The Middle-Class Blues
The economy has been on our minds lately. All you have to do is turn on your television or read a newspaper and the “talking heads” seem to be more than willing to give their opinion on the state of our economy. There are indeed several reasons for the downturn we're in and will be in for the foreseeable future.
This week, I'll devote some time to a topic often under-reported; that of the shrinking (or struggling) middle-class. Adjusted for inflation, real wages have done very little in the past 20-30 years. On the expense side, there have been significant increases such as health insurance and higher education. It's safe to say that such expenses consume much more of our income, making a typical American's disposable income much less.
To help make up for stagnant real wage growth and increasing expenses, many Americans turned to credit cards and home equity loans. This had occurred for the past several years. Like the derivative market, things were going well as long as real estate and other asset prices kept increasing. (This occurred due in large part to Government and the Federal Reserve System making money too available…but that's another story for another time). Suffice it to say that the Fed's “easy money” policies have greatly assisted in the creation of bubbles (technology, credit, housing, etc.).
Easy money encourages spending in times when there would otherwise be no fundamental reason for doing so. Government spent (and unfortunately continues to spend) FAR beyond its means. American consumers have been inundated with advertising and encouraged to spend. We've spent so much, that consumption is estimated at 70% of our GDP (gross domestic product). That is a staggering statistic. What this means is that much of our economy is tied (even dependent) upon consumer spending! Such irresponsibility cannot be sustained and we are finding that out now. Fundamentals return (as they always do) and prices begin to reflect reality. (Reality means the prices for which people can actually afford to purchase the underlying asset based on income, etc). I believe we are in the beginning of this phase now.
To recap, your average middle-income American has seen little real (after-inflation) increase in his wages for quite some time. To help make up for it, he has turned to home equity loans and credit cards. This model worked as long as asset prices continued to rise. When underlying asset prices (namely real estate) started to fall there is no longer anything to borrow from. Therefore there is a marked decrease in spending.
Now, add the credit fiasco to the situation above and you have a situation where lenders (who used to lend just about anything to anybody) are hesitant to lend. You can see from this scenario that spending is going to constrict in a large way. Unfortunately, since so much of our economy is service-based vs. manufacturing-based, it will be a much more painful recovery. We must remember that for the last several years, a significant portion of our manufacturing base went overseas.
This in turn will have trickle down negative effects on our economy. For example, if consumers don't spend, then companies don't need to make as much “stuff”. Therefore the companies lay off workers of go bust, etc. This ripples through the economy and the end result is higher unemployment and recession.
The negative effects of the economy will not just be in the United States, but for most of the world. At the risk of over-simplifying, China makes stuff and the U.S. consumes stuff. If one part of the equation isn't there, the other part is also negatively affected. So because we're not spending as much, China won't need to make as much stuff and that affects them.
As you can see, there are many reasons (and many more I do not have time to write about in this article) for the economic downturn. It is particularly important to re-assess your financial situation and obtain guidance if needed.
Safeguarding your Small Business in Difficult Economic Times Back to Top
The volatility in the financial sector and the outlook for the economy may have you a bit more on edge than normal. If you're a small business owner, this may be especially true. One thing is for certain; as a small business owner you're not going to be “bailed out” if you make mistakes. You know that if you make foolish mistakes, you will have to pay the consequences.
As a small business owner, you're used to juggling a lot of things around. You hardly need a weak economy to make things even more challenging! Obviously a difficult economy has different effects on different businesses. For example, a high-end retailer may see significant decreases in sales while a retailer providing more basic services may not notice much of a difference in their business.
However, there are steps you can take in order to enhance your profitability and get you through some rough spots. At the end of the day, it's your actions that will help determine how well you weather the storm. Here are some ways to help safeguard your small business.
1. Protect Your Credit - If you need a loan for your business (whether now or in the future), it's certainly a good idea to make sure that you're as credit worthy as possible. Pay your bills on time and if you're unable to do so, let the bank know why.
2. Cut Expenses - You should always be thinking of ways that you can effectively cut expenses but this is especially true in difficult economic times. Sometimes, it takes a mini-crisis for us to act on things we know about or think of things where we can improve).
3. Emphasis on your customer service - One area in which all businesses should always strive to do better is customer service. The closer you stay to your customers, the better off you'll be. Plus, small businesses are almost always more flexible than their larger counterparts and can help meet client needs as they arise. Also, listen to your customers. Allow them to provide feedback to you as well. Communication is a two-way street.
4. Show appreciation to your employees - Just like providing good service for your customers, it's important for you to treat your employees well. Think of it as customer service for your employees. Employees know when things aren't going as well due to the economy. They realize that you may not be able to give them pay increases, etc. Communicating with your employees about the tough times and just showing them how much they're appreciated will go a very long way in helping you get through difficult times.
5. Manage your accounts receivable/credit terms/Inventories, etc. - These are areas that you should always be on top of, but it's particularly important in hard economic times.
6. Know your Competition - For some businesses this is critical in difficult economic times. What's working for your competitors? For example, a car-dealer may have some special program/promotion that is very effective. Remember, customers like to get more “bang for their buck” in hard times and will go towards those who are providing it.
7. Keep up on your industry/business - Read trade magazines, speak with others in your business, geographic area, etc. By knowing what's going on, you're obviously in a better position to be proactive in a rough economy.
There are many other things you can do to help safeguard your business in rough times. Most of this is common sense. Regardless of the economy, if your business has a good solid foundation and you take the necessary steps to protect your business, you can survive much more easily.
Keynesian vs. Austrian Economics Back to Top
As you all know, the global economy is going through a rough spot to say the least. In these times we are witnessing loans, bailouts, buy-outs of toxic assets, lowering interest rates, “economic stimulus” packages, you name it and Governments around the world are trying it.
As you can also imagine, not everyone is in agreement in regards to our so-called “fixes” to the economy. Herein lies two major schools of thought; one mandates government intervention (Keynesian economics) and the other focuses on allowing the market to dictate the economy, a more laissez-faire approach (Austrian economics).
Keynesians believe that government intervention is necessary to smooth out the valleys and peaks in an economy. They do this by such tactics as artificially controlling interest rates, providing guarantees (backing up loans) to risky businesses and individuals who would otherwise not be able to get them, tinkering with the money supply, providing direct subsidies to specific industries, etc.
Keynesians try to control the economy and treat it like a machine that (in their belief) can be tampered with to achieve maximum performance.
People who believe in the Austrian school of economics (I'll refer to as Austrians for purposes of this article) believe the opposite. They believe that the economy is not a machine but rather behaves more like a living, breathing organism with a mind of its own. Austrians believe that tampering with the free enterprise system will inevitably result in many unintended consequences.
For example, Austrians would argue that our current economic woes are a direct result of years and years of manipulation by the government, particularly the U.S. Federal Reserve (the Fed). In recent years, the Fed kept interest rates artificially low. This led to a great influx of money into the economy. (Savings is discouraged and spending is encouraged under such a low-interest rate environment; at least in the beginning). Asset prices rose during this period. (Bubbles, like technology, finance, and housing flourish under such circumstances). This created, Austrians would argue, the APPEARANCE of prosperity!
This “prosperity” led to what former Fed Chairman Alan Greenspan called “irrational exuberance”. Irrational exuberance is another way to explain irrationally spending money and investing in things that are little understood. It also means that individuals and businesses have a much higher propensity to take undue risk. The government also during this timeframe encouraged, even mandated lenders to take undue risk (all in the name of helping those less fortunate obtain a house), even when they had no realistic way of paying back loans). All sorts of financial “instruments” were created to accommodate these and other loans. Other financial “inventions” also ended up wreaking havoc on our financial system because they were based on the assumption that real estate always increases in value. The press has labeled the finance side of this mess as “Wall Street”.
Meanwhile on “Main Street” your average American was also racking up debt. This is due in large part to the reality that wages for your average American have been rather stagnant. Our “prosperity” like I mentioned earlier was perceived prosperity, not actual prosperity. To help make up for the lack of real wage growth, Americans turned even more to debt to help fill in the gap of stagnant wages and increasing expenses such as food, energy, healthcare, and tuition. After all the cost to borrow was low, home values to borrow against kept increasing, and most Americans quite frankly needed the money.
Regardless of which way you lean toward (Keynesian or Austrian), it's quite apparent that our Nation follows a Keynesian approach and has for quite some time.
Some Reasons for Economic Slowdown Back to Top
Ordinary Americans are now realizing that we have some negative factors out there affecting our economy. There are many who argue that this is the “perfect storm”. In this article I'll list some issues that we're facing now and in future articles I'll go into more detail on some of these issues. My hope is that you will see how all these things are connected and their effects on our economy and the health of our Country as a whole.
1. Globalization - Without question, globalization has had both negative and positive effects on our economy. Whether you think you're “for” or “against” globalization, the fact is that it's here to stay.
2. Consumer-Based Economy - Much of our manufacturing base has decreased in recent years. This too has had effects on various aspects of our economy and our citizens. In fact our economy has increasingly become more of a service-based economy vs. a production based economy. In general this means lower-paying jobs and activity based around services vs. hard tangible goods that are produced. In many ways, we are dependent upon others in order to maintain our levels of consumption. Likewise, developing countries like China are dependent upon our country's consumption levels for their own prosperity.
3. Massive Government Spending/National Debt - It's no secret that our friends in Washington have enjoyed an orgy of spending; much the same way as those on Wall Street. In addition, much of our current deficits are now financed by foreign debt. This has many long-reaching effects including a drag on the strength of our dollar, inflation, and a lesser ability to pay for things we need. (Because we are making interest payments on our outstanding debt).
4. De-regulation - For many years (not just the current Bush Administration), there has been a downward trend in safeguards; many of which were put in place after the Great Depression. In particular the provisions of the Glass Steagall Act of 1933 were repealed in 1999. Amongst other things, the Act prohibited commercial banks from collaborating with full-service brokerage firms or participating in investment banking activities.
5. Significant leveraging and use of “creative” financial instruments. Most are now finding out how little understanding there was and/or the fragility of how these debt instruments worked. Sub-prime lending, Collateralized Debt Obligations (CDOs), Credit Default Swaps (CDSs), etc are behind much of the current negative activity in our credit markets.
6. Fall in the Value of Real Estate - Much of the credit problems we're now facing is due to the fall in real estate values, particularly in certain urban areas of the Country. In fact there was a “bubble”, much like the technology bubble of the late 1990s. Debt instruments were centered on the very incorrect and illogical premise that real estate would continue to increase forever.
7. Laws by the Government strongly encouraging more risky loans. One thing we're NOT hearing is that the Government can share in the blame for some of this mess. For example, the Community Reinvestment Act encouraged depository institutions to help meet the credit needs of low and moderate income neighborhoods by requiring federal regulators to assess the record of each bank or thrift in helping to fulfill its obligations to the community. Although the intentions may be good, it did help encourage banking institutions to make more loans in the sub-prime market. In a competitive market, it's only natural that some of these loans would get out of hand.
8. Selling mortgages after making risky loans - It's fair to say that irresponsible behavior occurred because original lending institutions knew that it would soon sell mortgages to other institutions, get the money, and make an immediate profit. In fact, it was not unusual for mortgages to be sold several times, bundled, etc. This is one of the reasons that it's so difficult to value some of these debt instruments.
As I said, there are many problems facing our economic health and these are not all inclusive. In the future weeks (as time allows), I'll go into detail on some of these topics in an attempt to provide you with a better overall understanding of the problems we face.
Emergency Economic Stabilization Act of 2008 Back to Top
As you know, the Federal Government signed the Emergency Economic Stabilization Act of 2008 (EESA) into law. Most of the press has focused on how this Act attempts to help solve the credit crunch. However the EESA also serves as one of the largest tax bills in recent years. In fact, the new law makes nearly 300 changes to the Internal Revenue Code. This week, I'll focus on some important tax changes.
Alternative Minimum Tax (AMT) patch - I've discussed the AMT before. Basically this is a separate tax code that was originally intended to make sure certain wealthy taxpayers were paying their fair share of taxes. However the AMT did not have yearly inflation increases to “keep up with the times”. This has led to middle-income taxpayers being exposed to this tax code. Rather than fixing the underlying problem, Congress has continued to make yearly “patches” that increase the amount of income exempt from the AMT. Exemption amounts have been increased to $69,950 (married filing jointly), up from $66,250 in 2007. (Single filer exemption amount has increased to $46,200, up from 44,350). Without the patch, the exemption amount would have reverted back to an incredibly low $45,000! (married filing jointly) and $33,750 (single). The patch also allows taxpayers to take non-refundable personal credits to reduce their AMT liability.
State and Local Sales Tax Deduction - The American Jobs Creation Act of 2004 and subsequent legislation allowed individuals to deduct state and local general sales taxes in lieu of state and local income taxes. This deduction expired at the end of 2007. The new law makes the deduction retroactive for 2008 and extends it through the end of 2009. (This is important, especially for people who itemize their deductions and might have made a large purchase during the year. In other words, if you paid more in sales tax than State income tax, it would make sense to take the sales tax deduction).
Higher Education Tuition Deduction - This deduction is extended through 2009 and allows eligible taxpayers to deduct the costs of qualified higher education expenses paid during the year for themselves, a spouse, or a dependent. The maximum deductible amount is $4,000 for taxpayers with adjusted gross income of less than $65,000 (Single); $130,000 (MFJ). The HOPE and Lifetime Learning Credit (LLC) is also an option. For most taxpayers who qualify for these credits, HOPE and LLC will continue to be your most beneficial option.
Teachers' Classroom Expense Deduction - Another popular deduction that would have expired, this deduction has been extended through 2009 and allows for teachers and other education professionals to deduct up to $250 of certain out-of-pocket expenses including supplies, books, equipment, and software used in the classroom. This deduction is available to those qualified regardless of whether or not they itemize their deductions.
Tax-Free Distributions from IRAs for Charitable Purposes - This has also been extended through 2009. Basically this is for those individuals who do not need income from their IRAs. This popular charitable contribution allows you to take up to $100,000 from your IRA and avoid having to pay taxes on it if you donate the proceeds to a qualified charity.
Child Tax Credit - The EESA enhanced the Child Tax Credit by lowering the earned income floor from $12,050 to $8,850. This means that more people will receive more money from this credit.
There are many more provisions for businesses and of course the issue of addressing the credit crunch. In short, this Act was quite sweeping in its scope and depth.
How much is a Trillion Dollars? Back to Top
I don't know about you, but I've had a hard time accepting all the bailouts, loans, and giveaways that the government has been dolling out lately. I think few people really have a grasp on the magnitude of just how large these expenditures are. And this is only the beginning. I don't believe we've seen anything yet. If you don't believe me wait until the government starts to provide even more spending to “stimulate” the economy. This all comes on top of the massive spending that had occurred already under the Bush Administration (the highest of any U.S. President).
Between the government and the Federal Reserve, also known as the Fed, (which is a quasi-government organization at best), over one trillion dollars have been generated to “stimulate” our economy. This is just in the recent past few months! The figure is actually much larger than 1 trillion dollars but try to find a real estimate and you'll be hard-pressed to do so.
How much is a trillion dollars? Well first of all, one trillion dollars is a 1 followed by 12 zeros. So one trillion dollars would be written as 1,000,000,000,000.
To help give you an idea of just how large a trillion dollars is, here are a few things to consider:
1) It would take the average person 190,259 years just to count to a trillion!
2) A Trillion seconds would be equivalent to 31, 546 years!
3) Outside on a clear night one can see about 2,000 stars with the naked eye. With 1 trillion dollars, you could buy all of those stars for $500 million dollars apiece.
4) A trillion dollar bills stitched together end to end in a line would stretch about 94 million miles. This is more than the distance between the earth and the sun.
5) NASA was founded and first funded by the federal government in 1958. In its 50 year history, NASA has put men on the moon, launched space probes that have visited all the planets of our solar system, orbited space telescopes, space shuttles, and space stations, and has funded basic space-science research, training thousands of students. Over these 50 years, NASA has been allocated a total of $800 billion dollars (200 billion less than a trillion)! (Dollars have been adjusted for inflation).
Right now on a cash basis, our national debt is approximately 10.7 trillion. The United State's estimated population is around 304 million. This means that each American's share (what each American owes) of the Federal deficit is slightly over $35,000.
I'm only speaking of the Federal deficit on a cash basis. If you use the generally accepted accounting principal of the accrual based accounting, the deficit would be reported at an estimated 50 trillion. (Accrual basis basically means that you record future liabilities that are currently incurred). So for example, you would estimate future healthcare claims under Medicare and Medicaid for our existing population. The goal of accrual basis accounting is to give us a more complete picture of our actual liabilities.
The main thing I want to get across is that a trillion dollars is a lot of money! We as a society need to be very careful about doling out billions here and billions there. There is no question that the more we continue to do this; the more we're mortgaging our future. And isn't this (irresponsible credit/borrowing) the reason we're in the mess in the first place?
American Recovery & Reinvestment Act of 2009 Back to Top
As many of you are aware, there are many changes in store for taxpayers as a result of the recently passed stimulus package. Regardless of how you feel about the American Recovery & Reinvestment Act of 2009 (ARRA), there are a lot of changes that will affect many taxpayers for 2009. This week, I'll summarize the major provisions of the act.
First-Time Homebuyer Tax Credit - This is an improvement over the existing credit that first-time homebuyers took advantage of for the 2008 year. First of all, the amount has increased from a maximum of $7,500 to $8,000. Second, instead of having to pay it back on your future tax returns over the next 15s, the new credit does NOT have to be paid back! These enhancements to the existing credit apply to purchases of a principal residence by a first-time homebuyer AFTER December 31, 2008 through November 30, 2009. Please note that if you qualify in 2009 for this credit, you do NOT have to wait until filing your 2009 tax return. The IRS will allow you to amend your 2008 return even though you didn't purchase your home until 2009!
New Car Deduction - If you purchase a new vehicle in 2009 (cars, SUVs, light trucks, motorcycles or motor homes), you may deduct sales tax paid on the first $49,500 of the purchase price. This can be deducted even if you do not normally itemize.
Education Credit - The new law temporarily enhances the existing HOPE credit for 2009 & 2010 only. The maximum amount of credit has been increased from $1,800 to $2,500 per year. The credit can also be used for all four years of college. (Before this change the HOPE credit could only be used for the student's first two years of college). Finally, expenses for course materials are now considered qualified expenses for purposes of this credit.
Child Tax Credit - Basically, the refundable portion of the child tax credit for 2009 and 2010 has been increased by setting the income threshold down to $3,000 from $8,500. The effect is that this credit will be increased significantly from prior law.
Making Work Pay Credit - This credit is only for those with earned income and allows a credit against your income tax liability equal to the lesser of 6.2% of an individual's earned income or $400 ($800 for married filing jointly). This credit is for both 2009 and 2010. The credit begins to phase out for those with modified adjusted gross incomes above $75,000 ($150,000 for married filing jointly). Generally speaking, qualified taxpayers will take this credit via a reduction in wage withholding where self-employed individuals will take it as a lump-sum when filing their tax return.
$250 Economic Recovery Payment - For those who do not have earned income the new law provides for a one-time payment (this one is for 2009 only) of $250. Again this is meant for those individuals on fixed incomes (primarily Social Security recipients, railroad retirees, disabled veterans, etc.). Retired Federal Government workers who generally are ineligible for Social Security also will receive the one-time payment.
AMT Patch - This one is no surprise. There has been an Alternative Minimum Tax patch during the last several years. The only difference this year is that the politicians aren't going to debate the issue at the end of the year. The exemption amount has increased to $70,950 for joint filers and $46,700 for Single and Head of Household filers. This is up from $69,950 and $46,200 respectively.
Earned Income Tax Credit - The new law provides a temporary increase in the Earned Income Tax Credit (EITC) for 2009 and 2010. This is being accomplished by increasing the percentage from 40% to 45% of the first $12,570 of earned income.
There are also some other items that will effect individual taxpayers but they are relatively minor. The Act also has some other provisions that are geared towards businesses that I will most likely highlight in a future article.
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Bob Tackabury is owner of Robert L. Tackabury, CPA 2556 Rt. 12B, Hamilton, NY 315-825-0255 and is an Investment Registered Representative. Securities offered through IBN Financial Services, Inc., 404 Old Liverpool Rd.Liverpool, NY 13088. 315-652-4426.
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