Blessed by the Potato

The S&P500 was down nearly 4% today, which is a pretty huge one-day move. We’re now below the point we were at two weeks ago before the Greek bailout package was announced (the close after the “flash crash”).

This is not purely out of partially-unfounded fears over what’s happening in Europe: some fairly bad news has been coming out of North America, including US numbers indicating that inflation has gone away, raising the probability that we are facing a protracted or double-dip recession.

So, what does that mean for the young investor? Periods of panic and weakness are generally good times to buy (or to choose to rebalance and shift more of your portfolio from strongly-performing safe assets to underperforming equities). However, in the past I’ve bought too early and used all my cash in the early innings. Since buying a car and paying rent at two places while I finish my PhD has lead to negligible savings, I don’t have any dry powder at the moment to invest. That’s forced me to sit on my hands through this and wait for some truly delicious bargains.

I am considering using some modest leverage if prices seriously decline (ala 2008/2009), though getting Wayfare to sign-off on that plan will be a challenge since she’s allergic to debt (she is also allergic to cats, so it’s nothing personal, debt). However, while I can appreciate the logic behind leverage (and bringing your future purchases forward if you’re young and saving), I’m also not one to get too comfortable with debt. Even if I maxed out my LoC, that’d only leave me about 7-8% leveraged.

The question then becomes, at what point do I start buying? When is it truly “raining gold”? I doubt we’ll go as far down as the March ’09 lows, but who’s to say how long or how deep this panic will run. The big bear lasted over a year; the two moderate corrections on the way up lasted about a month and were less than 10%. Some may argue that it’s better to wait for the bottom to be in and buy on the way up, and I don’t have a good comeback to that except to say that then it becomes easy to continue to sit on the sidelines until long after the bottom has passed. I’m not trying to get my timing perfect — I’m trying to tell myself I’m not timing at all — I just want to buy at a fairer price. So, I’ve got a few stink bids in now for a few stocks, sitting about 10% below where they are today (which for many is already 10-15% below where they were last month). After that, I’ll probably buy again when I save more money or if the market goes down another 10-20%…

The point to remember is that for many of us, this is a better time to invest than it was last month, despite the calm markets then.

A weird, weird day in the markets today, as on basically no new news there was a huge negative spike at about 2:45pm. The markets are still down considerably as I write this (a few minutes before the close), but if you check there are a lot of companies with a big spike right at that time, some down 30% or more.

My day started off weird too, as I tried to put a bid in for SPB just to have it cancelled instantly by TD; the stock went down to $8.40 at one point with no bids (and that was when I really wanted to be the only low-ball bid!) before trading was halted. When it resumed it came back to the $13 range. Again, a weird computer issue at the exchange?

Update: it looks like they are indeed blaming a computer glitch, and are reversing some trades.

I was bullish on Priszm (QSR.UN) for a long time the last two years, the thesis being that even in a recession, people still need their 11 herbs and spices fortnightly, and that there were fairly decent levels of cash being generated, even after the declines that were taking place. Unfortunately, I ignored the little voice that had lost confidence in management after whip-sawing their distribution all over the place every few months (3 cents! 10 cents! 5 cents! 1 cent… nothing!).

The last annual report was 80-some pages and put up as a nice PDF… this last quarter’s was faxed and then scanned or some godawful thing. No conference call, either, which I can only assume is bad news.

Buried in that tough-to-read garbled mess is a little line saying that their current lender (who is never identified in anything I can find) will not be renewing their loan in December. They find a new lender, or die basically. With a new loan, their debt:equity will be over 1, so it may be hard to find a lender, or at least get an interest rate that keeps them in business.

Now, last year they generated $0.50/share in distributable cash. Even with negative tangible book value that’s pretty damned sexy for a stock trading at $0.89.

However, they’ve been a steaming pile of failure the last few years. They whipsawed investors around with the distribution; they’ve provided zero clarity on the issues of renewing this loan; they haven’t announced their plans for post-2011 (perhaps because they’ll be out of business?); and of their earlier plan to sell 147 under-performing locations, only something like 21 actually got sold.

If they do manage to find attractive refinancing (and renegotiations of their franchise agreements) that lets them go back to generating (and distributing!) cash, then I may get consider getting back in, but for now, they look to be too close to the brink of bankruptcy for me, soI’m taking my 86% loss and getting out.

And remember: you don’t have to make it back the same way you lost it.

There’s some interesting discussion taking place over at Larry McDonald’s blog on the flat-tax issue.

Larry asked:

“But does a flat tax necessarily entail a higher tax burden for lower income persons and/or less public service?”

I don’t have a source for you, but the math is fairly simple. If we’re to avoid less public service, then the total tax revenue has to be the same as it is right now, however that gets distributed.

Then you have three basic options for how to set a flat tax:

First, a true flat tax of X% (say, ~20%) from your very first dollar of income. Obviously, there are people right now who are very low income and pay no tax, and under this new system they would be paying tax, and the people at the top would pay less tax (so the total revenue is the same).

That goes against the progressive sensibilities of many people, so the next suggestion is to add a floor. Then you have two variables to play with: how high to set the floor, and what tax rate to set.

Now, assume that for the very, very wealthy, their total tax rate approaches the top tax bracket (if you’re making $20 million, the first $127k at a lower tax bracket is virtually meaningless).

So, if you set the tax rate to be less than the current highest marginal rate (29% federal), and set some middling tax floor ($20k, whatever), then the very wealthy will still pay less tax, so again if the total tax grab is constant, that must mean that someone lower down is paying more, but this time that’s likely to be the upper-middle class rather than the very bottom of the income distribution.

Then the only way to make sure that you’re not moving the tax burden down the income strata with a flat tax is to set the flat tax rate higher than the current highest marginal tax rate, and then have a fairly high tax floor — but I don’t think I’ve ever heard a flat-tax proponent suggest that version.

I’m in this deep, so what the hell, let’s put some actual numbers to this. I quickly looked up what the distribution of incomes is, and plugged that into excel. I know I probably shouldn’t worry about the 0.01% of Canadians who make more than $3 million when trying to figure out a tax system for most of us, but I decided to try to come close for the sake of argument. Now, this is not quite exact because it doesn’t take into account the various deductions available which will definitely skew the results — this is just taking the incomes listed from Stats Can (which are in ranges — I took the middle of the range and called it close enough), and applying the progressive tax brackets to them to find a current tax burden, and then examining different flat tax schemes to see how they fare.

So, using this model, we find that:

To get the same total revenue with one flat tax (from the first dollar on), the average rate would have to be about 14.5% (a bit higher in real life since I don’t quite add up to the same actual total tax revenue as the government pulls in with this model).

If we set a low floor, at $5.3k, a 16% tax rate gets us about the same total revenue. However, the tax burden is shifted quite dramatically towards the lower income bins. This chart should get the point across:

If we want to use a 22% tax rate, currently the second bracket ($41-$82k of income), the floor can be set at $15.8k, and we see that the very poor pay no tax (no change from current), those close to the floor pay a little less (those with incomes up to $27.5k), the middle class people ($30-$85k) pay more, while the very rich (over $85k) pay less.

The current top tax bracket of 29% lets us set a floor of about $24.5k, and even all the super-rich bastards pay at least the same (though those at $42.5k would start paying more, with $47.5k being enough to make the difference more than 1%, while those millionaires have a fractional percent difference because as I hinted earlier, their tax rate approaches 29%; deductions, off-shore tax fraud/evasion, and sheltering aside).

If we want to move the floor up to say $35k (the current average income) and really flip the flat tax idea around on the rich, then the flat tax has to be about 40.5%, and only those with incomes over $65k would be worse off than they are today (though as you can imagine, the difference would be quite dramatic since there’s a lot of slack to make up in a thin slice of population).

So you can see why I’m against a flat tax: it benefits the well-to-do in almost every incarnation — even when you set the flat tax rate at the current highest marginal rate so that the very rich pay at least the same, you still end up taxing the upper middle class (those below the ultra-rich) even more. And that is not the version championed by the likes of the Fraser Institute — they’d want one with a tax rate closer to 15-20%, which tends to shift the tax burden down to the poor and middle class. I like the progressive tax system, so if I were to make changes, I’d pull out the Ontario Health Premium, and add in another tax bracket on $1 million+. Yes, it only affects a very select few (<1% of the population), but there is definitely a big difference in your ability to pay tax between $200k and $2M.

You can have a look at my work in excel yourself, check me for errors, get more up-to-date or better resolution stats for the model, etc, right here.

Sources:
Federal tax brackets: http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html (plus basic personal exemption of $10k)
Incomes, from Stats Can, and highest few slices from the daily (also, a simpler breakdown from HRSDC).
In my very rough excel spreadsheet, I got about $140 trillion billion for income tax revenue — I figured it would understate things because the stats can data doesn’t even go to the highest tax brackets. I also probably had an overstatement because I was having tax come off even the very low income people at 15%. Then I added in a $1.5k credit to everyone and it looked more realistic, but brought the revenue down to about $100 trillion billion. So, to try to more closely model the actual case, I added a $125k income bracket for which I have no source data — the population at $100k was fudged to get the total tax revenue to come out close! I also assumed that some 10% of those millionaires making over $3M/year would be over $10M, though that didn’t have much of an effect (not enough people). The actual numbers: http://www40.statcan.ca/l01/cst01/govt02a-eng.htm says that there is $133.7 trillion billion of revenue from income taxes (in 2005, which is when the income data is from). One other source of error may be that I looked up the 2009 tax rates, but have 2005 income/tax revenue data.

Edit: I made a billions/trillions error above. The spreadsheet looks like it was ok, it was just my words that failed. Also, another handy link on spending breakdown.

Larry McDonald is back at it with the flat-tax fantasy. Now, in part my hackles get raised whenever anything the Fraser Institute champions comes up, but there are a number of good reasons why a flat tax either will not come to Canada, or if it does, why it won’t be the miracle many hope for.

First off, the government needs a certain amount of revenue for all of its programs. So the total tax grab would have to be the same at the end of the day, no matter which tax system is used, which means that for the majority of middle-class Canadians, their tax bill will not change. Flat taxes are often championed by rich people since whatever the new flat tax is, it will be lower than the highest marginal rate — this naturally means that people in the lower tax brackets will have to pick up the slack. To some, this is fairness. To others (such as myself), it’s not. For a long time we’ve had a progressive tax system, such that there is some point at which you stop paying the government, and the government supports you instead — and that to date has been the Canadian idea of fairness. It’s still possible to achieve that with support systems (direct welfare payments, etc), but then it becomes a little disingenuous to claim to have a simple flat tax system when the reality is that the complexity and progressivity just gets moved somewhere else.

Next, many of those special tax situations and tax breaks are there as incentives to drive behaviour. Just look at the temporary initiatives brought in specifically because of the economic crisis last year: the home renovation tax credit, the 100% write-off of computers, the first-time home buyer’s tax credit, all to get people out spending money. Now, I think that there was far too much focus on the wrong areas of the economy there (real estate, which was the one sector that was already overheated with the emergency interest rates, and computers which are overwhelmingly not made in Canada), but the fact is that they were possible and fairly easy to implement into the existing hodge-podge of tax credits and deductions. And bizarrely enough, people seemed to respond better to saving a little bit of tax on their home reno or bus pass than I suspect they would have if the government had directly subsidized renos or bus passes to the tune of 10-15% — either because the math escapes them (which is a point I need to get to) or because people take more joy from not paying $X in tax than they do in saving $X up front (probably the same reasons why there are huge line-ups whenever the superstore has a tax-free event, when their regular sales often lead to more savings). Again, in a flat tax system these incentives could probably be implemented in a different way, but that’s just moving the complexity elsewhere — a tax-return on a postcard, plus an additional form HRTC-1 to mail in to a different department, and a TCD for your business, and a FTHBTC to fill out in triplicate and send in…

Now, that’s not to say that I think the current system is perfect. I like the basics of the progressive tax system — and indeed, that part is not the complex part of the tax return. You could still have a tax return on a post-card even with a couple of tax brackets. However, the current tax system is very complex. Indeed, Wayfare was lamenting last weekend as we were compiling our taxes and having to stop and look stuff up that “it shouldn’t be this hard for two people with a master’s degree and a PhD to figure out their taxes!!” There is definitely room for improvement. The hard part is figuring out what your net income is after all the deductions and various classes of income (dividend vs scholarship vs T4 vs self-employment vs interest vs capital gains) — the part about then dividing that net income line up and paying tax according to different progressive brackets is trivial. Unfortunately, the most complicated parts for us were in dealing with tracking our adjusted cost base over the years on securities with DRIPs and RoC — which probably isn’t going to go away in a flat tax system unless the government wants to stop considering capital gains as taxable income — and in dealing with what is and is not an expense/deduction for self-employment income. The self-employment issue is going to torpedo this notion that a flat tax would automatically be simpler, because there’s no simple way to implement that unless you start taxing revenue rather than income.

There is a huge amount of room for simplification there too though. For example, Wayfare bought a new business computer in 2009. There were at least four different classes for depreciating a computer (or, “general purpose electronic data processing equipment (commonly called computer hardware)”) which is absurd. I also don’t think that we need to have as many round-about tax breaks for natural resource exploration, such as flow-through shares — drilling for oil and gas is its own reward (and indeed, should be a generator of revenue for the government). On the other hand, the guys at MaRS make a good case for bringing that kind of incentive to medical and technology start-ups.

As we move into the digital age, it may be possible to have the CRA create its own tax software with an interview method like QuickTax, and hide the complexity that doesn’t apply to most Canadians (it would, naturally, have to be open-source so if you wanted you could see where your tax liabilities came from and to optimize your tax situation). Because while I can see a number of ways to simplify the tax code, not all of the web of deductions will go away.

Though there are interesting consequences if they do. Consider one deduction that many average tax-payers take: charitable donations. Much overhead is wasted in charities proving that they’re charities, soliciting donations, in tax-payers tracking their donations, and audits, etc. What if there were no registered charities? Right now, even some of the best charities can only promise that about 80% of your donation will actually go to, for example, medical research. But, I’m a medical researcher. You could give me some money directly and I can guarantee you that 100% of what you give me will go to medical research (I currently study pain and brain imaging applications, but hey, if cancer’s your bag I’m all over it). No more wasting weeks and months writing grants for peer-review funding committees, no more wasting time sitting on said committees (for older scientists, not me yet) — I just need to come up with a pitch geared to the average donating Canadian!