Taxes. Just hearing the word makes most people cringe. How a couple of easy steps can go a long way in making the process more bearable.
The first thing you need to know is that you don’t need to know how to prepare a tax return. You just need to know a couple of things that will make the amount of tax you pay as little as possible.
The second thing is that you don’t need to become an obsessive-compulsive record keeper. You can continue being a regular person, just one with a few more envelopes. You can live with that.
This discussion is not meant to replace your tax advisor, if you have one. Rather, it’s meant to give you the tools to reduce the fee she charges by keeping track of key expenses, and make sure you can manage the process – not do it yourself.
How Federal Taxes Work
The Internal Revenue Code (“IRC”) contains the rules for paying Federal taxes. It’s long, boring and has been patched together over many years and is now nearly unreadable, because it constantly refers you to lots of other places while you’re trying to read it. What’s important to know is that it contains Congress’ encouragement for you to do certain things, by reducing the taxes you pay if you do them.
Adjustments
Some tax incentives are called “above the line” adjustments. Above-the-line adjustments are more valuable than tax deductions because they come right off the top by reducing your income. Examples of above-the-line adjustments are contributions to retirement plans or health care savings accounts. People in Congress really want you to fund your retirement plan, and have given you every financial reason in the world to do so. So, if you go no further than to learn that there is yet ANOTHER reason to invest for your future, do that. It will very likely make a difference in the amount of tax you pay, too.
If you lend money to municipalities by buying municipal bonds, you usually don’t have to pay tax on the interest you receive for that loan. If you lend money to the Federal government by buying Treasury bills, bonds or notes, you generally won’t pay state tax on the interest you receive for those loans.
Deductions
You’ve heard of tax deductions. Deductions are subtracted from your adjusted income. To see what the current standard deduction is, go to http://www.irs.gov/publications/p501/index.html Under “Publication 501 Contents,” go to “Standard Deduction,” and click “Standard Deduction Amount.” Scroll down to Table 7 to determine the amount of your standard deduction. You may have more deductions than that standard deduction amount. If you do, you will itemize their deductions, or provide a list that adds up to more than that standard deduction.
How do you know if you should itemize deductions?
Congress, through the tax code, encourages home ownership because it is seen as a stabilizing force in building communities, so both mortgage interest and property taxes are deductible. If you own a home, you will probably itemize deductions. You need to keep your property tax receipt, if these taxes aren’t part of your monthly mortgage payment . Otherwise, you’ll get a year-end statement with that amount from the bank that will also give you the total mortgage interest you paid, both of which are generally deductible.
Congress also encourages supporting charitable causes. So, if you contribute a significant amount to charity, it may make sense to itemize deductions.
And, with medical cost rising at an alarming rate, deductions are available for those, too - if they are more than a certain amount of your income .
So, if you have a lot of contributions to charities and/or medical expenses, it is a good idea to make envelopes called “Charity” and “Medical” and save all those receipts.
Like property tax, your state taxes are also deductible if you itemize your deductions.
If you work for someone else, and have lots of employee job expenses that were not reimbursed, you may be able deduct these, as well as education expenses that were directly related to your current job. Save those receipts in an envelope called “Employee Expenses.”
If you own your own or are starting your own business, you will probably file a “Schedule C.” This is the form that allows you to deduct business related expenses from your income. You are someone who definitely needs the help of a tax preparer – the sooner the better – particularly if yours is a home based business. While Schedule C itself does not appear to be a particularly complicated form, that is deceiving. Don’t do this yourself, but do save all business expenses.
Are there more? Yes, there are others. Lots of them. But, these are the big ones, and will give you a good start.
By organizing your deductions and knowing approximately how much you can deduct in each category you will have relatively organized information to give – and discuss with – your tax preparer.
Exemptions
These are also subtracted from your income. If you are single person, you are entitled to one exemption. A married couple filing a joint return receives two exemptions, and one more for each minor dependent child.
The amount of current Federal tax exemptions can be found at http://www.irs.gov/pub/irs-pdf/p501.pdf
Tax Calculation
In a nutshell, then the way taxes are figured is:
• Income minus
• Adjustments (like retirement contributions) equals
• Adjusted Gross Income minus
• Tax Deductions minus
• Total Exemptions equals
• Taxable Income which is multiplied by your tax rate.
Tax Rates
Your tax rate is determined by whether you are married. Single people pay a higher rate of taxes on their income than married people.
Your tax rate is also “graduated.” That means that your money is lumped into groups, and each group is taxed at a progressively higher rate. Then, they’re all added together, and that is the amount of tax you owe.
The lower the income, the lower your tax rate.
Tax brackets are useful for thinking about the rate you’ll pay on taxable investments, like dividends and interest.
Your average tax rate is different than your tax bracket. Here’s how to figure your average tax rate.
Amount of Tax Paid divided by Total Income
8,922.50 / 50,000 = 17.8%
Your goal in tax planning is to try to reduce your income as much as you can with above-the-line adjustments like retirement plan contributions, then reduce the tax you pay as much as you can by taking all the deductions that are available to you.
If you have a simple tax situation - a W-2 form, and interest from savings - you may prepare your own taxes. If you have a lot of any of the categories mentioned under “Deductions,” you may review whether it would benefit you to itemize.
Tax Preparers
At any point that you feel that preparing your taxes is overwhelming, get help. The kinds of people available to prepare your taxes are
Tax Preparer Attended tax preparation courses, usually sponsored by their employer firm, such as H&R Block, Jackson Hewitt, etc.
Enrolled Agents Extensive training in personal tax preparation
Accountant A person who has a Bachelors degree in Accounting
CPA Certified Public Accountant, a professional designation requiring experience, education and passing an examination.
Generally, an Enrolled Agent has more than adequate training for any tax preparation or tax planning question the majority of people will have. Some employees of national tax preparations firms are enrolled agents, but you’ll need to ask their qualifications. Questions you will want to pose to potential tax preparers are:
• What credentials do you have?
Again, an Enrolled Agent will have extensive personal tax preparation training.
• How long have you been preparing tax returns professionally?
You want at least five years of experience
• Describe your typical client.
You want a tax preparer who has experience with the tax issues that you have; e.g., similar income, profession, investments, etc.
• Does your fee include representing me if I’m audited?
You want representation if audited included, or for a small additional fee
If you keep your receipts organized and have a relatively simple tax situation, you may want to try preparing your taxes on your own. If so, software such as “TurboTax,” “TaxACT,” and others are helpful, but obviously will not include answering questions or representation in case of an audit.
Tax Planning
There are a few simple things that people who itemize deductions can do to decrease their taxes. These should be reviewed each year in mid-November.
• If you make State “estimated tax payments,” your last payment is due January 15 of the following calendar year. By making that payment before year end, it will be deductible.
• If you are considering any charitable contributions, make them prior to year end.
• If you own your home, consider making your January mortgage payment before year end, in order to deduct the interest from that payment.
• Schedule any doctor or dentist appointments before year end, especially in any year when you have high medical bills.
• If you’re planning to get married anyway, it’s better to do it in December than January to qualify for lower Married Filing Jointly tax rates.
Even if your spouse prepares your return (or oversees its preparation with a tax professiona, you are responsible for the tax return that you sign. Don’t sign it if you don’t understand it. Don’t be shy about asking questions.
In conclusion:
There is yet another reason that you should put as much money as you can into your retirement account and health care savings account.
There is yet another reason that you might consider buying a home (deductible mortgage interest and property taxes), if you don’t already have one.
If you just put all receipts for deductible expenses in separate envelopes - medical, contributions business and employee expenses every year - you’ll be way ahead of the game.
You know the basic concept for how taxes are calculated.
You know how to interview a tax preparer.
You won’t sign a tax return that you don’t understand, and won’t be shy about asking questions
Tuesday, March 23, 2010
Is Janet Yellen the Best Candidate for Vice Chair of the Fed?
San Francisco Federal Reserve Bank President Janet Yellin is Obama's nominee for Vice Chair of the Federal Reserve Bank. Why this policy dove may be a perfect short term answer, and a long term disaster.
Mission
The primary role of the Fed is the pursuit of maximum employment and price stability. Sounds simple.
It's anything but.
I. Maximum Employment
To pursue the goal of full employment, the Fed must make business conditions favorable to hiring. That means that businesses must be able to borrow easily, expand and hire employees to facilitate such growth. As you know, banks must keep a certain amount of their deposits with their local branch of the Federal Reserve Bank in order to have sufficient liquidity to prevent panics that contributed to the Great Depression. When short term interest rates are low, banks can more freely lend to businesses because they don't have to keep as close an eye on their cash reserves. Money's cheap.
When rates rise, banks keep a tighter rein on lending by strengthening borrowing standards. It's harder to get a loan, business expansion slows and jobs are harder to get.
Why not have a continuing policy of low interest rates?
II. Price Stability
Price stability is another way of saying low inflation. Inflation is the amount prices go up every year. Anyone who lived through the 1970s remembers that prices rose much faster than wages. Every year our same dollars bought less and less.
When inflation takes hold, it's hard to stop. People want more money to afford what they could afford last year. If they get raises, however, their businesses have to raise prices to cover higher payroll costs, so costs rise. A vicious circle ensues, where labor wants raises and businesses want higher prices. What stops the circle? A recession, when businesses lay off workers and can contain prices. The higher inflation, the more prolonged the recession.
The problem is, during the recession, the Fed is pressured to lower interest rates to stimulate the economy. But, r
Once inflation takes hold, it's very hard to stop.
A Dovish Policymaker
Janet Yellin is described as an inflation "dove." That means that her decisions have been "growth and employment" oriented and less focused on containment of inflation. You may think, that with unemployment rates hovering in the double-digits, this is just what we need. Certainly, that political opinion would be currently popular. But, would it be a good long term policy?
Deficits and Inflation
No reputable economist of whom I'm aware would not have advised deficit spending to stimulate the economy during the last recession. It was a necessary evil that prevented the country from likely sinking into a Depression. But historically, the relationship between deficit spending and inflation is problematic.
Generally, when government borrowing increases, the amount of funds that remains for businesses and individuals to borrow decreases, and the competition for these fewer dollars causes rates to increase.
So-called inflation "doves," who generally advise keeping rates low, can accommodate both government and business lending only by printing more money for the government to buy its own debt, causing the money supply to expand and debt to contract.
Expanding the money supply is inflationary. Instead of raising taxes to pay its debt, printing more money makes the dollar less valuable. The cost of everything goes up when your dollar is worth less.
The Federal Reserve Board of Governors
At its last meeting, only one Fed governor, that of St. Louis, voted against keeping interest rates low. The majority (11 members) voted to keep rates low because their perception that the risk of sinking back into recession was more significant than the threat of inflation. Dr. Bernanke, current Fed chairman, is considered one of the premier scholars of the Great Depression. One significant factor in its length is thought to be insufficient economic stimulus. It is a mistake about which Bernanke argues eloquently, and apparently the majority of the board agrees.
With a propensity of more dovish members, however, it is of some concern that one who has been one of the most consistent would be considered as the Vice Chair. Generally, upon the retirement or failure to reappoint the Chair, the Vice Chair is likely to assume this influential post.
At a time when deficit spending is so high, the national debt is ballooning and the nation only recently stepped back from the brink of Depression, is it wise to choose a member who is so dovish about inflation that she stated last February, "If it were possible to take interest rates into negative territory I would be voting for that."?
Perhaps a candidate with a more balanced approach to the Fed's dual mandate would be a more reasonable decision.
Mission
The primary role of the Fed is the pursuit of maximum employment and price stability. Sounds simple.
It's anything but.
I. Maximum Employment
To pursue the goal of full employment, the Fed must make business conditions favorable to hiring. That means that businesses must be able to borrow easily, expand and hire employees to facilitate such growth. As you know, banks must keep a certain amount of their deposits with their local branch of the Federal Reserve Bank in order to have sufficient liquidity to prevent panics that contributed to the Great Depression. When short term interest rates are low, banks can more freely lend to businesses because they don't have to keep as close an eye on their cash reserves. Money's cheap.
When rates rise, banks keep a tighter rein on lending by strengthening borrowing standards. It's harder to get a loan, business expansion slows and jobs are harder to get.
Why not have a continuing policy of low interest rates?
II. Price Stability
Price stability is another way of saying low inflation. Inflation is the amount prices go up every year. Anyone who lived through the 1970s remembers that prices rose much faster than wages. Every year our same dollars bought less and less.
When inflation takes hold, it's hard to stop. People want more money to afford what they could afford last year. If they get raises, however, their businesses have to raise prices to cover higher payroll costs, so costs rise. A vicious circle ensues, where labor wants raises and businesses want higher prices. What stops the circle? A recession, when businesses lay off workers and can contain prices. The higher inflation, the more prolonged the recession.
The problem is, during the recession, the Fed is pressured to lower interest rates to stimulate the economy. But, r
Once inflation takes hold, it's very hard to stop.
A Dovish Policymaker
Janet Yellin is described as an inflation "dove." That means that her decisions have been "growth and employment" oriented and less focused on containment of inflation. You may think, that with unemployment rates hovering in the double-digits, this is just what we need. Certainly, that political opinion would be currently popular. But, would it be a good long term policy?
Deficits and Inflation
No reputable economist of whom I'm aware would not have advised deficit spending to stimulate the economy during the last recession. It was a necessary evil that prevented the country from likely sinking into a Depression. But historically, the relationship between deficit spending and inflation is problematic.
Generally, when government borrowing increases, the amount of funds that remains for businesses and individuals to borrow decreases, and the competition for these fewer dollars causes rates to increase.
So-called inflation "doves," who generally advise keeping rates low, can accommodate both government and business lending only by printing more money for the government to buy its own debt, causing the money supply to expand and debt to contract.
Expanding the money supply is inflationary. Instead of raising taxes to pay its debt, printing more money makes the dollar less valuable. The cost of everything goes up when your dollar is worth less.
The Federal Reserve Board of Governors
At its last meeting, only one Fed governor, that of St. Louis, voted against keeping interest rates low. The majority (11 members) voted to keep rates low because their perception that the risk of sinking back into recession was more significant than the threat of inflation. Dr. Bernanke, current Fed chairman, is considered one of the premier scholars of the Great Depression. One significant factor in its length is thought to be insufficient economic stimulus. It is a mistake about which Bernanke argues eloquently, and apparently the majority of the board agrees.
With a propensity of more dovish members, however, it is of some concern that one who has been one of the most consistent would be considered as the Vice Chair. Generally, upon the retirement or failure to reappoint the Chair, the Vice Chair is likely to assume this influential post.
At a time when deficit spending is so high, the national debt is ballooning and the nation only recently stepped back from the brink of Depression, is it wise to choose a member who is so dovish about inflation that she stated last February, "If it were possible to take interest rates into negative territory I would be voting for that."?
Perhaps a candidate with a more balanced approach to the Fed's dual mandate would be a more reasonable decision.
Thursday, March 11, 2010
Examining Tea Party Allegations of Higher Taxes and Increasing Debt
The "Tea Party" movement alleges that the USA is moving toward socialism with higher taxes and increasing levels of public debt.
I discussed where the US stands with respect to public debt in an article published last December.
Let's take a look at where the country actually stands with its taxation. All data referenced in this discussion are compiled from the Organisation for Economic Co-operation and Development.
I. Taxes as a Percentage of GDP
Taxes in the US, as measured as a percentage of Gross Domestic Product, were 25th lowest out of the 30 participating countries. As of 2006, the latest year for which complete data are available, Denmark paid the highest at 49.1% of its GDP, the US paid 28%, and the lowest taxes were paid by Mexico, at 20.6% of GDP.
II. Top Marginal Taxes
As you know, the US has a "progressive tax." In this method of taxation, lower levels of income are taxed at lower levels, and higher levels of income are taxed at a progressively higher rate. Most people pay Federal income tax as follows
The USA ranks right in the middle (15th of 30 countries) for top marginal tax rates for employees, with Denmark again at the top (59.7%) and the Czech Republic with the lowest rate (15%).
III. Corporate Tax Rates
As of 2009, the average corporate tax rate for the thirty countries in the OECD is 26.3%. Two countries, Ireland and Iceland, have rates significantly lower than the average, 12.5% and 15%, respectively. The remainder are between the Slovak Republic and Poland at 19% and Japan at 39.54%. The US is second highest at 39.10%.
We rank 20th as a debtor nation. We rank 25th in total taxes as a percentage of GDP. We rank 15th in personal income taxes. It is only in corporate taxes that the US ranks very high: We are second in the world, after Japan.
It is a laudable goal to decrease deficit spending and lower the National Debt. It is, however, important that we put the issue into perspective, and not overstate our current circumstances.
I discussed where the US stands with respect to public debt in an article published last December.
Let's take a look at where the country actually stands with its taxation. All data referenced in this discussion are compiled from the Organisation for Economic Co-operation and Development.
I. Taxes as a Percentage of GDP
Taxes in the US, as measured as a percentage of Gross Domestic Product, were 25th lowest out of the 30 participating countries. As of 2006, the latest year for which complete data are available, Denmark paid the highest at 49.1% of its GDP, the US paid 28%, and the lowest taxes were paid by Mexico, at 20.6% of GDP.
II. Top Marginal Taxes
As you know, the US has a "progressive tax." In this method of taxation, lower levels of income are taxed at lower levels, and higher levels of income are taxed at a progressively higher rate. Most people pay Federal income tax as follows
- 10% on income up to $8,350
- 15% on income from $8,350 to $33,950
- 25% on income from $33,950 to $82,250
- 28% on income from $82,250 to $171,550
- 33% on income from $171,550 to $372,950
- 35% on income over $372,950
The USA ranks right in the middle (15th of 30 countries) for top marginal tax rates for employees, with Denmark again at the top (59.7%) and the Czech Republic with the lowest rate (15%).
III. Corporate Tax Rates
As of 2009, the average corporate tax rate for the thirty countries in the OECD is 26.3%. Two countries, Ireland and Iceland, have rates significantly lower than the average, 12.5% and 15%, respectively. The remainder are between the Slovak Republic and Poland at 19% and Japan at 39.54%. The US is second highest at 39.10%.
We rank 20th as a debtor nation. We rank 25th in total taxes as a percentage of GDP. We rank 15th in personal income taxes. It is only in corporate taxes that the US ranks very high: We are second in the world, after Japan.
It is a laudable goal to decrease deficit spending and lower the National Debt. It is, however, important that we put the issue into perspective, and not overstate our current circumstances.
Thursday, March 4, 2010
A Rose by Any Other Name
As our nation grinds to a halt under the failure of statesmanship, I refuse to take a side. You may not characterize me with a word, when doing so will only give me the opportunity to give countless examples of when that word does not accurately describe my position.
Democrat, Republican, Independent, Libertarian - or Capitalist
In my study of political structures, and which function best, I've concluded that capitalism is my preference. I prefer that to Democrat, Republican, Independent, or Libertarian. In societies where capitalism flourishes, there is likely
Pursuit of a Rising Standard for All
With that definition in mind, it is interesting that the ratio of compensation of CEOs to workers was 30:1 in 1970 and 120:1 in 2000. These data were provided by the Economic Policy Institute, a think tank dedicated to including the interests of low to middle income workers in economic policy.
The growth in CEO earnings virtually mirrors in the growth in the S and P 500 Index over that same period. While workers are generally paid in the form of cash compensation, CEOs in non-financial firms earn over 70% of their compensation in the form of equity pay. Therefore, the inequity appears to be based more in the performance of the price of their company stock options than any other factor. If the CEO is ultimately responsible to her stockholders for the performance of the company, then this inequity is readily explained.
Further, during this period retirement savings changed from company-provided defined benefit pensions to retirement programs where employees make contributions that are deducted from their income. For example, a worker who contributes 15% of her $50,000 salary to a 401 (k) plan will show a taxable income of $42,500 after deducting the contribution. Because the IRS limits the dollar amount of contributions, a $250,000 executive at that same firm would be limited to a $16,500 contribution.
The worker's salary in this example would be decreased by 15%, and the executive's by less than half that (6.6%), even though the executive contributed $9,000 more. As you can see, workers contributing to these plans make their income appear proportionately less than CEOs.
Finally, because transfer (unemployment, welfare, disability and social security) payments are taxed, if at all, at a lesser percentage for lower income taxpayers, those amounts are not fully represented as income, based on tax return data.
A 2007 article by the Cato Institute demonstrates that many studies, including recent work from Paul Krugman, grossly overstate the disparity between CEO and worker income, and estimate, based on Congressional Budget Office figures, that the top 1% of earners in 2003 earn between 14:1 to 15:1 more than workers, up from about 9:1 in 1981.
So, while the current climate is not one that shows capitalism in its finest light, we do appear to be in a rising tide that lifts most boats. And, with that, I will add a codicil to my "Capitalist" title.
Barron's Byline Admission
One of my favorite economists is Gene Epstein, who is the Economics Editor of Barron's magazine. I have often referenced his work when teaching Security Analysis at UCLA because of its data-orientation and lack of agenda.
Mr. Epstein recently gave a speech to young people that he was kind enough to share with me, wherein he described himself as a "bleeding heart capitalist." It was at that moment that I adopted a party affiliation.
I am in favor of a system that is most likely to result in greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy. I am, indeed, a capitalist.
But, I also demand that that system results in a rising standard of living for the clear majority of their citizens. Rather than a "laissez faire" approach to free markets, I favor a properly regulated financial system that compels those who take extraordinary risk be subject to extraordinary loss - and be outside the realm of Federal insurance, either by mandate or by being "too big to fail."
I favor protection of the finest educational system in the world by protecting the free exchange of ideas in a meritocracy, encouraging participation with the world's greatest minds regardless of their country of birth, and funding their priceless contributions to our competitiveness in the global economy.
I, too, am a bleeding heart capitalist, and will support whichever political party that furthers these ideals.
Democrat, Republican, Independent, Libertarian - or Capitalist
In my study of political structures, and which function best, I've concluded that capitalism is my preference. I prefer that to Democrat, Republican, Independent, or Libertarian. In societies where capitalism flourishes, there is likely
- Greater opportunity
- Tolerance of diversity
- Social mobility
- Commitment to fairness
- Dedication to democracy.
Pursuit of a Rising Standard for All
With that definition in mind, it is interesting that the ratio of compensation of CEOs to workers was 30:1 in 1970 and 120:1 in 2000. These data were provided by the Economic Policy Institute, a think tank dedicated to including the interests of low to middle income workers in economic policy.
The growth in CEO earnings virtually mirrors in the growth in the S and P 500 Index over that same period. While workers are generally paid in the form of cash compensation, CEOs in non-financial firms earn over 70% of their compensation in the form of equity pay. Therefore, the inequity appears to be based more in the performance of the price of their company stock options than any other factor. If the CEO is ultimately responsible to her stockholders for the performance of the company, then this inequity is readily explained.
Further, during this period retirement savings changed from company-provided defined benefit pensions to retirement programs where employees make contributions that are deducted from their income. For example, a worker who contributes 15% of her $50,000 salary to a 401 (k) plan will show a taxable income of $42,500 after deducting the contribution. Because the IRS limits the dollar amount of contributions, a $250,000 executive at that same firm would be limited to a $16,500 contribution.
The worker's salary in this example would be decreased by 15%, and the executive's by less than half that (6.6%), even though the executive contributed $9,000 more. As you can see, workers contributing to these plans make their income appear proportionately less than CEOs.
Finally, because transfer (unemployment, welfare, disability and social security) payments are taxed, if at all, at a lesser percentage for lower income taxpayers, those amounts are not fully represented as income, based on tax return data.
A 2007 article by the Cato Institute demonstrates that many studies, including recent work from Paul Krugman, grossly overstate the disparity between CEO and worker income, and estimate, based on Congressional Budget Office figures, that the top 1% of earners in 2003 earn between 14:1 to 15:1 more than workers, up from about 9:1 in 1981.
So, while the current climate is not one that shows capitalism in its finest light, we do appear to be in a rising tide that lifts most boats. And, with that, I will add a codicil to my "Capitalist" title.
Barron's Byline Admission
One of my favorite economists is Gene Epstein, who is the Economics Editor of Barron's magazine. I have often referenced his work when teaching Security Analysis at UCLA because of its data-orientation and lack of agenda.
Mr. Epstein recently gave a speech to young people that he was kind enough to share with me, wherein he described himself as a "bleeding heart capitalist." It was at that moment that I adopted a party affiliation.
I am in favor of a system that is most likely to result in greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy. I am, indeed, a capitalist.
But, I also demand that that system results in a rising standard of living for the clear majority of their citizens. Rather than a "laissez faire" approach to free markets, I favor a properly regulated financial system that compels those who take extraordinary risk be subject to extraordinary loss - and be outside the realm of Federal insurance, either by mandate or by being "too big to fail."
I favor protection of the finest educational system in the world by protecting the free exchange of ideas in a meritocracy, encouraging participation with the world's greatest minds regardless of their country of birth, and funding their priceless contributions to our competitiveness in the global economy.
I, too, am a bleeding heart capitalist, and will support whichever political party that furthers these ideals.
Tuesday, March 2, 2010
The Case For (and Against) Raising Interest Rates
One of the Federal Reserve Bank's most powerful tools is raising short term interest rates. Why they should (and why they shouldn't) do just that now.
Short Term Interest Rates
Didn't the Fed just raise rates? Yes, they raised the Discount Rate by 50 basis points (1/2%). The Discount Rate is the rate that the local branch of the Federal Reserve Bank charges for short term loans. There are three types of loans available from the "Discount Window."
There is also the Fed Funds Rate, which is the rate banks lend money to each other at the local branch of the Federal Reserve Bank, in order to meet the reserve requirements they must set aside for liquidity purposes. This rate, currently .25%, was set on December 16, 2008, during the recent financial crisis.
Extraordinary Measures
The Federal Reserve undertook several extraordinary measures to assist financial institutions during the recent the financial crisis. Besides providing loans to banks through the discount window lending programs referenced above, the Fed established other ways to provide liquidity to financial institutions, including:
Now, by most measures, the liquidity crisis has been averted, and many of the programs listed above have been suspended. Some economists feel that it is now time for the Fed to raise the Fed Funds rate and unwind other extraordinary credit facilities, and some feel that it should wait. Here are the pros and cons.
Raise Rates Now
Those in favor of raising rates now generally feel that by raising rates gradually, the economy will avoid creating future excesses like inflation caused by holding rates artificially low. This position represents the free market philosophy that the economy must move through the process of recovery without intervention by the Fed.
Such economists see the 3% - 3.5% projected US growth in Gross Domestic Production this year partially due to previously provided economic stimulus, but more importantly through sustainable growth in global demand. Acknowledging the problem of high unemployment rates, they think that potential problems created by guaranteeing low rates for the foreseeable future will create more serious economic excesses in rate sensitive sectors in the future. In effect, this policy is seen as "postponing the inevitable," and proponents of this philosophy favor no economic intervention unless absolutely necessary.
Keep Rates Low
Those in favor of keeping short term rates near zero generally agree with the 3% - 3.5% projected US growth in Gross Domestic Production this year, but feel that reliance on growth in global demand is more precarious. Citing recent concerns with the sustainability of the current recovery, including high rates of US unemployment and sovereign debt risk abroad, proponents of this philosophy feel that Fed intervention will lessen the risk of slipping back into recession, and see that risk as more probable than creating inflation by keeping rates artificially low.
Weighing the Probabilities
Those who participate in this discussion often do so by labeling their opinion as "capitalist" or "progressive." To do so is to grossly oversimplify the issue. Whether rates should be raised or not lies simply in the measurement of future global demand. Should demand be sufficient to sustain US growth, then interest rates should be raised, and the growth in production will result in new hiring that will eventually lower unemployment. The amount of projected global growth in 2010 depends upon whose data you rely.
The World Bank projects 2.7% growth this year, slightly more pessimistic than the International Monetary Fund's projection of 3%. The two organizations use different methods in calculating GDP, which partly accounts for the disparity.
For comparison purposes, global GDP growth was 5% in 2004, 4.5% in 2005, 5.1% in 2006, 5.2% in 2007, 3% in 2008, and -1.1% in 2009.
Those in favor of raising interest rates feel that relying on growth from global demand projections in an admittedly sub-par year present less risk than the potential inflationary excesses that may be caused by keeping rates low.
Those in favor of keeping rates low feel that the probability of damaging a fragile recovery by raising rates are higher than causing future inflation by not doing so.
Clearly, choosing the wrong course of action may result in significant economic problems.
What is your opinion, and why?
Short Term Interest Rates
Didn't the Fed just raise rates? Yes, they raised the Discount Rate by 50 basis points (1/2%). The Discount Rate is the rate that the local branch of the Federal Reserve Bank charges for short term loans. There are three types of loans available from the "Discount Window."
There is also the Fed Funds Rate, which is the rate banks lend money to each other at the local branch of the Federal Reserve Bank, in order to meet the reserve requirements they must set aside for liquidity purposes. This rate, currently .25%, was set on December 16, 2008, during the recent financial crisis.
Extraordinary Measures
The Federal Reserve undertook several extraordinary measures to assist financial institutions during the recent the financial crisis. Besides providing loans to banks through the discount window lending programs referenced above, the Fed established other ways to provide liquidity to financial institutions, including:
- Term Auction Facility,
- Primary Dealer Credit Facility,
- Term Securities Lending Facility,
- Commercial Paper Funding Facility,
- Money Market Investor Funding Facility,
- Term Asset Backed Loan Facility, and
- Section 13(3) of the Federal Reserve Act loans to support specific institutions to avert their disorderly failures.
Now, by most measures, the liquidity crisis has been averted, and many of the programs listed above have been suspended. Some economists feel that it is now time for the Fed to raise the Fed Funds rate and unwind other extraordinary credit facilities, and some feel that it should wait. Here are the pros and cons.
Raise Rates Now
Those in favor of raising rates now generally feel that by raising rates gradually, the economy will avoid creating future excesses like inflation caused by holding rates artificially low. This position represents the free market philosophy that the economy must move through the process of recovery without intervention by the Fed.
Such economists see the 3% - 3.5% projected US growth in Gross Domestic Production this year partially due to previously provided economic stimulus, but more importantly through sustainable growth in global demand. Acknowledging the problem of high unemployment rates, they think that potential problems created by guaranteeing low rates for the foreseeable future will create more serious economic excesses in rate sensitive sectors in the future. In effect, this policy is seen as "postponing the inevitable," and proponents of this philosophy favor no economic intervention unless absolutely necessary.
Keep Rates Low
Those in favor of keeping short term rates near zero generally agree with the 3% - 3.5% projected US growth in Gross Domestic Production this year, but feel that reliance on growth in global demand is more precarious. Citing recent concerns with the sustainability of the current recovery, including high rates of US unemployment and sovereign debt risk abroad, proponents of this philosophy feel that Fed intervention will lessen the risk of slipping back into recession, and see that risk as more probable than creating inflation by keeping rates artificially low.
Weighing the Probabilities
Those who participate in this discussion often do so by labeling their opinion as "capitalist" or "progressive." To do so is to grossly oversimplify the issue. Whether rates should be raised or not lies simply in the measurement of future global demand. Should demand be sufficient to sustain US growth, then interest rates should be raised, and the growth in production will result in new hiring that will eventually lower unemployment. The amount of projected global growth in 2010 depends upon whose data you rely.
The World Bank projects 2.7% growth this year, slightly more pessimistic than the International Monetary Fund's projection of 3%. The two organizations use different methods in calculating GDP, which partly accounts for the disparity.
For comparison purposes, global GDP growth was 5% in 2004, 4.5% in 2005, 5.1% in 2006, 5.2% in 2007, 3% in 2008, and -1.1% in 2009.
Those in favor of raising interest rates feel that relying on growth from global demand projections in an admittedly sub-par year present less risk than the potential inflationary excesses that may be caused by keeping rates low.
Those in favor of keeping rates low feel that the probability of damaging a fragile recovery by raising rates are higher than causing future inflation by not doing so.
Clearly, choosing the wrong course of action may result in significant economic problems.
What is your opinion, and why?
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