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You Win Some, You Lose Some, and You Just Plain Blow Some

August 2022 Insight

Disclaimer: Economics, and therefore investing, is at times impacted by politics. Politics are by nature controversial – and even more so in today’s polarizing environment. This Insight will be wading into the impact of recent political events on investing and wealth building. There is no intent to offend, nor back any specific political party. If you are highly tied to your political bearing, please continue with caution, or choose to sit this one out until next month.

My dad was my little league baseball coach for the three years, up until I was 12 years old. We were fortunate to win a lot more games than we lost; and we learned some good life lessons along the way. One of my biggest take-aways from my dad as our coach was a saying he shared often, “It is okay to get beat, but we never want to lose.” Or said another way, if we show up well prepared, give it our best effort and the other team just outplays us, so be it. But we never want to end up with the lower score because we were sloppy and didn’t play our hardest. Sometimes you get outplayed, but you should never lose because you blow it.

I thought of this saying this month when observing political wins and losses. It was quite a busy month for the current administration, with some definitive wins, and some things that may well turn out to be losses. We will feel the impact of those wins and losses in our lives and investment portfolio.

The Big Win: As is typical with any political maneuvering, the name given likely has nothing to do with the legislation itself. This is certainly true with the “Inflation Reduction Act”, which to the best of my analysis has nothing to do with reducing inflation and much more to do with reducing carbon footprint. Depending which half of the news you follow, you were told this bill is either the biggest political win since the New Deal or a complete disaster. As is often the case, the truth is somewhere in the middle. It is a nice political win for the President, but with a majority in both the House and the Senate this sort of bill should not have been this difficult to get approved. The fact that zero Republicans voted for the bill shows the extent to which partisanship has become engrained in political maneuvering. The following are my takes on the various components of the Act.

  1. Minimum Corporate Tax:
    • What it is: Companies that earn an average of at least $1 billion in adjusted book income (the earnings reported to shareholders) over a trailing three-year period. This book income (subject to some allowed adjustments) would then be multiplied by the minimum corporate tax rate of 15%, and the higher of the historical way of calculating taxes owed and this new method is what will be owed to the IRS. This also impacts foreign companies operating in the US, but at a reduced threshold of $100 Mil of US sourced book income.
    • Pros: If there is a tax on something (profit), and if that something is being reported as earned/received, then the tax should be paid. This closes the loophole of not paying taxes on earnings.
    • Cons: This creates a two-tier system to the benefit of private companies because they don’t have to report to shareholders in the same manner that public companies do. This in turn incentivizes companies to stay private – a trend that was already growing prior to this bill going into effect. Only the rich generally have the opportunity to invest in private companies, meaning opportunities that historically would have been available to the population at large, may now be restricted. This in turn exacerbates the rich/non rich divide.
    • Analysis: Corporate tax revenues have dropped by almost 50% as a share of GDP from 2015 – 2020, largely an effect of the 2017 Tax and Jobs Act – so this change will help government coffers. And, as mentioned above, if there is a tax in place on profitability and that profitability exists, then the taxes should be paid. At a higher level though, we have to ask why companies can be in legal tax compliance and not pay any taxes while profitable. The answer is because of loopholes that Congress itself has put into place. I would have much rather seen a true simplification of the tax code to reduce special interest loopholes than a tax band-aid to hide the loopholes in the first place.
  2. Tax on Stock Buybacks:
    • What it is: Public companies will have to pay 1% of the value of any stock repurchase, called a stock buyback excise tax.
    • Pros: I struggle to find anything to rally around on this one. Not that I hate it, taxes have to come from somewhere, but the secondary effects of this legislation aren’t good for anyone.
    • Cons: The tax revenues expected will not materialize as promised. For one, interest rates have increased dramatically, increasing the cost threshold in the analysis of companies when considering a buy back. Secondarily, the tax itself increases the cost threshold, so the quantity of buybacks will plummet, reducing the calculated tax revenue with it.
    • Analysis: Stock buybacks have two primary purposes. The first is to offset the dilution of new share issuance. New shares are issued either to help a company recapitalize or provide stock-based compensation to employees. This bill increases the cost of offsetting dilution, therefore raising the cost of recapitalizing during periods of turbulence, and also increasing the cost of providing stock ownership to employees. Secondarily, stock buybacks provide a floor to stock prices. Most American’s own stock, even if just through their retirement plans. Stock buybacks increase the value of those shares, both when the share price is beat up and the company believes the company is undervalued, and when a reduction in shares leads to higher EPS and therefore higher stock prices. Could there be an argument against increasing debt to reduce outstanding shares versus using operating cash flow to purchase shares? Absolutely, but that should be part of normal responsible corporate governance. This approach seems to throw the baby out with the bathwater.
  3. Nuclear Power Production:
    • What it is: Starting in 2024 and running for eight years, utilities will get a $15/megawatt hour tax credit for electricity produced by existing nuclear plants. Several other zero emission tax credits in the bill also can apply to the nuclear energy production, including an Investment Tax Credit for facilities that go into service after 2025. The tax credit is up to 30% of the investment in any new zero emission facility. There are also loan guarantees of up to $250 billion to be provided by the Department of Energy.
    • Pros: As is apparent in much of the world, there simply isn’t enough green energy being produced to immediately ween ourselves from fossil fuels. Supporting nuclear energy as a bridge and adjunct is a sensible path forward, encouraging new production.
    • Cons: This tax credit applies to existing nuclear production, not new power production; so more than anything, it is a handout to existing nuclear producers. It also requires labor at the nuclear energy production facilities to be paid prevailing wages. Since prevailing wages are generally higher than market wages this increases the cost of the energy production, and thus increases what the consumer pays.
    • Analysis: I have long been a believer in nuclear power, including writing about it here in previous Insights. I don’t understand the need to pay existing producers through this credit and am not in favor of the government picking winners and losers in general. However, if the government is going to pick winners, I am happy they are picking nuclear power. I don’t love the loan guarantees. The government tried that for solar during the Obama administration with pretty disastrous results. The guarantees end up being used as political favors and the beneficiaries often end up taking on far more risk than they should, which, as it did with the solar panel guarantees, end up costing taxpayers a lot of money.
  4. $80 Billion in Additional Funding for the IRS:
    • What it is: According to Treasury Secretary Yellen, the funds will be used to clear the backlog of unprocessed returns, improve customer service, overhaul technology, and hire new workers.
    • Pros: At face value, none of the priorities set forth by Yellen are overly concerning. Improved customer service and technology would make a lot of citizens’ lives a lot less frustrating.
    • Cons: Yellen also said the funding will allow the IRS to enforce tax laws for “high net worth individuals, large corporations and complex partnerships who today pay far less than they owe.” According to several sources, there are only 614 billionaires in the US and only 717,000 taxpayers in the top 1% – the high-net-worth individuals. There are currently 78,661 full time employees at the IRS. Are we saying that 78,000 IRS employees isn’t enough to audit 717,000? Additionally, this claim by Yellen makes a rather large unsubstantiated leap that these 717,000 taxpayers are the source of the preponderance of tax evasion.
    • Analysis: Digging further into the numbers, only 4% of the $80 billion will be spent on improving taxpayer service while 58% will be spending on monitoring and compliance. This does not appear to be the benign altruistic use of funds that the Treasury Secretary claims it to be. One of the justifications of this outsized allocation of funds is that 50,000 IRS employees are scheduled to retired in the next 5 years (think about that – 64% of the workforce – how is that even possible) and that the funds will be needed to hire replacement employees. Except that if they are “replacement” employees, then the cost should also be a wash, or at least relatively close to it. At the end of the day, and while I hate how inefficiently tax dollars are spent, we should be paying what is owed under the laws of the country. I don’t mind an increase in audits if it truly and meaningfully increases compliance (which assumes poor compliance in the first place). However, as anyone that has ever been audited can attest, the audit process is not about finding tax transgressors. It is about finding any possible mistake or difference in interpretation and making one’s life miserable through the process. Very easily, and especially with this amount of funding, the audit process could be streamlined so that the first-tier audit could quickly review and move on from taxpayers that are obviously not trying to game the system. But this is the government, so it won’t happen. And we should all expect an increased likelihood of audit. If you are like me, it won’t change anything you are doing, except maybe thinking about stashing some cash aside to pay the tax accountants bill for handling the audit.
    • What doesn’t fit into any narrative coming from those that supported this bill is a job description posted on the IRS website shortly after the bill’s passage, “Carry a firearm and be willing to use deadly force, if necessary.” I know nothing is certain but death and taxes, but death and taxes together?
    • Not acknowledged by the Administration is the expected impact on small businesses. According to the Joint Committee on Taxation, an estimated 78 – 90% of the estimated $200 billion the IRS will collect through the increase in funding will come from businesses making less then $200,000 annually. Additionally, the Congressional Budget Office estimates that the changes from this bill will result in $20 billion of additional tax revenue collected by households making under $400,000 per year.
  5. Prescription Drug Price Control:
    • What it is: Requires the Federal Government to negotiate with manufacturers to obtain lower prices for some high-cost drugs, requires drug companies to pay rebates to Medicare if their prices rise faster than inflation, and places a $2,000 cap on out-of-pocket spending for prescription drugs for Medicare recipients.
    • Pros: The administration estimates these changes will save the Federal Government $250 billion over ten years.
    • Cons: The government is becoming further entrenched in private enterprise (drug companies).
    • Analysis: Price controls are never good for an economy over the long term. There are other ways that prices could be impacted without price controls. For instance, reducing the patent time lines before generic competitors could come to market.
  6. Energy Efficiency Tax Breaks and Rebates:
    • What it is: Up to $10,000 (and more in some cases) in tax breaks and rebates for consumers for electric vehicle purchases, solar panels installation, efficient appliance purchases, and home energy upgrades.
    • Pros: If the government is going to try to influence action, this is probably a decent place to do it.
    • Cons: The way the bill is written is going to severely limit who can benefit, thereby limiting the overall impact of the credits and rebates. For instance, the home improvement rebates are limited to households making less than 150% of the area’s median income. According to Market Watch, that puts the national average limits at ~$102,000 (April ’22). That same $102,000 was the median income of home buyers in 2020, with it surely being higher now. This means ½ of home buyers are eliminated from using the program. The question then becomes, how much can the qualifying half afford. The US median home price is $428,000. Assuming 20% down and 4.5% interest rate, housing costs are roughly $29,000. If we take the highest possible qualifying income of the $102,000, apply some conservative taxes (payroll tax, Social Security and Medicare, even if there is no income tax) of ~20% or $20,000, and reduce by the average car ownership cost of $10,728/year (AAA), this leaves $42,000 remaining for all of life’s non-housing and non-vehicle related expenses…food, babysitting, medical, etc. Can someone with $42,000 to cover all non-housing/vehicle expense afford to drop $8,000 to get a $4,000 rebate? This conservatively assumes only one car being used in the household, whereas most households have two. And, it assumes the highest possible income eligibility. Of note, home owning households earning less than 80% of the area median income are eligible for 100% rebates, but relatively few such households exist.
    • Analysis: Seemingly solid in concept, the roll out of this part of the bill will be slow (it will be administered by the individual states) and may not have the impact expected simply because of the lack of qualifying households that can also afford the improvements. I have no doubt enterprising energy upgrade companies will figure out work arounds, and good on them for doing so, but that extra effort, as with anything tied to the government, comes with an added cost to the consumer.
  7. 45L and Section 179D:
    • What it is: 45L was a pre-existing new builder home credit of $2000 for qualifying homes, which expired at the end of 2021 (Altus has qualified projects for this credit in the past). This bill reinstitutes the credit and extends it for another 10 years. The 179D is a tax deduction for energy efficient commercial buildings, with the tax deduction attributable to either the building designer or builder. This bill increases the base deduction from 50 cents per foot to as high as $2.50 per foot, and opens up qualifications to include REITs and designers of commercial buildings owned by not-for-profits.
    • Pros: With the same disclaimer as above that I don’t think the government should be incentivizing action and picking winners and losers through the tax code, if they are going to do it, this is a solid way to reduce energy use. Additionally, and especially with residential construction, increasing interest rates have decreased profitability and therefor quantity of new product being produced. These tax credits may offer enough relief to get some projects off the ground.
    • Cons: As with other parts of the bill, the benefits here are most specifically for prevailing wage projects. But when you look at what type of projects are prevailing wage…you immediately eliminate most housing projects (other than low income), so the benefit that would have existed in bringing more housing units to a housing starved country is greatly diminished. Additionally, most smaller commercial buildings (and even large commercial buildings not in primary markets) are not built with prevailing wage labor. The tax benefits of the added write offs don’t come close to offsetting the added cost burden of having to use prevailing wage. Additionally, for both the 45L and the 179D, the regulatory burden of qualification was increased considerably via this bill.
    • Analysis: We will certainly be digging into this to see where our projects can benefit, and we will likely be able to qualify some of our housing projects for the original $2000/unit. It is unlikely any of our ~800 residential units or 2 million square feet of industrial space will be able to qualify for anything beyond the $2000/unit, and even many of the residential units won’t qualify.
  8. The Name:
    • Most people probably won’t think much about the name once they hear it, but why would a bill that’s deemed the greatest environmental victory in history be called the “Inflation Reduction Act”? Inflation is on voters’ minds more than is the environment. It is all about marketing, baby.
  9. Noticeable in Absentia:
    • SALT unwind: Thankfully those clamoring for the SALT limit reductions to be undone didn’t get their wishes. The desire for the unwind was one of the most hypocritical things we have seen in politics in many years, which really is saying a lot. So, this bill being passed without those changes being included is a win for common sense.
    • Carried interest elimination: In the 2017 Jobs Act, the requirements for income to qualify for carried interest treatment was increased to a three-year minimum holding period. In effect, compensation for fund managers is taxed as ordinary income if realized inside three years and as long-term capital gains if realized after three years. That is generally a 17% tax margin, or almost double the tax rate for income in less than three years than over three years. The initial drafts of the Inflation Reduction Act had proposed changing this to a five-year minimum holding period. The final bill included no changes. Altus benefits from the carried interest provision and many of our deal structures are built with this taxation benefit in mind. However, even as a lucky recipient of such favorable treatment, I find it hard to argue in favor of special carried interest treatment. There certainly are economic reasons for having it in place and encouraging the investing and risk taking that go along with it, but I can hardly opine against other special interest tax treatments and then be in favor of this one.

A Loss: The administration has said they had no involvement in the raid on the residence of past President Trump. I think we have to take them at their word. But even without involvement, the fact it happened is something they have to deal with. Those who hate Trump love that the raid occurred. For those that love Trump it just strengthens the opinions that the establishment is out to get him. Nothing that happens is going to influence the thoughts or voting patterns of those two groups of people anyway. The real question is how the much larger silent majority perceives the events. It is quite likely that something illegal occurred, but something similar happened only a few years ago and the same group of people now pursuing the charges previously declined pursuit. My fear is more and more of the population will believe that political retribution is becoming the norm, further driving a wedge between those that make up most of the center to keep those at the edges happy. In business investing predictability allows us to build lasting excellence. When the tax, regulation, and enforcement (to say nothing of the social narrative) whip between extremes, returns, whether in business or investment, become less about consistent excellence and more about being in position to catch the pendulum at the right time and place. Maybe this is just the new truth we are going to deal with for the coming years, but I sure hope not.

We Blew It: Forgiveness of student debt. One of my biggest complaints about economic domestic policy of the previous administration was how much they played favorites. This administration is now doing the same, but with voters instead of companies. I am quite opinionated on this topic and think this move by the administration is terrible for the country and is a bald-face attempt to gain votes heading into the mid-term elections. If you are a tax paying household, congratulations, your share of the national debt just increased between $7,000 and $12,000, depending on whose calculation you use for the total amount of forgiveness. Didn’t go to college so didn’t have debt? Too bad. Worked through college? Too bad. Worked like crazy once you were out of college and scrimped on life to pay down/off your college debt? Too bad. The administration is trying to play this off like it is a specific benefit trying to help the working-class voters citizens. But this forgiveness is for any household bringing in less than $250,000 in income per year. As referenced above, the national median household income is somewhere around $68,000. This forgiveness applies to over three times the median household income.

It could be argued that this debt forgiveness isn’t so different than the PPP funds that were distributed during the depths of the pandemic. I could sympathize with that viewpoint, but for one major difference. Businesses were forced to be closed by government mandate. Altus literally was not allowed to be open, and there were thousands and thousand of businesses like ours. No one forced students to go to college and take on debt. That was a conscious decision. Granted, it was likely made at a young age, but we allow people to sign up to go to war at the same age. In the last election cycle several states tried to get the voting age reduced to sixteen years of age. Voting is the greatest responsibility of citizens in a democracy/republic. We are okay with someone voting that can’t make decisions on debt?

Other than the increase in our share of government debt, I don’t know if there is a direct immediate impact on our investing activities. Longer term actions such as these reduce feelings of responsibility by those that use our products or services through moral hazard. We have experienced this in spades over the past couple years with many of our residential tenants taking advantage of government largesse and eviction restrictions to avoid paying rent (I am not including those that simply couldn’t pay in here). A reduction in collections requires an increase in price to offset the loss in collections. This is effectively a tax on responsible parties. Just like the direct forgiveness of student debt.

Other August happenings:

  1. Sixteen states, led by no other than California, are sending out Inflation Relief checks. Yes, that is an oxymoron. But unfortunately, it is also really happening. There is either an incredible amount of ignorance about the causes of inflation (remember MMT?), or maybe those in power have an understanding, but they choose to ignore it in order to stay in power. Neither speaks well of said leaders. It should be mentioned that these states are both red and blue, so this is not political party specific.
  2. A bunch of Starbucks, and now a Chipotle, have unionized. Unions are an important part of our national history and were especially important in the development of the middle class and worker rights in the early part of the 20th The key benefits to unionization are clear definitions of a career path with associated increases in compensation, and union dues going in part to create solid health and retirement benefits. I have been under the impression that working at Starbucks (and Chipotle, etc.) was a steppingstone job to other careers or into store/corporate management (which isn’t part of the union). By unionizing, employees are donating a solid chunk of earnings to the union for benefits they will never receive.

Happy Investing!

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.