of a recession and viable alternatives don’t exist, and 3) they don’t like paying their neighbor’s mortgage. Go figure.

This week saw the beginning of another new taxation proposal that the public will likely find just as endearing- taxing health care benefits as income. Ironically, during the campaign this idea was floated by the McCain campaign, and quickly became fodder for attack ads from the Obama campaign. The ads failed to note that McCain’s plan called for tax credits to partially offset the new tax, but even if they had it probably wouldn’t have made the proposal any more palatable. The public hated the idea, and if Obama travels down this path he will find that he has indeed become a post-partisan leader. Both the U.S. Chamber of Commerce and the SEIU oppose the idea, which would mark the first time they were on the same side of an issue since, well, I don’t know, WWII.

You can’t blame Obama or his coterie of highly-intelligent-yet-socially-handicapped economic advisers. The proposal makes economic sense. Non-taxation of health care benefits has resulted in an arms race for employers and contributed to skyrocketing health care costs for the entire economy.

For example, let’s say you are a small manufacturing company and you are negotiating a new contract with your line workers. If their base salary level is $40,000, than for every additional $100 you increase it, after backing out a 25% income tax, 7.5% social security tax, medicare, state and local taxes, your employees will only end up taking home about $65 of the $100 you paid out. If instead you offer $65 in health care benefits, your employees would get the same utility, while you as a company would pocket the $35.

Unfortunately you don’t get to keep that $35. The market recognizes your newfound windfall, so your insurance companies and health care providers keep increasing their prices until you find that the marginal cost of providing another cent of health care to your employees is the same as the marginal cost of another cent of salary. At the same time, it has artificially raised the cost of health care by $35 for everyone in the system, which especially impacts those people who have to buy their own insurance.

In a conservative’s ideal world, we wouldn’t have taxes so this imperfection wouldn’t exist. In a Scandinavian’s ideal world, there are no taxes, because the government runs the system and imperfection is a given. Here in real-world America, there is a middle course available to President Obama. Tax health care benefits, but do it at a lower rate than income taxation. A health care benefits tax of 20%, phased in over three years (vis-à-vis tax credits to both individuals and businesses) would be a good target. At this low level, you would get some of the economic benefits and a degree of political solvency for the plan.

One more thing…it should be a flat tax. If we are shooting for a world in which equal access to equal health care is a “universal right” shared by every American, then $100 of health care should have the same economic utility for every American, irrespective of their income level. A household comprised of schoolteachers making $70,000 a year gets the same utility from $100 of birth control and Propecia as does a household comprised of a two investment bankers. OK, that was a bad example. Instead of investment bankers, how about two pawn shop brokers?

Budget Nomenclature

Here's something that's a little fun...Every time a new President submits their budget proposal to Congress, they give it a catchy slogan. You’ve got to hand it to these Presidential wordsmiths, they are nothing if not consistent. See if you can match the official budget slogan with the right administration:

1) “A vision of change for America”
2) “Building a better America”
3) “America’s new beginning”
4) ”A new era of responsibility”
5) “A blueprint for new beginnings”

a) Barack Obama
b) George Bush
c) Bill Clinton
d) George H.W. Bush
e) Ronald Reagan

Very creative.

Comparing the future- a historical look at budgets

Unprecedented, or unremarkable?
Radical, or reasonable?
Foolish, or prudent?

These are just some of the adjectives being used to describe the 2010 budget proposal submitted to Congress by President Obama. The Republican opposition has already begun to refine its red scare messaging, while liberal special interest groups are salivating over the pork that’s coming out of the budgetary oven. The seemingly optimistic economic assumptions underpinning the budget’s spending goals have led some economists to question whether the President can get what he wants without raising taxes, while others are goading him to spend more.

So where does this budget stand in relation to his predecessors’ proposals?

A quick look at previous budget proposals reflects a lack of connection between a president’s initial budget and what ends up happening. President Obama’s proposed increases in receipts might be a bit rosy given the current economic downturn, but they are in line with previous administration’s increases. The same can be said of proposed increases in spending.

Some consistencies emerge….

Receipts forecasted to grow over prior periods, but the actuals usually end up lagging predictions...

Spending is usually forecasted to grow over previous periods, but always increases even more than predicted…


Concordantly, deficits continue to outpace expectations…

The concern held by many is that Obama's spending priorities will further exacerbate deficits, but if the historical data is any indication, anything can happen. The unique combination of Bill Clinton, a conservative congress and a booming economy resulted in a government that took in more than it forecasted, spent less than it expected, and brought the first surplus in decades.

A little help for the FDIC

The FDIC is taking a little breather from bailing out failed banks to... wait for it... be bailed out itself. Turns out that this "no cost to the taxpayer" program that was supposed to be funded by deposit insurance premiums was charging too low of a rate, and is now stock dangerously undercapitalized (thanks to a provision that the FDIC's fund should be capped at 1.25% of deposits). So Senator Chris Dodd (D-CT), Chairman of the Senate Banking Committee, introduced a bill at the behest of FDIC Chairwoman Sheila Bair to raise the FDIC's borrowing maximum from $30B to $500B, a better than 10x increase.

This is a prudent move. The FDIC's deposit insurance fund is running dangerously low, with only $35B in the insurance fund as of Q3 2007, dropping to $19B by year end. The result is a paper-thin base of capital to insure deposits: the FDIC's $19B of capital amounts to 0.4% of U.S. deposits (known as the Deposit Insurance Fund Ratio, or DIF ratio). This is a substantial drop from the usual 1.2%+ range. To raise this ratio, the FDIC has two options: borrow from Treasury, or make the banks pay more. Making the good banks pay for the bad banks' mistakes during a credit contraction has drawn howls of protest (including from this space). Eliminating any doubt of the FDIC's solvency is the right move at this moment in the crisis... let's hope Congress speeds through this policy change.

Stimulus 2009 – Tax Relief for Debt Repurchase

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009. A portion of the bill allows for tax relief to companies that repurchase their own debt at a discount. The bill will provide significant benefits for private equity funds that repurchase debt on behalf of their portfolio companies. The rationale behind the bill is to incent cash strapped, highly levered companies to repurchase their debt; the reduced burden of the high debt service (interest and amortization payments) would leave the companies more nimble and less likely to layoff employees in the downturn. The tax relief is estimated to cost the Treasury $1.6B over the decade; however, it will be more costly in the near term – $42B reduction in tax receipts over the next three years.

Part IV – Rules Relating to Debt Instruments (starting on page 224), Section 1231 lays out the specifics regarding the repurchase of debt; the law firm Sidley Austin LLP provides a good summary of the new legislation as well.

‘‘(1) IN GENERAL.—At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument shall be includible in gross income ratably over the 5-taxable-year period beginning (in 2014)

Current tax requires a company that repurchases its own debt at a discount to recognize income in the current year in the amount of the discount of the debt. For instance if the company issued $1.0mm of debt, but repurchased the debt for $700,000 to recognize $300,000 ($1,000,000 - $700,000) of cancellation-of-debt (COD) income -> resulting in a ~$100,000 tax bill if taxed at 34% marginal tax rate.

New tax legislation allows companies or related parties (private equity funds) that repurchase debt a discount in 2009 and 2010 to defer the COD income over a five period beginning in 2014. In the above example, the Company would recognize $60,000 ($100,000 / 5) of COD income in each tax year 2014-2018.

The legislation also allows for tax deferral if the debt is restructured via a debt-for-debt exchange, from significant modification of the existing debt instrument, or from complete debt forgiveness – which may the case for ‘debt’ provided by financial sponsors.

The legislation should provide the appropriate incentives for companies to delever and maintain a prudent capital structure. The reduced leverage and cash savings also should reduce the number of bankruptcies and out of court restructurings, hopefully reducing layoffs. Critics point out that companies with enough cash to repurchase debt are not in need of a stimulus, thus the $42B in tax relief could be more effectively placed in other areas of the economy. While these companies may have the cash today, the bill is designed to reduce the likelihood that currently solvent & liquid companies become insolvent and/or illiquid.