Friday, January 28, 2011

More than maybe you want to know on corporate income tax

Politicians from both parties are calling for big changes to the corporate income tax.  There are two major sets of issues on the table.  As shown in this NYT article, the tax is applied very inconsistently across different sectors of the economy.  Companies exploit a wide range of tax exemptions and deductions that vary by industry.  The net result is that companies in industries such a trucking and electric utilities pay close to the maximum rate of 35%, whereas biotech, pharma and IT pay 10% or less. Economically, this means we are unduly restricting output in the high-tax sectors and subsidizing the low-tax sectors.  Mucho deadweight loss could be eliminated by equalizing tax rates across all sectors.  Of course the politics of this are dicy; no one likes for their taxes to be raised especially while others are being lowered. 

The other major issue is whether the US relies too much on the corporate income tax to fund government activities.  Some Republicans want to eliminate the corporate income tax.  Of course, if the corporate tax were scaled down, some other tax would probably have to go up unless radical steps are taken to cut spending -- which is not too likely with split government in Washington.  My guess is that this talk will die down quickly.  "Cut deadweight loss by reforming the corporate income tax" is not likely to pave anyone's way to the presidency in 2012. 

Succinct explanation of 2008 financial crisis

Not from the official Financial Crisis Inquiry Commission, but from three of the commissioners in a one-page WSJ op-ed.  Here is the story in a nutshell:
  1. Credit bubble in US and Europe
  2. Housing bubble in US (and other places such as Spain)
  3. Growth in subprime lending accompanied by lax regulation
  4. Failures in credit rating as derivatives based on subprime mortgages get passed on as AAA
  5. Broad range of financial institutions become exposed to risk of housing bubble bursting
  6. And same institutions are way, way too highly leveraged
  7. And they are way too interdependent, so when one firm goes under it creates big problems for counterparties
  8. And since almost everyone has placed all their bets on a continued rise in home prices, we see
  9. PANIC with failure or restructuring of household name financial institutions
  10. Leading to questions about the health of almost all financial institutions, regardless of their exposure to toxic mortgages
The official commission report (all 545 pages of it) appears to place most of the blame on lax regulation and supervision (at least that is what I get from newspaper accounts and the executive summary).  Has the Fed -- the very agency that now has enhanced regulatory powers -- forgotten how its own low interest rate policies provided rocket fuel to this entire scenario?

Wednesday, January 26, 2011

Will for-profit universities be the next big short?

Readers of Michael Lewis' The Big Short are familiar with Steve Eisman, one of the few to see how the housing bubble would create a buying opportunity on the short side of the market.  Guess what?  Eisman has found another strong candidate for bubble-bursting: for-profit higher education.  Eisman gave a talk at an investment research conference last year where he laid out his case.  From his prepared remarks (link available on this page):

My name is Steven Eisman and I am the portfolio manager of the FrontPoint Financial Services Fund.   Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry.  I was wrong.  The For-Profit Education Industry has proven equal to the task.   

Here are the issues he sees: rapid growth in enrollment has been heavily subsidized by government-issued debt in colleges with high dropout rates and not-so-great job prospects for those who complete degrees.  Taxpayers ultimately end up bearing the risk once indebted students start defaulting on the loans. 

Eisman is hopeful that this train wreck will be slowed down by new regulations that make school eligibility for government loans contingent upon degree completion and gainful employment criteria.  Otherwise,
But if nothing is done, then we are on the cusp of a new social disaster.  If present trends continue, over the next ten years almost $500 billion of Title IV loans will have been funneled to this industry.  We estimate total defaults of $275 billion, and because of fees associated with defaults, for profit students will owe $330 billion on defaulted loans over the next 10 years.  

Tuesday, January 25, 2011

What happens to health insurance reform without individual mandates?

Thoughtful piece by Chicago Booth's Richard Thaler in Sunday's NYT about what might happen to the health care bill if the portion mandating individuals and firms to buy health insurance were deemed unconstitutional.  Thaler, one of the world's leading behavioral economists, points out that there are other ways to strongly encourage people to buy health insurance that stop short of the mandate.  One would be to automatically enroll laid off employees into a state insurance exchange.  Another mechanism would be to lose some insurance rights (e.g., ability to buy insurance at subsidized rates from the government, lost coverage of pre-existing conditions) if they fail to stay continuously enrolled.  Finally, give states the right to opt out of the program -- but with the understanding they opt out of federal health dollars as well. 

ACG Case Competition

Last night we had the first ACG Case Competition for the NC State Jenkins MBA program.  Four teams competed for the rights to move on to the state competition next month against Duke, Meredith, UNC-CH, and Wake Forest.  The case required each team to evaluate an offer for an acquisition, which means taking a hard look at the company value as well as the true value of the offer.  Kudos to the winning team: Jessica Barnes, AJ Kramer, Adam Leath, Gulcin Menekse, and Terry Munroe. 

Monday, January 24, 2011

Where, oh where, did the stimulus go?

Stanford economists John Cogan and John Taylor look at how households and state/local governments reacted to the 2008 and 2009 stimulus plans.  They show that most of the stimulus money was used by households to pay off debt and most governments used it to issue less debt.  In other words, the federal government borrowed money so that individuals and government could borrow less.  Overall, a wash and hence no real stimulus.  Does not make you real hopeful that this year's temporary cut in payroll taxes will do any better.

Saturday, January 22, 2011

iPhone study raises questions about trade deficit with China

Economists at the Asian Development Bank Institute took an in-depth look at how the iPhone is handled in our trade statistics.  The manufacturing cost of an iPhone is $178.96.  Final assembly of iPhones takes place in China so every iPhone we import drags down the trade deficit by that amount.  However, it turns out that only the final assembly takes place in China whereas other components are made elsewhere.  The Chinese contribution to the iPhone amounts to a mere $6.50.  The point?  Be very careful when you start to make claims about the trade deficit with China based on official trade statistics which use the $178.96 not the $6.50. 

Even if iPhones contribute to the trade deficit, they make up for it in other ways.  The iPhone is sold at a considerable markup in the US and other countries, and don't forget about all the music and app sales, data and voice plans, and the emerging trend of retail purchases by phone.   

High-powered incentives for the UAW?

WSJ reports that General Motors wants its unionized workers to have part of their pay tied to the company's financial performance.  From a financial standpoint, this appears to make a lot of sense on the surface, as worker pay would go down when the company has bad years thus reducing the variance of profits. 

I see at least two reasons why this may not end well.  First, GM stockholders and bondholders have multiple ways of hedging any risk associated with the assets they own, as anyone who has taken an MBA level finance course should easily understand.  Are profit-sharing or bonus plans desirable for UAW members?  These are individuals who for the most part have limited financial resources beyond their wages, benefits and home equity.  By putting more pay at risk, it is not clear what they can do to offset that risk.  Perhaps UAW members would have more stable jobs if the price of labor fell during downturns, but if I were a UAW member familiar with the long run trend of employment in the domestic auto industry I would be skeptical.  On the surface this looks like a classic case of inefficient shifting of risk from stockholders to workers. 

Second, how much would a pay-for-performance plan affect employee behavior?  This looks like a classic case of what I call the 1/n problem where individual workers see that the impact of their own behavior on the bottom line is virtually zero in any organization where the number of employees (n) is 100 or more.  Given the decades of mistrust between GM and the UAW, it is hard for me to see any new pay scheme changing productivity, especially in an industry where workers have little control over the pace of work and the connection between individual contributions and company outcomes is tenuous. 

Privatizing the ABC system

Governor Perdue announced this week that she will not support any attempts to sell off the state's ABC system of liquor distribution and retail.  Republicans in the state legislature say they still want to take a look at selling off the system.  In a time when the state is facing over a $3 billion deficit, it is natural to ask how much privatizing the system would help. 

Last year the ABC system generated $275 million in taxes for state and local governments on sales of $727 million.  Having lived (and, I admit it, shopped) in three states with privatized liquor stores, one would expect that a privatized system would feature more stores, open longer hours, more choice and selection, and better customer service.  Opponents of privatization cite concerns about increased liquor consumption and likely increases in highway fatalities and alcohol-related illnesses.  They are no doubt correct, as inconvenience acts as a tax on alcohol consumption that tax would vanish under privatization.  Demand curves slope down. 

A key issue that has not been addressed in the press reports I have seen is how much money would be generated by ABC store privatization.  Keep in mind that some of the increase in alcohol sales that would take place would be at the cost of other adult beverages, some of which generate tax revenue (beer, wine) and some which do not (moonshine).  To get big bucks, the legislature would need to open up the entire state to private liquor stores including dry counties and cities.  This is not likely to happen.  So one has to ask how much extra tax revenue would be generated by privatization -- even a 50% increase ($137.5 million) would not go very far in plugging the state's deficit.  If the state is serious about generating extra revenue it could think about raising the tax rate on alcohol on top of privatizing the system.  A recent meta-analysis by an Australian economist estimated that the elasticity of demand for alcohol is -0.7, so higher taxes would definitely mean more revenue, fewer accidents and better health. 

Thursday, January 13, 2011

Business school makeovers after the financial crisis

Just found out about a new website Poets and Quants that focuses on MBA issues.  (Plus do not miss some MT SLoan students' take on the Daily Show.)  It is run by John Byrne, who used to write for Business Week.

P&Q ran a story recently about how business schools have reacted to the financial crisis and, at least among the top schools, it seems to be business as usual.  Schools such as Stanford, Wharton, Berkeley, Columbia, Yale and Darden have all launched new curricula, some with supposedly "revolutionary" changes.  But most of the program changes were almost fully planned before the crash and in many cases amount to underwhelming adjustments: in most cases we see more electives and fewer core courses, a trend that has been underway for quite awhile. 

This is not necessarily bad.  Any changes to MBA programs should be based upon research and there has been precious little time for researchers to fully understand the financial crisis, much less any role MBA education may have played in it.  Although clearly we need to have a better understanding about how macroeconomics and finance interact, the fundamentals of accounting, marketing, organizational behavior, operations, etc. today are more or less the same as they were pre-crash. 

At NC State, we just adjusted the core curriculum this fall in response to student concerns about modular, half-semester courses.  With the Poole gift for the College of Management, we will be taking a closer look at sustainability, ethics and entrepreneurship in the coming year. 

Rajan's take on unemployment

Booth Chicago finance prof Raghuram Rajan has a recent column in the Guardian concerning unemployment.  I found the following excerpt interesting:

In the last boom, construction jobs expanded significantly, with investment in housing as a share of GDP increasing by 50% from 1997 to 2006. As my colleague Erik Hurst and his co-authors have shown, states that had the largest rise in construction as a share of GDP in 2000-2006 tended to have had the greatest contraction in that industry in 2006-2009. These states also tended to have the largest rise in unemployment rates between 2006 and 2009.

The unemployed comprise not only construction workers, but also ancillary workers, such as real-estate brokers and bankers, as well as all those who work on houses, such as plumbers and electricians. So, the job losses extend far beyond those in the construction industry.

It is hard to believe that any increase in aggregate demand will boost the housing market – which, remember, was buoyed by visions of steady price appreciation that few seem likely to hold today – sufficiently to re-employ all these workers. Hurst estimates that this "structural" unemployment may account for up to three percentage points of total unemployment. In other words, were it not for construction, the US unemployment rate would be 6.5% – a far healthier situation than today.

Obviously our employment situation is still far from healthy and this research indicates that it may take a very long time for the excess labor force from housing and housing-related jobs to be redelpoyed elsewhere. 

Friday, January 7, 2011

Do we need Fannie and Freddie?

Two recent articles coming out quite differently on this question.  In a WSJ op-ed the American Enterprise Institute's Peter Wallison argues that most other countries get along fine without any implicit federal guarantee of repayment.  In a NYT op-ed journalist Bethany McLean raises concerns that banks would make significant changes in mortgages if government guarantees were to vanish, such as ending 30-year and fixed-rate mortgages. 

In simple economic terms, McLean essentially argues that interest rate subsidies for housing are socially worthwhile whereas Wallison is unconvinced. 

The bond market is watching Illinois carefully

One of the interesting stories we will see play out this year is what will happen in states that are heavily indebted and have made little to no progress toward balancing their budgets.  Exhibit A in today's WSJ is Illinois, which has issued debt to pay current operating expenses (always with a promise to come up with a better solution next year, and the year after, and the year after that).  Illinois 10-year bonds are priced a full two percentage points above the broader state-local bond market. 

What's a bond buyer to do?  The two extra points look attractive, but maybe the spread will widen.  If the state does not get its budget in order, what is the default risk?  Would Bernanke and Geithner swoop in and save Illinois with federal dollars?  The state is considering raising its personal income tax from 3 to 5.25% as part of its budget deliberations. 

Tuesday, January 4, 2011

EU antitrusters strike again

Add Google to the list of successful American companies to run afoul of the antitrust apparatchiks in the European Union.  Their offense?  Dominating the markets for web searches and search advertising.  Fortunately for Google, any legal action is years away (which moves fastest -- a glacier, a tortoise or an antitrust case?) by which time the market situation will likely have totally changed.  European antitrust laws focus as much on protecting competing firms as they do on customers, so the legal threat is real.  Prediction: Google profits will be mildly diluted over the next 2-3 years thanks to increased attorney fees. 

How is that QE2 thing working out for you?

Fed announces aggressive plan to buy long term bonds to lower long term interest rates and stimulate the economy.  Contrary to expectations, fears of inflation lead to slightly higher long term interest rates.  Don't pull on Superman's cape and don't mess with the bond market.

2011: not likely a good year for public sector employees

The biggest economic story of the new year is the probable contraction of government employment at all levels, which will be accompanied in some states and cities by reductions in salaries and benefits and changes in rules governing collective bargaining.  The driving forces are the changes in leadership in the US House and many state legislatures, which likely mean (1) federal stimulus dollars will no longer be keeping state and local governments afloat and (2) tax increases will not be a viable option for replacing those funds. 

Salary levels in government lag behind the private sector, but this is offset by much more attractive health and pension benefits in government along with greater job security (a subject where I did the definitive study; it is hard to lay off a unionized government worker).   The pension and health care liabilities facing state and local governments make Social Security look like a soundly financed program. 

What should we expect?  In many states unions are going to have a hard time maintaining the status quo, according to NYT.  Some states are taking steps to make it more difficult for unions to collect dues via automatic payroll deductions whereas others are considering limits to the right to strike.  In North Carolina, there is no collective bargaining for government workers, but there is talk aplenty of pay cuts and/or layoffs. 

Unlike the federal government, almost all states must balance their budget year in and year out.  Government services are labor-intensive, so some reduction in payroll costs will be necessary.  I am not sure how much weight these looming cuts are getting in all of the suddenly rosy economic forecasts that have come out recently.  There will need to be big boosts in consumption, investment and net exports to offset the probable declines in government spending that are on the way.