So it’s been a while since we’ve added to the Grand Plan here on the samaBlog. And I’ve had this notion ruminating in my head since the Obamacare decision came down. But I haven’t had the spare cycles to devote to writing this until now. So excuse me if this seems a few months late.

So the Roberts Obamacare decision comes down to this: the power to tax as expressed in the 16th amendment to the Constitution is unlimited, and any objective that cannot be met by using any of the enumerated powers can be coerced of the citizenry by means of the tax code. So while the commerce clause doesn’t give congress the right to compel people to buy insurance, the tax code in effect does.

It goes without saying that this interpretation of Congress’ power to tax, an interpretation which contradicts Supreme Court rulings from the time of the 16th amendment’s adoption, grants effectively unlimited powers to Congress to compel or outlaw whatever behavior it so chooses, so long as it is clothed in the power to tax. Anybody with half a brain can see how such a power is incompatible with the idea of a free society, and can and likely will lead to abuse in the future. And so we ought to propose the tax rectification Amendment, which would read more or less as follows:

The power to tax is limited to raising revenues to enable the federal government execute the enumerated powers given it by this constitution. Congress may not, under any circumstances, require abusive or excessive taxation, or taxes which are which encourage changes in the behavior of the citizenry.

I am not a Constitutional scholar, and I would be open to better wording from someone who has been trained in the art of such things, but you get the drift.

The problem with such an amendment, of course, is that it would not just invalidate Obamacare. It would lay waste to much of the tax code as it currently exists. I am in favor of such destruction, but it seems to me that many in congress are not, especially on the Democrats’ side of the aisle, given their proclivity towards Obamacare (and telling people what to do generally). And so should the Tax Rectification Amendment be rejected, we shall motivate those who differ from us by exercising our newfound powers under the Roberts decision, and enact the Tax Rectification Act. The Tax Rectification Act, of course, is just a series of punitive taxes against hot button cultural items that are adored by the SWPL crowd. I came up with a few ideas off the top of my head. Surely by the time the new congress takes power, we can come up with a mile-long list that will infuriate the left. But here’s my start for now:

• 100% tax on organic produce
• $1,000,000 annual excise tax on food trucks
• $1,000,000 annual excise tax on any restaurant or food establishment that does not serve meat
• $2,000,000 annual excise tax on any restaurant or food establishment that does not serve animal products of any kind
• $1,000,000 annual excise tax on every institution that performs abortions. Couple with a $10,000 excise tax on every abortion performed
• 500% sales tax on any sticker, flag or other item sold with a rainbow on it
• $10,000,000 excise tax on every motion picture produced in the United States
• $1,000 excise tax on bicycle helmets
• $500/lb excise tax on the production and sale of tofu
• $100 excise tax on every bumper sticker produced
• $1,000,000 annual excise tax on medical marijuana dispensaries

I could go on, you get the drift.

But you object, and exclaim, “But Rob, I despise Obamacare as much as you. But I enjoy some or many of these things on this list too. I watch movies, and eat at food trucks, and ride a bicycle..” To which I say: you’re missing the point. The point is not to actually put all these things out of existence, but rather to tell those on the other side that we are willing and able to use this new fangled power in crazy ass ways to destroy the things that you hold most dear. And that the longer you wait on ratifying the Tax Rectification Amendment, the more likely you will reap irreparable damage to those you hold dearest. So Join with us and pass the amendment. Yes you lose Obamacare, but you also gain the assurance that we won’t tax the accouterments of the SWPL lifestyle just out of spite. Indeed, it is designed to give those on the other side a newfound appreciation of why limited government is a good thing. And such an appreciation will only have good consequences over the long term.

At Megan McArdle’s, a commenter writes:

You’ll have a hard time finding any market as highly regulated as mortgages and finance. The idea that a LACK of regulations are a major problem here is laughable. It also comes from this bizarre idea that a lot of people have that there is some “Regulation Knob” that government has control of, and they can turn the knob to the right to “increase regulation” and turn it to the left to “decrease regulation”. This just is not the case at all – there is bad regulation and good regulation. The idea that some people think the solution to all of our problems is simply more rules and more employees at regulatory agencies is bizarre.

In the Rob Sama Grand Plan, Financial Plank:

We have heard a common refrain from the left since the economic crisis hit. The refrain goes that the crisis was due to there being no financial regulation during the Republican years. It was as if a switch had been turned off at some point in the last 8 years, and now it’s time to turn it back on. As if we had a brief experiment with no-holds barred Laissez-Faire Capitalism, and it didn’t work, and now it’s time to return to a more sage time of managed markets.[...]

But that is not to say that the current regulatory regime that we have in place is fine as is. We do need to make changes. But the operative question is: what do we hope that these changes will achieve? To answer that question, we will dispense with the mantra, “Regulation good, markets bad” from the left and the imagined, “Markets good, any regulation at all bad” mantra from the right, and instead set out to determine what it is that we want from our financial regulations, and then set out to make some modifications to our current system to better achieve those ends.

It’s always been strange to me to hear the left refer to the right as anti-intellectual and reactionary, when you hear the left arguing that more regulation, no matter what it is, is always the solution for everything. It’s not bizarre as McArdle’s commenter calls it. It’s idiotic.

I hate to toot my own horn, but here’s what I wrote on this matter back in August of 2009:

Unwind The Mortgage Backed Securities

So the mortgage backed securities are toxic, and have been valued at near zero in many cases, precisely because nobody knows what is in any one bundle of securities. It would seem axiomatic then, to unwind these securities and find out exactly what is in each one. Doing this will have a number of positive effects:

• Homes can be foreclosed upon more readily: This one is simple. If you can see that there are non-performing loans in your portfolio, and there are real, valuable properties backing those homes, then you have a real motivation to get those homes foreclosed upon and resold so as to get a cash return on the non-performing loan. Today, too many homes are languishing unsold or unattended to because the mortgage owner is unclear that he owns the property. Unwinding the MBS takes care of this problem.
• Performing loans can be identified and valued properly: This is the flipside of the point above. performing loans are likely undervalued in today’s environment, and identifying them within the bundled security will allow them to be properly valued.
• Fraudulent securities can be discovered and removed from the system: There is a fair amount of evidence that many holders of mortgage backed Securities were naked short sold them, i.e. they were sold securities that has no loans or mortgages backing them up. This is fraudulent, and those lonas need to be identified and removed from the system, and the parties who issued those loans need to be prosecuted. I’ll have much more to say on this topic in the financial regulation portion of the Grand Plan.

The commonality here is that the bundling of mortgages into Mortgage Backed Securities has hindered proper price discovery, and caused something of a panic in the marketplace. When prices cannot be discovered, people bail, and that is exactly what has happened here. The sooner prices can be discovered, the better off everybody will be.

Once prices are discovered, home owners should be given an opportunity to refinance their homes at the lower principle by buying back their mortgage on the open market. Particularly if the Fed is the current holder of the mortgage. Doing this will enable people to get themselves out from under water, and will recapitalize the banking system. it should be a win win for everybody involved.

So apparently, we now have a situation where not only have the banks been selling mortgages with no property behind them into mortgage backed securities, but we have a system for tracking which mortgage belongs in which security which has no clear legal title to foreclose on those mortgages which actually do have properties backing them. (link via Joan)

I think the solution here is mass mortgage default. Yes, it will cause some major financial institutions to collapse, but they deserved to collapse two years ago, and staving it off only generates moral hazard and leaves our economy in its current zombie state. Better to let people take their homes outright, default on their debts, and recapitalize the economy that way. Doing this will cause a national reset in property values, which is the first prerequisite to getting the economy back on track. Once we’ve done that, maybe we can retire Fannie and Freddie and set up something more akin to what they have in Denmark.

The principal reason why we’re dealing with this portion of the plan so early, and yes, there’s much more to come, is that our President has insisted on pushing this issue to the forefront of his policy agenda. Regardless, in the Grand Plan we tackled issues that are prerequisites to taking on health care reform before tackling the issue itself. In fact, much of the Rob Sama Grand Plan for health care has already been implemented in earlier planks. Didn’t notice that happening? That’s ok, I’ll walk you through it.

But before we begin, we need to state clearly what it is we’re setting out to accomplish. If we act without delineating our goals, we’re not likely to achieve much good. So here goes:

• Stop the runaway cost inflation: Any and every other problem relating to health care is related to the spiraling cost of delivery. Take care of this and most other problems become easy to fix.
• Encourage the development of new medical technologies: Medical advances don’t just happen, and they don’t just happen anywhere. Yet we all benefit from them. Any changes to our medical care systems cannot discourage the development of new medical technologies, whether they be devices, drugs or techniques.
• Address concerns about portability and pre-existing conditions: People are upset about losing health insurance coverage in between jobs, and about insurance companies using the notion of a condition being pre-existing so as to not have to make payments. These are two sides of the same coin and are addressable concerns.
• Stop the looming catastrophe that is Medicare bankruptcy: Medicare cannot continue as is, or it will bankrupt the country. At root a new system needs to be devised for seniors so that their medical care costs do not become an undue burden on the rest of society.
• Retain patient autonomy in decision making: patients and their loved ones ought to be able to make decisions regarding their health without interference from the government.

One thing that it’s important to note that is not a goal is universal or free coverage. Universal, free national health care is not possible or compatible with our earlier stated goals. People’s appetites are unlimited, and where their appetites are limited their tastes are not. As a result, if you make something free, people will consume as much of the highest quality stuff as they possibly can. Unfortunately, while their appetites and tastes are unlimited, our means are not. Therefore, granting free health care to people is a surefire way to go broke. Alternatively, the government can get intimately involved in every healthcare consumption decision, which destroys our earlier goal of patient/doctor autonomy. In short, free health care provided for by the government is simply not affordable and not compatible with freedom.

What’s more, utopias don’t exist. Humans are imperfect creatures and they form imperfect societies. But when utopian promises are made by a society and those promises aren’t kept, invariably a scapegoat is sought, and then the ugliness begins. Putting the entirety of health care under the government’s umbrella puts enormous power in the hands of government. A government that controls whether or not you can receive medical care is a government that can dictate anything to you, whether or not you ostensibly have freedom. For that most fundamental reason, government health care is incompatible with freedom, and thus not a part of the Grand Plan.

If you don’t value your freedom than you’re fundamentally on a different page than I am, and the Grand Plan is probably not for you. For the rest of you who do value your freedom, let us continue.

So why is it we’re not currently achieving our objectives except for new medical innovations? The short and simple answer is that there is a disconnect between he who pays for medical coverage and he who is receiving the service. Virtually never does the patient pay his own bill. Rather, today, the patient has his insurance company pay the bill, and the insurance premium is paid for by a combination of his employer and a deduction taken from his paycheck. Alternatively, it’s paid for by the government if you’re on Medicare. But the point is, it’s never paid for by YOU.

This is a crucial point to grasp. If a good is not paid for by a consumer, then two things occur: the consumer makes no effort to limit his consumption of that good, and he makes no effort to price shop, he only shops for quality. Because human appetites are unlimited, they can literally gorge at the medical trough without even knowing that they’re doing so. Medical bills need to be reconnected to the person paying for the service, and insurance needs to return to its original purpose – to insure against the unexpected.

You will note if you remember in the Taxation plank of the Grand Plan, we eliminated the corporate income tax. This means that corporations no longer benefit from offering health plans to employees. They can if they wish to, of course, but it’s all income to the employee. Over time, most companies will stop offering insurance, and will instead opt to just pay employees in dollars, which makes more sense. This leaves employees to procure insurance on their own dime, in a non-tax subsidized way.

If you think about it, this is no different that the way your car insurance works today. You shop around for a policy that will cover you in case of catastrophe, and you carry that policy with you no matter who you’re employed with. Your policy is priced in part on your driving record, but also on what type of coverage you want. And in most cases, barring some sort of disaster with one’s insurance company, you hold your policy throughout your life. That’s how insurance ought to work.

Because consumers will be paying the bill themselves, they can make an informed economic trade-off as to how much they’re willing to self-insure before insurance benefits kick in. They can choose to pay high premiums for something more all-inclusive, or a lower premium for something with a higher deductible. I strongly suspect that most people will choose a higher deductible. When the consumer puts money away to self insure, there is no need for any special health-savings account or other such paperwork generating nonsense. Simply put the money in an interest bearing account, and it’s assumed to be invested under the Grand Plan tax setup. And when consumers spend their money, they’ll be encouraged to shop on price, as they shop for everything else in their lives. This simple change will encourage health care provides to drive costs down, and provide better service to their consumers, who will now be paying their own bills.

So the changes we’ve already made to the tax code alone, will go an enormous way toward reducing costs in health care. Moreover, these changes will also eliminate problems regarding portability and alleviate problems regarding preexisting conditions. Because you own your own health care plan, you’ll take it with you wherever you go. And consumers will be motivated to keep some form of catastrophic insurance with them throughout their lives. Costs will be lessened, and the price for not doing so may be getting caught without should a medical emergency arise. Yes, some people will wind up getting stuck or take undue risks, not hold insurance, and then get sick. But we’re not seeking an utopia here. The best solution is for people to maintain catastrophic insurance, maybe coupled with unemployment insurance, so that the premium gets financed for the consumer is they’re unemployed for a period of time.

The other thing we’ve done to reduce costs is enact tort reform. Any serious proposal to bring medical costs down must include tort reform, if not begin with it. Though we’re discussing the Grand Plan here, it should be noted that the plan passed by congress and signed by the president does not include any meaningful version of tort reform. It is, in my opinion, an unserious bill.

We should also discuss life insurance here. You may not be aware of this, but currently, the biggest lobby in favor of the death tax, also called the inheritance tax, is the life insurance industry. The reason for this is that when a person wants to pass down a non-liquid asset to his descendants, an asset such a business or a piece of land, he must find a means of paying off the inheritance tax in order to avoid liquidating the asset. In order to accommodate this need, life insurance was born.

However, in a world without an inheritance tax, the need for life insurance diminishes substantially. So let’s repurpose it. Instead of life insurance, let’s call it “End Of Life Insurance”. After all, we all know that somewhere at the end of our lives, we may encounter large, end of life medical expenses. These are not the type of expenses that should be covered by catastrophic medical insurance, because death is inevitable. But the expenses are not necessarily inevitable. So here’s how it would work: you buy end of life insurance, which is available to be cashed in on any time after you’ve reached the average of death, 75 years or so. It’s up to you if you want to spend it on keeping yourself alive, or if you’d rather let your descendants get the money. But the point is, it’s up to you. And like life insurance now, it could even expire after a point, say 95 years of age, if you think you’ve lived a full enough life. The great part about this is that the infrastructure for this already exists. All that needs to happen is for existing policies to be repurposed from being life insurance to being end of life insurance.

There are a few things that do need to be changed to further lower costs beyond what we’ve already discussed in the Grand Plan however. Let’s talk about them now:

Allow Insurance To be Purchased Across State Lines:

As it currently stands, citizens are forced to buy health insurance within their state borders. This is patently absurd. You can get your mortgage from anywhere, hold your retirement accounts across state lines, get credit cards across the country, incorporate in any state regardless of where you reside. So why should ou be restricted to buying insurance from within your state borders?

The problem with this limitation is twofold. Firstly, people who live in small states have a limited number of insurers to choose from. Limited choice will always drive up costs. Secondly, state laws differ as to what insurance plans are required to cover. Some states cover quackery like chiropractic and acupuncture. But if you don’t want those services, why should you be forced to pay for those who do? The easiest way to drive those inefficiencies out of the system is to make the states compete with their laws, the same way that they do with incorporation statutes and lending statutes. That way, you can buy a plan in Delaware regardless of where you live, so long as you like the plan, just as you can incorporate there today.

Roll Back The FDA

The FDA imposes enormous costs on the development of new drugs and devices in the medical field. Approval of a new drug or device can take years. Because patents only last 20 years, this process significantly diminishes the ability of companies to adequately recover sunk R&D costs when selling new products. So the approval process need to be seriously scaled back.

Currently, the FDA tasks itself with two things: ensuring safety and efficacy. But why should the FDA concern itself with efficacy? Does denying a drug to a sick patient because the FDA is uncertain of its effectiveness a smart idea, so long as it has been deemed safe? Does anybody want to spend money on drugs that aren’t effective? Clearly not. Yet the FDA delays letting drugs come to market, using up valuable patent time attempting to do what the market is better able to do more quickly and more effectively. And in the meantime, they’re denying treatments to patients who need it, while they satisfy themselves as to whether or not those treatments are effective. Let patients and their doctors make that determination. There is no need for government intervention there.

Moreover there’s no need even for the FDA to be in the safety certifying business either. Certifying safety is something private licensed agencies can do perfectly well. SImply make the agencies post a large enough bond in case of failure, and let them compete with each other on price and time spent testing. Competition in the safety certification market will reduce costs and time to market, which ought to lower costs across the board, all the while ensuring that new technological advances make it to market in a timely manner. Should a certification company screw up, it can lose its posted bond, or even its license to certify.

Unwind Medicare:

It should be apparent by now that there is little need for government sponsored health insurance for the middle class under the Grand Plan. In old age, most people should still have their own insurance policies, and they should have end of life insurance policies that would cover them with end of life medical expenses, should they choose to incur such medical expenses.

However, in the current time frame, too many people are dependent on Medicare to simply shut it down. But entry into the program ought to be limited, pending implementation of the remaining portions of the Grand Plan. I would support a cutoff of something like 35 or 40 years of age, under which Medicare would no longer be offered. Furthermore, any new entry into Medicare ought to be strictly means tested for those over the cutoff age. In this way, we limit the public exposure to future medical costs. We will likely incur debt to pay off the reminder of Medicare participants, but at least it is capped, and with a growing economy we ought to be able to handle the load.

Government Oversight:

It ought to be acknowledged here that any insurance provider, private or government run, has an incentive to collect premiums and simply to not provide payment when it is required. While it is difficult if not impossible to get the government to police itself, it is part of the normal functions of a proper government to police private industry. To that end, having a specialized agency, either at the state or federal level, enforce insurance contracts and payouts is a proper and desirable function of government. I would also be supportive of a fund established to aid plan participants transition over to other providers should an insurance company go under. However I should also state that I believe that insurance is best handled in a cooperative fashion, where the participants are also the shareholders. It’s how I buy my home and car insurance, and how I would choose to buy my health insurance, were that option available to me.

Recap:

So let’s just recap what life looks like for a consumer under the Rob Sama Grand Plan from a health insurance perspective:

As a consumer, you buy health insurance in much the same way you buy car insurance. You likely buy a high deductible plan, which is competitively priced because it’s competing for your business on a national basis. You self insure for the remainder, and pay ordinary medical costs out of pocket, price shopping in the process, thus further driving down costs. This policy will cover any catastrophe but perhaps have limits for normal, end of life medical costs, For those costs, you carry an “end of life” insurance policy, which will cover a fixed dollar amount, and which can be drawn on after the age of 75 for medical costs should you so choose. Current Medicare subscribers would continue unchanged, but a cutoff ill be instituted after a certain age, with younger people and people of means prevented from entering the system. Medicare is finally wound down some 30-40 years from now.

It goes without saying that nothing I’ve seen in the Obamacare proposal is compatible with the Grand Plan.

During my lifetime, there are three political issues that I remember from my teenage years as being issues then that are still issues today. Those are the poor state of our public education system, the mathematical certainty that our entitlements systems would collapse, and our jackpot justice system. Of these the last one should be the easiest to solve. And it is necessary to solve it before any talk of health care reform.

Philosophically speaking, there are two competing conceptions of justice at work in the United States. The first and older of the two is what’s called strict liability. Which is to say, he who is at fault pays the damage. In such a system, people pay the price for their own stupidity or negligence. The competing theory is what’s called the deep pockets theory of the law, which is to say that because somebody is going to have to pay for the damage that’s been done, best that the party who is most able to pay do so.

The problem with the deep pockets theory, of course, is that it motivates the less than scrupulous to put themselves in situations where they can sue those with the deep pockets for compensation. And not just those with deep pockets themselves such as large companies and governments, but those who are well insured as well, such as individual doctors. Indeed, an entire industry has blossomed around suing such deep pocketed parties. The result has been catastrophic.

One part of any long term answer to this problem is to only appoint judges who rule on the basis of strict liability law. But there’s more to it than that. We need to eliminate the idea that going to court is a potential bonanza. And that requires some structural changes to our current ways of managing tort disputes.

I’m going to propose a few simple reforms, and then walk through how those reforms would have worked in some famous cases.

English Rule – Loser Pays Winner’s Legal Fees

The United States stands alone in requiring everyone to pay for their own leal fees in a civil suit. In most countries, what’s called the English Rule applies, which is to say that the loser pays at least some portion of the winner’s legal fees. This is only natural and just. In the event one party is wronged and goes to court to seek justice, that justice should include the cost of going to court. Likewise, should a party have been dragged into court by a jackpot justice seeker out on a fishing expedition, justice ought to include that his cost of acquittal be paid for by he who is wrongly accusing.

The lack of such a rule encourages legal extortion throughout society. Here’s how it works. Legal extortionist files a lawsuit against MegaCompany. MegaCompany knows that the suit has no merit, and that they’ll win in the end. But legal costs will exceed $3 million to put this to bed. So they offer to settle for $1.5 million, even though they did nothing wrong. Not only is this situation manifestly unjust, but it acts as a tax on all of productive society for the benefit of a class of legal leeches. The only reason why this situation hasn’t been rectified is because our legislators are in hoc to the legal lobby, and have no regard for their constituents.

In any event, you can read much more on the English Rule here. Suffice it to say, this one reform alone would do wonders for ending the system of jackpot justice we’ve created in this country.

Class Action Reform

I don’t object to the existence of class action suits per se, though I spent a long time considering whether or not they should just be done away with. However, I can see how they serve a purpose, when scores of people have been wronged by the same party. Nevertheless, some reform is desperately needed here.

The first step is to mandate minimum damages to be a viable suit. I’ve been “involved” in 2 class action law suits, one of which resulted in getting a coupon and the other in a check for $15. In the latter case, I was not only a customer but a shareholder, so I was literally robbing myself on that one. But in either case, it wasn’t worth it. In neither case did I feel I’d been wronged, or really want a lawsuit to proceed. And when it did proceed, the result was stupid.

So there needs to be some sort of minimum damages per person for the class action to make sense. Without that, this just amounts to lawyers raiding companies on behalf of themselves. So we need a rule that says something to the effect that “If you can’t prove damages of at least $100 per class member after legal fees, then you’ve wasted everyone’s time and you lose.”

Now the objection to this will be, “But the purpose of class action lawsuits are to stop companies from screwing their customers in little ways. If you eliminate any suit where damages are under $100/class member, then what’s to stop companies from behaving badly?” And the answer is, the marketplace. When a business does something small and petty to make me unhappy, I cease frequenting that business. Conversely, when something is industry practice, like the way that a monitor size is measured, I simply learn about it and adjust my buying behavior. I just don’t need class action lawsuits to “help” me, and businesses learn from their petty bad behavior by virtue of losing customers.

The second reform that needs to be made with respect to class action lawsuits is to strictly regulate legal fees, which get paid out only after the minimum $100/claimant is paid. Something like 2.5 hours should be billable for every hour of court time, with a strictly regulated rate per hour. Without a real client to answer to who can fire the attorney or dispute the bills, a fixed rate is the only way to assure there are no abuses with legal fees.

End Punitive Damages

Punitive damages, it seems to me, is a confused concept. Punishment, by definition, ought to be for the state to engage in for violations of the law. Citizens ought not be engaging in it against each other; that is vigilantism. Punitive damages, it seems to me, seeks to legalize a form of vigilantism, or citizens meting out their own punishments.

There are several problems with this. The first is that punitive damages put the plaintiff in the position of receiving a windfall for being harmed, which only serves to encourage him to be harmed, or to not take proper precautions on his own. The second problem with this is that it violates the principle of having no ex post facto law. If something were already against the law, then there would be established and publicly debated fines for violations, and citizens would know before acting what the consequences were. That’s only just. But punitive damages undoes that, in effect creating law on the fly. And that’s unjust.

Take for example the lady who spilled hot coffee on herself after going through the McDonald’s drive through. First off, according to strict liability she’s the one at fault because she spilled the coffee, not McDonald’s. Nevertheless, her contention, and reason for seeking punitive damages, was that McDonald’s served their coffee at unreasonably hot temperatures. But McDonald’s was acting within the scope of the law at the time. And if coffee temperatures needed to be regulated, then the proper method isn’t by creating law on the fly in a courtroom and exacting insane punishments upon the company. The proper thing to do is to legislate a regulation on the maximum temperature coffee can be served in the state.

So to that end I would be supportive of any measure that eliminated punitive damages, and remanded legislative recommendations to the legislature in extreme cases where action needs to be taken. Because the proper way to assure that behavior changes is to change the law.

But at a minimum, if you are going to have punitive damages, then by God put an upper limit on them, and have the proceeds go to the state. Barring that, we will continue to see frivolous lawsuits and an increased cost of doing business if not living as a result of them.

Other Reforms

There are two other reforms that are needed. The first of which is what I’ll call specialist reforms. Basically, there’s too much junk science and other nonsense allowed in today’s courtrooms. Particularly when it comes to medical related lawsuits. A simple sanity check form a panel of experts, appointed as judicial advisors as it were, would alleviate this problem. I envision it as acting as a screen allowing or denying suits from moving forward. Basically, allowing a legitimate medical malpractice claim through, while denying the “vaccine caused my kid’s autism” lawsuit to pass.

Finally, in recent years, lawyers have taken to suing companies for the fact that their stock has dropped in price. This is about the most asinine thing imaginable. as if the proper response to a decline in stock price is to partially liquidate, as if management has control over the markets, as if management should withhold bad news from the public. These types of lawsuits should be eliminated entirely. If you buy stock, you take risk, end of story . If there’s fraud involved, let the state mete out punishment and a bankruptcy judge handle liquidations. If you don’t like the way management performs, sell your stock or vote for different directors.

It’s worth noting that apparently the Democrats are attempting to accelerate required Sarbanes Oxley compliance for small businesses. This is the exact opposite of what I said we should do in the financial regulation portion of my Grand Plan.

Good work guys. You’re turning America into the land of stillborn/aborted IPOs. Maybe we’ll have to take companies public in Canada from now on…

We have heard a common refrain from the left since the economic crisis hit. The refrain goes that the crisis was due to there being no financial regulation during the Republican years. It was as if a switch had been turned off at some point in the last 8 years, and now it’s time to turn it back on. As if we had a brief experiment with no-holds barred Laissez-Faire Capitalism, and it didn’t work, and now it’s time to return to a more sage time of managed markets.

When asked to specify which regulations, exactly, were repealed, the usual fallback is that the ban on bank ownership of brokerages and insurance companies had been repealed by the Gramm-Leach-Bliley Act. But of course, this doesn’t make an ounce of sense, as cross ownership between banks, brokerages and insurance companies was clearly not the cause of our current economic turmoil (as Phil Gramm himself refuted). Government intervention into the housing markets was, which was the subject of my last post in the Grand Plan.

But that is not to say that the current regulatory regime that we have in place is fine as is. We do need to make changes. But the operative question is: what do we hope that these changes will achieve? To answer that question, we will dispense with the mantra, “Regulation good, markets bad” from the left and the imagined, “Markets good, any regulation at all bad” mantra from the right, and instead set out to determine what it is that we want from our financial regulations, and then set out to make some modifications to our current system to better achieve those ends.

So what are those ends that we ought to be seeking out? Let me name the important ones that come to mind:

• Transparency: Investors ought to be able to know what it is they are buying. Basic financial information should not be obscured, and meaningful disclosure should be required.
• Liquidity: The ability to buy and sell financial instruments on the open market should not be hindered more than necessary.
• Price Discovery: In a sense price discovery is the culmination of the above two principles. Investors ought to be able to determine a value for a good or service quickly. In addition, investors ought to be able to quickly compare relative prices across comparable offerings.
• Protection From Fraud: Investors ought to be protected from fraud, to the extent that they can be without being protected from their own stupidity (in other words, some people are so stupid as to seek out fraud, and they cannot be protected by any amount of regulation). I should emphasize here the distinction between this and any attempts to alleviate a buyer from asymmetrical information. Asymmetrical information is the difference in knowledge about a product between the seller and the buyer, namely the one party (typically the seller) always knows more. While transparency can alleviate that problem, it will never fully eliminate it, and eliminating it is not a realistic goal. Fraud, on the other hand, is when the seller uses deception to sell a product, which is an entirely different thing.
• Enable Competition: Competition is what creates redundancy in the financial system. A financial services industry dominated by a few giants creates systemic risk in the event of failure.
• Reward Wealth Creation/Punish Wealth Destruction: This seems obvious, but it isn’t always obvious. Basically, you want to reward good economic activity, and punish bad economic activity, and not the reverse. Business is not a charitable enterprise.
• Align Interests: Interests among financial parties ought to be aligned. An investor ought not worry that the manager of his money has different goals than he has, thereby taking inappropriate risks.

I’m going to break this down into two categories: regulations that effect industry and those that effect markets. In other words, those that effect companies who stock (may or may not) trade on Wall Street, and then again on those who do the trading on Wall Street.

Industry Regulations:

Repeal Sarbanes-Oxley
Sarbanes Oxley was passed by congress in response the Enron scandal, which cost investors billions of dollars. In order to understand just how silly Sarbanes-Oxley is, we first need to understand what happened at Enron.

Enron engaged in a number of highly risky strategies, strategies which had not paid off well for the company. Accordingly, Enron’s upper management engaged in a number of accounting shenanigans to hide what they had done, hoping that later they would be able to, in effect, pay back the losses incurred with future year profits.

Now what Enron management had done was already illegal. What’s more is that Enron’s auditor, Arthur Anderson, caught the accounting fraud. What happened next is rather unbelievable; Aurthur Anderson colluded with Enron management to let the fraud pass for a year, with the expectation that the company would recover in the next year, and then the fraud of the previous year wouldn’t matter. At a minimum, management would have bought themselves a year to fix things, but absolutely, positively they’d need to come clean in the subsequent year.

Of course, this is not at all what auditors are supposed to do.

There are a number of reasons why Arthur Andersen went along with the crackpot Enron plan, but we’ll get to those in a bit. First, let’s look at what the government passed in response to this discovered fraud: Sarbanes-Oxley.

Sarbanes-Oxley does a number of things, including making the CEO sign off on the financial statements as the CFO and the auditor currently do. But the main thing that it does is make a company certify that its internal controls are in order. That means that appropriate approvals are given at every level of an organization for any action to be taken, that all accounts are reconciled, etc. Basically, it’s a bottom’s up approach to ensuring that the assets are protected and that the numbers are right, stopping small missteps and errors at the lower levels of an organization from accumulating into material misstatements.

Do you see the problem here? In response to collusion by executive management with external auditors, the US government (by a vote of 99-0 in the Senate and 423-3 in the House) voted to create a stranglethorn of rules designed to catch accumulated small errors at the lower levels of an organization and did little to prevent a recurrance of what really happened at Enron. This is beyond stupid (as nearly anything that the Senate does by a vote of 99-0 is). Let us enumerate the ways:

1. Congress reached for a grab-bag wish-list of items that the accounting industry had long lobbied for , and just passed them without thinking. The accounting industry wanted these rules because a) it would create lots of work for them to get everybody certified and b) once certified, it would become nominally easier to perform the same financial audits that they had previously performed (and would presumably continue to perform at the same cost).
2. The accounting industry was in large part to blame for this mess, and should not have been rewarded with passage of their wish-list!
3. In response to fraud at the top of an organization, congress passed a law designed to stop it at the bottom. Congress in effect closed the wrong barn door! It really doesn’t get any more stupid than that.

There is a final point that needs to be pointed out with respect to Enron, one that must be completely understood: You can NEVER stop collusion between a criminal and an enforcement agency until well after the crime has been committed. I’m going to repeat that in italics just so it really sinks in:

You can NEVER stop collusion between a criminal and an enforcement agency until well after the crime has been committed.

Consider an FBI agent who decides to collude with the local head of the mob, thus enabling a 30 year crime spree. It’s happened. And while the politician’s instinct is to grandstand and say “We’re going to make sure this never happens again” they can’t actually follow through on such a promise, any more than they could claim to prevent all crime. The best you can do is promise to get to the bottom of it when it occurs, and prosecute fully when it happens.

So the problems with Sarbanes Oxley are that it is inordinately expensive to comply with, it does nothing to stop another Enron, and it rewards the accounting industry that enabled Enron to happen in the first place. Oh yeah, one more thing: its costs are so onerous that it has basically stopped all IPO’s in the United States. So Sarbanes Oxley has to go. Just repeal it. There’s a much better way.

Insurance Instead Of Assurance

The audit industry often refers to what they do as “assurance”. Namely, they validate what companies claim is there and what their activities have been (from a financial perspective). Audit partners are personally liable for their errors, and pay hefty insurance premiums as a result. In fact, the audit industry is the 2nd most sued industry in the country after doctors.

But the whole idea of providing “assurance’” is farcical. It is vague and absurd. Asking anyone to put their personal assets on the line for such a thing is silly, and in the case of most public companies, the assets of an accounting firm’s partners aren’t going to cover the damage from a misstatement anyhow.

Finally, nobody’s interests are aligned in the current setup. The audit partner’s concerns are with keeping the client and keeping costs down. Thus he underpays his field staff, and often gives in whenever he and his client disagree over the results of an interpretation of the accounting rules. The staff, for the most part, just want to do their three years to get certified so they can get out, and they’re not particularly motivated to do their best work because they’re overworked and underpaid. And management has no incentive to get things right because there’s little punishment for getting things wrong.

So here’s what ought to happen: public companies get insurance, and ditch the assurance. Insurance would cover a specific max set of damages, as determined by shareholder vote, with a deductible paid for by management in the event of a material misstatement requiring damages to be paid. Finally, insurance premiums would be based on the quality of the books maintained by management, thus insuring that quality controls are kept, but only in a cost beneficial way.

So consider what this does. Under the Grand Plan, companies will buy insurance as required by their shareholders to cover potential misstatements in the financial statements. This limits trial lawyers from suing for unlimited damages and probably puts them out of business. Insurance companies keep cash on hand to pay out damages should they occur, but management is personally on the hook for a portion of those damages as well (say 10%), incentivizing them to keep the books clean. And finally, one can do a real cost-benefit analysis of when it makes sense to implement new systems controls in vs paying a higher premium in your insurance policy, unlike the current system (under Sarbanes Oxley) in which you must maintain perfect controls no matter what the cost.

I am ambivalent as to whether or not existing insurance companies entered this new business thus hiring the current audit firms to just check regulatory compliance, or whether the current audit firms transformed themselves into insurance companies. But the current system is too costly with too many mis-aligned incentives to remain.

An alternative way to mitigate against collusion between auditors and management that is simpler and likely easier to pass is to require all public companies to change audit firms every 5 years, and perhaps having auditors chosen for publicly traded companies by the exchange, rather than by management. This won’t stop any such collusion within said 5 year time frame, but it would force more auditors to look at a company’s books skeptically when audit firms are changed. Audit firms already do this internally, rotating partners on major accounts every 5 years, but they’re motivated to cover for each other as they are all connected in the same partnership. Rotating actual firms will force questionable accounting practices to light, and do far more to mitigate against what caused Enron to happen than anything in the existing Sarbanes-Oxley law does now.

Fix Financial Reporting

Financial statement reporting and the rules that govern them have completely gone off the rails. In the years that I’ve been working (I graduated from college in 1993 for reference), financial statements have gone from being something that management and investors read, used and looked forward to receiving to something that everyone ignores. Nobody uses them for a few reasons:

1. Complexity: Accounting rules have gotten to be inordinately complex, with footnotes stretching as far as the eye can see. Complexity benefits people who work in the audit industry, who need to assure one’s compliance with said complexity and therefore profit from it, but it benefits no one else. Excessive complexity by definition detracts from transparency as well, and therefore serves the interests of neither management nor investors.
2. Cash Isn’t King: Cash is king to those who make business decisions, but accruals are king to the FASB and those who enforce accounting regulations. This means that the financial statements continue to get cluttered up with non-cash related numbers that management and investors need to adjust to get at what’s really going on.
3. Spaghetti Code: American accounting rules are set by the FASB which, in an attempt to stop any and all forms of accounting manipulations possible, has set up a spaghetti code set of specific rules that become increasingly impossible to comply with. Unlike in Europe, where principles are set forth that are to be complied with using professional judgment, in the United States, every possible scenario is expected to be regulated. Thankfully, the United States is moving over to international accounting standards in the coming years, which should help to alleviate this problem.
4. Relevancy: The FASB is made up of academics from the audit industry, and as academics, they are counting angels on pin heads while ignoring real needs in the marketplace. The principle financial measure that investors (and management) look for in managing a company is what’s called “Free Cash Flow”. Yet there is nowhere in a set of financial statements where one can find a pure Free Cash Flow number, nor is there a standard method of calculating Free Cash Flow stated anywhere in the accounting regulations.

There is a simple solution here. First off, minimize accounting rules that don’t relate to cash items. That goes for anything involving amortization or depreciation, or other oddities such as stock option compensation expense. Second, put a statement of Free Cash Flows in the financial statements, and make sound rules around how to pull one together. Don’t make investors fish through the Statement of Cash Flows and the footnotes to try to pull Free Cash Flows Together. And third, dismantle the FASB and adopt the European approach to using broad principles for accounting standards, drawing o both academics and those with expertise in industry to continue to maintain the accounting rules. Thankfully, it looks like this last part may be coming to pass already.

Corporate Board Reform

Corporate boards, in public companies at any rate, are far too often the friends and family of the chairman, even when the company isn’t majority family owned or closely held outside the trading shares. This is problematic in that these cronies of the company president rubber stamp everything he does, and do not do an adequate job of supervising the activities of management.

There is a simple solution here. First, force disclosure of any ties board members have or have had with each other or with management previously, e.g. “Mr. Smith was a coworker of the chairman at Company X from 1997-2002.” Second, force board members to invest a significant amount of their personal net work into the stock of the company they are overseeing, like 5%. This will align their interests with those of shareholders. And finally, do not let them divest their holdings until say 3 years after they leave the board. This ensures that what they are doing is in the long term interests of shareholders, and is not a short term stunt to suck value out of the company.

Yes, these requirements will make it more difficult to find board members, but that should exactly be the point. Board members shouldn’t serve on the boards of multiple companies where they can’t possibly devote enough energy to overseeing what’s going on. And it will require more individuals to be board members, rather than every CEO serving on other company’s boards in act of reciprocal cronyism.

I want to emphasize that these rules are unnecessary in privately held companies, where shareholders already can influence company management more directly.

Market Regulations:

Re-engineer the SEC

After the whole Bernie Madoff Ponzi scheme broke, I happened to catch an interview with Judge Judy on the television (Larry King I believe). She characterized the SEC’s failure as one of “failing to followup on leads.” Judge Judy is an intelligent woman, yet her characterization was fantastically wrong. It’s a characterization I’ve seen elsewhere too, so it needs to be addressed.

There was no “lead” that he SEC failed to follow up on. It is not like a murder investigation, where some piece of evidence was forgotten in the house and thus the police failed to crack the case. In this instance, the SEC literally didn’t know that a murder had occurred. Madoff hadn’t failed to file paperwork, or done so in a manner that would have or should have raised any red flags. Rather, what happened was that Markopolos, a quant trader who tried to reverse-engineer Madoff’s trading strategy, mathematically proved that Madoff was a fraud and informed the SEC, yet the SEC failed to act. The question is why?

Markopolos proved that Madoff was a fraud mathematically. It wasn’t as if he has some sort of documentary evidence that Madoff was cheating his customers. He didn’t. Rather, he proved using statistics that Madoff’s fund couldn’t be anything other than a Ponzi scheme. So why didn’t the SEC act on it?

Because the SEC is staffed with lawyers rather than mathematicians.

What this meant was that Markopolos was speaking Greek to the SEC (no pun intended), and they couldn’t understand what he was telling them.

In fact, the whole way the SEC is set up is wrong. Currently, the SEC is staffed with lawyers who aspire to work for the Wall Street firms they regulate. That alone is a recipe for disaster. But as we can see from the Madoff example, regulatory compliance isn’t the issue. Most firms, even ones perpetuating fraud, comply with reporting regulations.

In fact, regulatory compliance is best performed by existing audit firms (hired by insurance companies or the exchange, as earlier discussed). Privatizing this function makes a world of sense, as insuring compliance isn’t that difficult a job in the first place. In fact, the way it’s currently performed feels more like a government make-work program than an effective regulatory method.

Consider any website that hosts user-contributed content, like flickr or YouTube. Each of these sites are basically user policed. When someone uploads something inappropriate, pornography or copyrighted material, users flag it for review, and management eventually reviews and determines if the content needs to be removed. That’s the way it should work. But imagine if everything needed to be approved before it went up? That would require a legion of reviewers and would be cumbersome for the preponderance of uploaders, who are trying to play by the rules. It would like the Apple app store, or our current SEC.

Reporting compliance should be outsourced to each company’s audit firm (assurance or insurance). There is no need for the SEC to review any company’s filings before they are made public. Instead, there should be a flagging system for financial report users to request intervention on problematic filings. Flags would be prioritized based on the credibility of the flagger and the size of the problem. A mutual fund manager saying something appears fraudulent would take precedence over a blogger who found a typo. Doing this would enable the SEC to cut back on its legal staff and bulk up on what it needs, an actuarial and mathematical staff.

We need to hire a specific math group at the SEC, staffed by people with real industry experience. In fact, it’s what ought to be the bulk of the SEC investigation group. What they need to do is scour the market for mathematical improbabilities and statistical anomalies. When a guy like Madoff is reporting impossible returns, they discover it and launch an investigation.

Currently, major Wall Street Firms employ math PhDs to write algorithms to scour the market for opportunities to exploit. I say we hire the same PhDs, at the same rates if necessary, to scour the market for fraud. There is no reason why it can’t be done. And it would be a far more productive use of our money that paying SEC lawyers to argue over phraseology in 10-Ks as they currently do now. That adds value for nobody.

Revise Insider Trading And Related Rules

The intent of insider trading prohibitions is to eliminate or at best reduce incidents of people benefiting from asymmetrical information. There are basically two different types of insider trading that goes on, each of which I will address separately: insider trading by those inside a publicly traded company, and from those who are outside said company.

When a manager buys stock in his own company in advance of good news being released, who does that harm? Arguably, the seller of the stock management bought would like to have known the good news that the manager knows, but so what? If he needs to sell he needs to sell. Management, on the other hand, is being properly incentivized to add value to the company. So long as they disclose who they are when engaging in the purchase, the market can make any inferences from the purchase that they will. One should not fear that this incentivizes management to lie, as there are already audit procedures in place to protect against that. No, allowing management to buy stock in advance of good news being released may not be fair, but you can never eliminate asymmetrical information. In fact in this instance, it is better to give management incentive to make good things happen for the company than it is to attempt to eliminate asymmetrical information from the market.

Selling stock is another matter completely. Selling stock in advance of bad news being released to the market gives management an advantage when they have mismanaged the company. That is bad for shareholders. Management should not be allowed to profit for mismanagement. Therefore, a simple statement made at the time of the sale stating the reasons for the sale is all that is required. If management sells stock in advance of an adverse event being announced without disclosing said event in management’s statement, then penalties would be applied. I am open as to the specifics regarding what qualifies as such an event, and how long from the sale date it is disclosed. This is different from current practices, in that management announces they are making the sale well in advance of doing so, and commits to making the sale regardless of what the market is doing at that time. There is no reason to deprive managers from cashing out when times are good should they need to do so for personal reasons.

I should also add that there are currently rules prohibiting management from selling out at the time of an IPO. That rule, in particular, is beyond stupid. Entrepreneurs who toiled to get their stock to an IPO should not be prevented from cashing out a portion of their stock at a liquidity event. Moreover, managers should be incentivized to get the highest price possible for the stock at an IPO to best fund the company and get the highest value for the remaining shareholders. By forbidding managers from selling out at the IPO, you remove that incentive for him to do those things. In fact, if anything, a manager should be forced to sell a portion of his stock at the time of an IPO, to properly align incentives.

Again, ostensibly the reason for forbidding managers from selling stock at the time of an IPO is to prevent fraudulent IPOs. But current audit practices prevent that more than adequately. The current setup, however, encourages shenanigans. I’ll quote myself from May 2003:

So what does this have to do with IPO’s? It has to do with an SEC rule called a ‘lockup’ period. What that means is that for 180 days after an IPO (and some other types of transactions too, like a sale of a company), the management of the company cannot trade their shares on the stock market. In other words, on IPO day, all the shareholders get rich except for the founders and management that got them to the point of IPO.

So think about it. Management, working with investment bankers, spends all this energy determining what the right time is for an IPO, but then cannot benefit from the work themselves. Instead, they must wait for 6 months, when the market may be entirely different than what it is at the time of the IPO. This is manifestly unfair. The ostensible reason for it is to discourage management from taking public companies that have no longevity (boy, that sure worked well in the 90?s, huh?). What in fact happens, is something much different. Imagine this conversation between the CEO of a company about to go public and his banker:

CEO: This is awful. I’ve worked so hard for this long and now I have to wait six months before I can cash out some of my stock too. It’s unfair. Who knows what the market will look like then?

Banker: I hear you. I hear it all the time. I may be able to help?

CEO: Help, but how?

Banker: Well, see, just lower your offering price on the IPO a bit, say 15%? don’t worry, the SEC will just think we’re being conservative? Then, allow me to allocate all the initial shares offered to the public. I have five other companies who are doing the same thing. So while you can’t sell your own stock for 6 months, I’ll give you the opportunity to sell someone else’s stock at a discounted value by allocating their shares to you, to get in on their IPO so to speak. All you have to do is lower your stock price just a bit, so that the rest of us can benefit from the ‘pop’ you’ll receive on the day you go public.

CEO: It’s a deal!

See what just happened? The banker acts as a broker between the managers of different companies, facilitating the transaction that would not have happened were it not for the SEC regulations. Just like getting a bonus for washing the fire trucks. Furthermore, the process has become more muddied, less transparent, and has damaged the ordinary shareholder far more than it would had without the regulation. Now, the average shareholder doesn’t know how much stock management decided to cash out from at IPO time, and is having his stock sold at less than market value with no discernable benefit to him. Furthermore, every time one of these ‘pops’ occurs, the average investor gets jubilant. He develops a psychology whereby he believes that if he can just buy in early enough he can’t lose. So now stocks aren’t just popping 15% or so on IPO day. They’re popping 600% or more. And the banker needs more and more IPOs to feed his pipeline, while companies are more than willing to go public even when they’re not ready, because they know they can cash out right away without anyone really knowing. So the bankers (like Quattrone) benefit while the average Joe gets screwed. Way to go SEC.

So let’s wrap by seeing what would happen in a world without lockups. Management is no longer incentivized to price company stock artificially low, thus no more pops on IPO day. And with no more pops, there’s no more extreme exuberance either. And shareholders can see for themselves if management is dumping company stock, which speaks volumes about what management really thinks of their company. No more under the table freebies from bankers either, as their motive for giving them disappears.

Damn I’m good.

I should point out that the above exchange is already illegal, but that’s not to say it doesn’t happen or didn’t happen rather commonly during the Dot Com boom.

So let’s turn to the other side of the equation, when traders engage in insider trading. again, there are two versions of this, buying or selling on confidential company information, and doing so based on confidential trading strategies. The first should be illegal. If information from inside the company is to be released, it should be released to everyone. There is no incentive to good manage well by allowing cronies of senior management trade on insider information.

The second piece isn’t insider trading specifically, but involves disclosure rules about accumulating more than 5% of a company, and when you have to announce your intentions to buy out a company. Parties should be allowed to collude to accumulate stock without announcing themselves. This is no different than how Walt Disney bought all the land that eventually became Walt Disney World. But rules designed to stop this kind of collusion only serve to entrench incompetent management. Same for poison pill type laws. Stopping acquisition activity, hostile or otherwise impedes capital flows, which is the opposite of our goals here. So open the floodgates and let management be rewarded for good efforts and punished for poor performance.

There is one practice that appears to have been going on that does need to be stopped however. Namely, using analyst reports and crony newspaper reporters to drive down the price of a stock temporarily so that short sellers can benefit. That amounts to a type of slander by the reporters and theft by the short sellers and those activities should be prosecuted as such. I would even support a law enabling shareholders to sue reporters and analysts who publish false or poorly sourced information even without a connection to short sellers being proven. There’s just too many antics going on with business reporting right now, and it needs to be cleaned up.

Enforce Settlement

Counterfeiting stock is and should be, always illegal. There is no circumstance for counterfeiting stock and selling it on the open market, even if you intend to buy it back at some future date. Naked short selling is when someone electronically counterfeits stock, sells it on the open market to someone who doesn’t realize it’s counterfeit, thus driving down the price. Done in enough volumes, the stock price can collapse causing the stock to be de-listed, forcing the company into default on it’s debt covenants after which point it folds.

This is a criminal activity that played no small role in the financial crisis that we have just witnessed. The website Deep Capture has done an excellent job of documenting and reporting on the phenomenon, and I would strongly suggest you read through their site. Suffice it to say, naked short selling is and ought to be a crime.

Unfortunately, the SEC has chosen not to enforce laws regarding naked short selling as of late. As a result, many people have lost confidence in the markets, and this benefits only the short-sellers. What’s worse is the SEC requires a list be published of companies for whom significantly more shares are trading than have been issued, yet the SEC refuses to publish who it is that is selling these shares. It’s criminal. The SEC needs to immediately prosecute those firms who are selling counterfeit shares and force them to buy them back on the open market. People need to go to jail over this. There is just no two ways about it.

Finally, settlement of all trades must happen within 24 hours, no exceptions. Unsettled trades which accumulate to equal more than 1% of a company’s outstanding shares need to result in trading being halted in the shares and the names of those who have sold more stock than they own made public. While I normally would call for respecting the privacy of those who trade stock, I have no respect for those who are in effect counterfeiting shares. So when that happens, a full and public investigation is immediately necessary.

The pre-borrowing rule is a good start, but does not negate the need to expose naked short selling when it is occurring.

Systemic Risk in Banking

So it would appear that we have a problem with systemic risk in the banking industry. And while adopting my housing reforms and eliminating naked short selling will do more to eliminate systemic risk than anything described here will, there are a few things that ought to be said still.

First up is the fact that if a bank really is too big to fail, then it should be broken up by anti-trust statute before anything bad happens. Not that I really believe that any bank is too big to fail. But if we as a country are going to bail our banks above a certain size when they screw up, they they will ALWAYS screw up eventually, because of the moral hazard involved. Better to break up those larger banks into smaller banks first, than have to bail them out later.

Secondly, the best way to ensure that no bank gets too big to fail is to increase the degree of competition in the sector. For years now, retail establishments such as Walmart have wanted to be able to open bank branches of their own within their stores, just like they have pharmacies. Federal laws prevent this. But to my mind a retail establishment should be good at retail of all kinds, including basic depository banking. And Walmart would provide real competition to existing banks, drawing customers away from them, creating more diversity in the marketplace. And diversity in the marketplace, i.e. more players, is what increases redundancy and reduces systemic risk. So why not do it already?

I should also mention that it appears as if the Obama administration wants to attempt to reduce systemic risk by having increasing central authority in the Federal Reserve. This will, of course, have the opposite effect as any mistake made by the central authority itself will generate more systemic risk than any one large bank’s mistakes possibly could. The Obama administration also seems to think that Venture Capital represents a systemic risk, a claim too silly to take seriously. Finally, they seem to want to force private equity firms to open their books to the public, a move which seems designed to pry open proprietary trading strategies, and seems to be more about nosiness and probably spawning tax generation ideas than anything else. Again, dumping reporting or other types of regulation on private equity will do nothing to reduce systemic risk. Far better to go after naked short selling as described above and expose it when it happens. Forcing hedge funds who do legitimate trading to disclose proprietary trading strategies will just put them out of business.

I should point out that while I do have thoughts on monetary policy and the Federal Reserve, they are the subject of another chapter in the Grand Plan.

I should point out in conclusion that the Obama administration has a number of other reforms that have nothing to do with the aforementioned parts of the Grand Plan. ReasonTV does an adequate job of addressing them. Suffice it to say that their “reforms” have little to do with fixing the systemic problems that created our current mess, and if anything are harmful to the operation of the markets. But as the Grand Plan is for me to express my own views and not attempt to refute every other plan that is out there, I’ll leave it to others to address his plans, and to the viewer to choose whether or not to consider them.

I should note that monetary policy will be discussed in a later chapter of teh Grand Plan.

I want to thank Neil Gordon for reviewing this for me prior to its publication.

Postscript: It looks like Obama is going to reveal his own version of finance regulatory reform on Monday. Should be interesting to see how he matches up against what I’ve proposed here.

The housing crisis is the proximate cause of our capital crisis, and while I believe that altering our tax policies will have a more immediate effect on bringing us out of that crisis, we do need to address the proximate causes of the housing crisis if we are to avoid re-inflating the housing bubble.

Back in November I wrote a longish essay detailing the causes of the housing crisis. You should go (re)read the essay to get yourself oriented. But we should briefly enumerate the causes here just to review anyway:

• Local NIMBY attitudes towards building.
• Mortgage interest income tax credit.
• Community Reinvestment Act with its resultant relaxation of lending standards.
• Implicit government guarantees of mortgage backed securities put out by Government Sponsored Entities (GSEs) Fannie Mae and Freddie Mac.
• Non-recourse nature of home mortgages.
• Mark-to-market accounting on performing loans that are not intended to be sold.
• An apparent inability to unwind existing Collateralized Debt Obligations.
• Absurdly low interest rates.

Not all of these elements need to be resolved in order to fix the housing mess, but a number of them do. And we certainly would be better off if we addressed all of the relevant issues. So let’s break this up into two sections: necessary fixes and optional fixes. And I’ll wrap up with some final comments and policy changes which would help accelerate our road to recovery.

Eliminate the Home Mortgage Interest Tax Deduction:

I already covered the general motivation for eliminating all income tax credits and deductions in the tax plank part of the Grand Plan. But I do want to debunk the general motivation for this particular deduction, as it is the driving factor behind so much of our government policy today regarding housing.

The impetus seems to be that it always a good thing for a person to own his own home, that owners have a greater stake in society than renters, and that it is therefore better to have a society made up of home owners over home renters.

The problem with this of course is that it isn’t necessarily true. Germany seems to have a good model set up where people are both renters and good citizens, and of course, there’s nothing to stop an owner from being neglectful about his properties or otherwise being anti-social.

And there are distinct problems with home ownership, which should be enumerated:

1. Home ownership decreases a homeowner’s liquidity. Homes are difficult and time-consuming to sell, and therefore difficult to liquidate in a crunch. Consider that in normal times the inflation rate is 2.5% or so (which is rate at which your house should appreciate) and broker commissions are 5%. Therefore it will take you 2+ years of living in a house just to be able to cover the cash outlay on your real estate commission. That’s a long time to wait to get your money out of an investment, not to mention one that is likely to be larger than all your other investments combined.
2. Homes are expensive to own, and therefore create a lopsided investment portfolio for the home owner. Home owners find it difficult to diversify their investments when owning a home tends to take up over 3x the owner’s annual earnings. This runs contrary to every theory of portfolio management, which tells investors to diversify, or to “not put all their eggs in one basket”.
3. Home ownership limits an individual’s or family’s ability to move. This has two proximate effects: first they cannot quickly respond to changes in the labor market by moving to where labor is most needed; second they become sitting ducks for abuse and excessive taxation heaped upon them by their government. It takes an extraordinary amount of governmental abuse to motivate one to incur the 5% broker costs of selling one’s house and leave town.
4. The poor and the young especially need to be mobile. Poor people and young people, often one in the same demographic, are the ones who most need to be mobile because they are the least likely to have savings. Moreover, they are the group who would most like to be mobile because nobody wants to settle down in a slum or a run-down neighborhood if they can avoid it. Some neighborhoods are meant to be renter’s neighborhoods, and there’s nothing wrong with that. Those occupants should save up and put money down to live in a nice neighborhood when they’re ready, rather than be encouraged to

The mortgage interest tax credit amounts to a tax on those who rent their homes, and renters are people who need to be mobile, are not yet settled with their lives, or are living in neighborhoods in which they do not wish to set roots. Look at it on a surcharge on those people rather than a credit for homeowners, because that’s what it is. Taxing renters for being renters is regressive and encourages people who on their own would not logically enter into a long-term commitment to do so when it would not otherwise make economic sense for them to so do on their own.

Moreover, giving people a credit on their income taxes for their home encourages them to purchase the largest home they can possibly afford, in order to maximize their credit. This leads to all sorts of market distortions, including the rise of so-called McMansions. But it also encourages taxpayers to have extremely lopsided portfolios, putting as much as they can into the home in order to get that guaranteed tax credit, rather than diversify into different investments. This is a risky strategy, and can leave people in a lurch should the real estate market take a turn for the worst, as it recently has.

So get rid of the deduction. It introduces bad market distortions, punishes the poor and renters. There’s nothing wrong with renters, so stop punishing them.

Break up Fannie Mae and Freddie Mac. Fully privatize them.

Any entity two big to fail should be broken up by means of an antitrust lawsuit. That should be axiomatic. But Fannie Mae and Freddie Mac are problematic for reasons other than just being large.

Fannie Mae and Freddie Mac are what’s called Government Sponsored Entities (GSEs). That means these entities were formed by the government and can be taken back over by the government at any time. They are highly influenced by the Federal Government, and Fannie Mae in particular seems to have become a dumping ground for ex-Democrat politicians who are looking to manage social policy and collect an obnoxiously huge paycheck.

As a consequence of their tight relationship with the government, investors viewed Fannie and Freddie backed securities as coming with a guarantee from the Federal Government. This meant that Fannie and Freddie could engage in risky behavior, including outrageous accounting scandals that would have brought down any private company, and still have no trouble selling their securities to the open market. That fact alone created an inherent disfunction, but when congress started directing Fannie and Freddie to purchase the riskiest of mortgages and securitize them to be floated on the open market, that took the disfunction to a whole new level. Now the Federal Government, that’s you and me and the rest of the taxpaying public, was on the hook for the riskiest mortgages on the market. That’s systemic risk on a massive level.

The simple solution here is to divest the Federal Government from any involvement or say over Fannie and Freddie, and to break the two entities up into bite sized pieces, small enough to be owned by private equity firms. That way seasoned managers can weed out the political corruption inherent in these firms, adjust their risk profile to one that makes economic sense (as opposed to political sense to the likes of Barney Frank) and restore a healthy market in mortgage backed securities.

Repeal the Community Reinvestment Act.

Assuming there ever was a need for such a thing, those days are long gone. Financial institutions are more than willing to do business in poorer areas of town, and make mortgages where they make sense. What doesn’t make sense is telling banks to alter their individual risk profiles, or to relax their lending standards below what makes sense to them.

And yet, the current insanity continues. Witness:

East Bridgewater Savings Bank has stood out from the current swirl of chaos in the banking industry. While other banks have been failing, this bank, with $135 million in assets, has not a single delinquent loan or foreclosure on its books. It is not just breaking even, it is making profits.

The bank’s secret to success? The Boston Business Journal reports that it has only made loans to credit worthy borrowers. Shocking strategy, right?

So how have government regulators responded? They penalized the bank with a “need to improve” rating under the Community Reinvestment Act. Out of five possible scores, that is the second worst rating. “There are no apparent financial or legal impediments that would limit the bank’s ability to help meet the credit needs of its assessment area,” the FDIC claimed in evaluating the bank.

Utter foolishness. So our government is going to spend its time punishing healthy banks for making the right decisions and avoiding an irrational mania during the housing boom. If that isn’t considered wrong-headed policy than I don’t know what is.

Repeal the Community Reinvestment Act and leave the healthy banks to grow.

Eliminate Mark To Market Accounting.

This has largely already happened, so I’m not going to spend too much time on it. But basically, the rule made banks state their loan assets on their books at the value that that asset would gain if sold on the open market today. This works fine if the market is functioning properly, but it doesn’t work in a panic. In order to establish a market price, one needs a willing buyer and a willing seller. Mark to Market in essence voids that logic, and says in a world where there is no willing buyer, what’s the highest price one could get? In effect, it makes banks value their assets at firesale prices.

In any event, this has largely been taken care of. I have no issue with disclosing what such a firesale price would be, but surely marking down performing loans to their market value as opposed to the value of their discounted cash flows is needlessly conservative, and throws banks’ covenant and compliance ratios all out of whack for no good reason. While Mark to Market is not the cause of the crisis, it threw fuel on the fire, which was completely unnecessary. Best to leave the rule repealed.

Interest Rates

Currency issues will be dealt with in greater depth in another plank of the Grand Plan. But suffice it to say the Federal Reserve has done a lousy job managing our currency. They repeatedly fuel rapid growth (booms) by means of artificially lowering interest rates, and then when they believe things are getting out of control, they raise interest rates causing a crash (bust). To get us out of the crash, they lower interest rates again, and the boom bust cycle continues. Read a detailed account of this process here.

Today, the Fed has lowered interest rates again, this time to absurdly low levels. Look for this to fuel another boom, this time I predict in green energy. And then look for it to collapse again. Suffice it to say that I believe interest rates need to rise immediately, and that a long term structural change needs to be made in our currency system in order to get out of these boom/bust cycles once and for all.

Unwind The Mortgage Backed Securities

So the mortgage backed securities are toxic, and have been valued at near zero in many cases, precisely because nobody knows what is in any one bundle of securities. It would seem axiomatic then, to unwind these securities and find out exactly what is in each one. Doing this will have a number of positive effects:

• Homes can be foreclosed upon more readily: This one is simple. If you can see that there are non-performing loans in your portfolio, and there are real, valuable properties backing those homes, then you have a real motivation to get those homes foreclosed upon and resold so as to get a cash return on the non-performing loan. Today, too many homes are languishing unsold or unattended to because the mortgage owner is unclear that he owns the property. Unwinding the MBS takes care of this problem.
• Performing loans can be identified and valued properly: This is the flipside of the point above. performing loans are likely undervalued in today’s environment, and identifying them within the bundled security will allow them to be properly valued.
• Fraudulent securities can be discovered and removed from the system: There is a fair amount of evidence that many holders of mortgage backed Securities were naked short sold them, i.e. they were sold securities that has no loans or mortgages backing them up. This is fraudulent, and those lonas need to be identified and removed from the system, and the parties who issued those loans need to be prosecuted. I’ll have much more to say on this topic in the financial regulation portion of the Grand Plan.

The commonality here is that the bundling of mortgages into Mortgage Backed Securities has hindered proper price discovery, and caused something of a panic in the marketplace. When prices cannot be discovered, people bail, and that is exactly what has happened here. The sooner prices can be discovered, the better off everybody will be.

Once prices are discovered, home owners should be given an opportunity to refinance their homes at the lower principle by buying back their mortgage on the open market. Particularly if the Fed is the current holder of the mortgage. Doing this will enable people to get themselves out from under water, and will recapitalize the banking system. it should be a win win for everybody involved.

Optional items.

There are a few items here that are optional. They’re methods that other countries employ in their home mortgage systems, that we may want to consider in our own:

• The Australian System: In Australia, mortgages are not non-recourse, meaning that you can not incur a mortgage and just walk away from the mortgage and hand the house back to the bank. If the house value is less than the amount you owe on the mortgage, you are still on the hook for the remainder. The benefit of this system is that it encourages the borrower to consider the true home value of the home and the risks that they can pay off the mortgage before taking out the loan.

  The other thing they do in Australia is they do not offer 30 year mortgages. Rather, they offer only 5 year mortgages with balloon payments at the end. If you want to take 30 years to buy your home, you refinance 6 times. The benefit to doing that is that it encourages the home buyer to buy less home and stay within his means in order to avoid repeated refinancing costs, and it represents less risk for the bank, making them more able to hold onto the loan themselves, rather than floating it on the open market in a Mortgage Backed Security.

• The Danish System: The Danish system securitizes mortgages and floats them as bonds as they do in the United States, but with a key difference. In the Danish system, the homeowner can always buy back their mortgage on the open market should it be trading at a discount, and present it back to the originating bank as a means of retiring principle. The benefit here is that instead of motivating the homeowner to walk away if the home value declines, the homeowner instead is motivated to buy back his mortgage at a discount, and retire or refinance it, thus avoiding the current problem of massive amounts of foreclosures. The Danish system has been in effect for over 200 years and has worked well, so it may be worth considering.

There are some problems which are strictly regional as well. Local NIMBY attitudes towards building can cause the cost of housing to reach astronomical heights. There’s not much that can be done on a federal level about that, other than perhaps suing local municipalities for unjust takings, perhaps.

And in some areas housing supply got WAY overbuilt. The problem with an oversupply is that is causes the price of housing to crash, which with non-recourse mortgages encourages people to abandon their mortgages, which in turn causes a cascade of failures. But there are also social problems with built but empty houses, namely they become occupied by drifters or they become crack dens. So Something needs to be done.

Holman Jenkins of the Wall Street Journal has suggested literally bulldozing these excess houses down. This would reduce the supply of houses, and increase the prices of existing houses, while eliminating the existence of empty houses that can become occupied by squatters. On the flip side, I’ve seen it suggested that we fast track immigration visas of anyone willing to buy and live in homes in these overbuilt areas, particularly inland California, Arizona, Nevada and Florida. This would make especial sense were we to fast-track highly educated immigrants this way, so that they use their education here and built businesses and the economy here rather than in the country of their origin. Given a choice, I would prefer the fast track to citizenship approach, but regardless, even bulldozing will be better than nothing.

Returning some sanity to the housing market will free up capital used in housing towards more productive ventures and enable proper price discovery so that bankers and investors are no longer afraid to invest. In total, my proposals will reduce the overall cost of housing, without encouraging those who should be renting from buying houses they cannot afford or otherwise should not be locked into, all while removing systemic risk from the system. The losers will be the construction industry and those who bought homes they could not afford, but they were bound to lose sooner or later anyway. But the biggest losers will be the GSEs and their politician masters. And again, they deserve to lose.

Because it would appear that as a country we are most concerned about the economy at the current time, I’d like to start there. There are many facets of economic policy, so let’s start with a big one: taxation. Given that there seems to be some current momentum behind enacting tax reform of some sort on both the right and the left, it seems like a good place to start the Grand Plan.

Taxation was a major facet of the supply sider’s revolution with Reagan’s presidency in the 1980′s, and the issue has been contentious ever since. Walter Mondale wanted to raise taxes and lost in a landslide, and ever since then, the left has attempted to parse the issue as one of fairness, or certain segments not paying their fair share. Unfortunately, intelligent discussion regarding taxes has basically flown out the window some time ago, and what we seem to have today is a “taxes bad” argument from the right and a “class warfare” argument from the left. Let’s try to sort through this a bit and see if we can’t come up with a more intelligent tax policy.

A sound tax policy ought to be governed by a few basic principles. Let’s enumerate them here then see what kind of policy can be derived from those principles:

• Encourage Capital Accumulation: Free market economies, or “Capitalist” economies, in order to work, require capital to be accumulated in order to be invested. Or, to put it more glibly, capitalism doesn’t work without capital. Any tax policy that confiscates capital accumulation retards economic growth. Therefore, a sound tax policy is one that rewards its citizens for investing earnings rather than spending them.
  As an aside, I should distinguish this from hoarding, which is not at all economically desirable. Hoarding, or stashing gold bars in the basement (or some such equivalent), removes capital from circulation, and is tantamount to consumption.
• Economically Neutral: Aside from the forementioned principle of encouraging capital accumulation and investment, any tax policy ought to be neutral as to where one should invest or spend one’s earnings. An economy cannot be centrally planned, and any effort to encourage people to invest or spend in one sector or item over another will eventually result in a misallocation of resources, and a boom/bust cycle.
• Once and Only Once: A tax should be levied once and only once. Earnings should not be subject to multiple taxes. Once a tax is paid, the earnings (and taxpayer) should be free and clear of future taxation on that dollar earned.
• Everyone Must Pay: It is important that everyone in society feel that they have a stake in how government funds are spent. That means that everyone must pay something, even if it is a nominal amount. Systems where some people pay and others don’t will result in the payors being looted of everything they have by those who pay nothing. Best that everybody pay, even if it’s just a token amount.
• KISS: You’ll remember the acronym from high school, Keep It Simple Stupid. Complexity favors the rich over the poor, the connected over the disenfranchised. Plus it costs all of us an enormous amount of money to comply with a complex system. So the simpler a tax policy is, the better it is. Simplicity should be preferred over perfection or absolute fairness. Because complexity is by definition overtly unfair.

Our current tax regime fails on all counts. It does nothing to encourage capital accumulation. Indeed, it taxes capital gains as incurred (and taxes inflation on capital gains to boot), it is unbelievably complex, having approximately 4.8 times as many words as the Bible, it enables large swaths of the population to pay nothing at all or worse, get tax “credits” on taxes they never paid, and is anything but economically neutral.

In fact, our current tax code is economically biased in favor of the highest bidder. Each corporation or constituency who wants a minor exemption carved out for itself lobbies congress and more or less gets what they want. The result is a tax code that favors those with the most money, and is incredibly complex, consisting of a trillion and one exemptions for a trillion and one constituencies. An overhaul of our campaign finance laws will be required to fully ameliorate this problem, but that is the subject of another plank in the Grand Plan.

I don’t need to explain to you how devising a tax code by means of creating exemptions for the highest bidder is completely insane, how it relates to a code of insufferable complexity, how complying with that complexity imposes enormous costs on the economy, costs which would both be better spent as capital invested by private enterprise and as revenue collected by the government. But I would like to briefly explain to you, by way of an anecdote, the enormous psychological cost that such a code creates.

My father was the head of the tax department for a number of Fortune 500 companies during his career. When he was first promoted into that position, in the early 1970′s, he happened to find himself in the elevator with the CEO on the way home at the end of the work day. The CEO, trying to make small talk, asked “So, Bob, do you have any good tax shelters to invest in?” To which my father replied, “Yeah, our company’s stock.” The CEO paused for a moment, taken aback, and slowly nodded his head and replied, “Yeah, you’re probably right.”

My father, of course, did not literally mean that investing in his company’s stock constituted a tax shelter. Rather, what he meant was that you’re always better off concentrating your efforts on how to make money, rather on how to avoid having it taken by the government. But while the former will always yield you more profits at the end of the day, the latter that has an inexorable psychological draw, a draw strong enough to suck in the CEO of a Fortune 500 company. Personally, I’ve seen would-be entrepreneurs spend hours trying to understand the complexities of taxation when they should be growing their business. It’s extremely damaging, and the only way to get people to focus on their businesses is to make the tax code economically neutral.

So having said that, let’s enumerate the Grand Plan tax proposal and then discuss each point individually:

• Eliminate the corporate income tax.
• Tax capital gains as ordinary income.
• Construct one and only one tax code.
• Allow individuals to defer income tax by (re)investing their capital.
• Eliminate death and inheritance taxes.
• Eliminate ALL deductions and credits other than for individual and dependents.
• Everyone must pay at least $500/year.

Ok, let’s take each of these at a time:

Eliminate the Corporate Income Tax:

I really wanted to do an analysis of how many dollars of revenue the Federal Government raises annually per word of corporate income tax code, vs the personal income tax code. I would guess that the difference would be of an order of magnitude, but when I went to attempt a word count on the code, I found it was too unwieldy and spaghetti like to be able to easily break apart the code into the two components. Regardless, the corporate income tax is a bevy of complexity, and it only accounts for 7.5% of the Federal Government’s annual revenue.

Surprised?

Don’t be. From all appearances, the purpose of the corporate income tax code is NOT to raise revenue for the treasury, but rather to give congressmen influence to peddle. Who better to peddle your influence to than to moneyed corporations. And what would you expect after said influence has been peddled? You have a code that is full of holes and isn’t all that effective at raising revenue.

But the corporate income tax code isn’t just insidious because of its corrupting effect upon congress. It’s insidious because it constitutes a double tax on earnings (capital gains being the other tax) and it discourages capital accumulation. A business that is retaining earnings to reinvest in its operations should be encouraged to do so.

But our current tax regime encourages businesses to spend money on any and all expense items possible (meaning not physical plants), including interest payments. In other words, the corporate income tax encourages businesses to finance their operations with debt instead of equity. This may be good for the banking industry, but it isn’t particularly good for business. And we can see the effects of an economy built on debt instead of equity today, namely that in a downturn the debt cannot be rolled over and businesses fail.

Best to eliminate the corporate income tax, and tax distributions made from dividends.

Tax Capital Gains As Ordinary Income (And Adjust Gains For Inflation):

The most obvious way to make up for the loss of revenue from eliminating the corporate income tax is to tax capital gains as ordinary income. There is no reason why capital gains ought to be treated as a special category that receives a preferential income tax rate. Taxing capital gains at a special rate only serves to encourage people do do contortions to get their earnings structured as capital gains.

Moreover, it creates a wedge between the “investor class” and everyone else in that the investor class is relatively immune from changes in the overall tax rates and complexity of the tax code. Investors ought to feel the pinch of tax rates that are raised too high just like everyone else does. Trust fund children ought not be spared from high tax rates. Psychologically, sparing them allows them to live in a fantasy world where tax rates don’t matter. And just in terms of having people pay their fair share, it’s manifestly unfair to exempt society’s richest people from paying the payroll taxes that everyone else has to pay.

So make earnings all taxed at the same rate. What’s earned is earned, and it shall be taxed according to one code.

Finally, capital gains should be adjusted for inflation. People should not be asked to pay taxes on the rate of inflation. Of course, we could eliminate the need for this calculation by having a more stable currency, but that is the subject for a different plank of the Grand Plan.

Construct One And Only One Tax Code

Today’s tax code has become so complex that it has become difficult even to debate about it. For one thing, the Alternative Minimum Tax is beyond obnoxious, both in its intent and its implementation. Requiring citizens to complete their tax compliance calculations twice according to two different sets of rules is not only overly burdensome from a compliance perspective, but it renders tax planning impossible at the margin when people slip from paying ordinary income tax to the AMT. Our principle of KISS demands that the AMT be done away with.

But that’s not all it demands. It demands that we eliminate all distinctions between payroll and income taxes. Today, the right makes absurd claims that the lower classes don’t pay a proportionate amount of income taxes while the left says a disproportionate amount of income taxes goes to pay for defense spending. But both complaints amount to accounting slight of hand. If you were to look at the paystub of the average person paying “no” income taxes, you’d find he is paying a substantial amount in what are called “payroll” taxes, namely FICA and Medicare, etc. Similarly, if you look at the Federal Government budget, you’ll find that social spending easily eclipses defense spending. By splitting up what is taken out of your paycheck into two different classes of taxes, each side is able to make absurd claims about how much money is being collected and spent.

So call all taxes collected “income taxes” because that’s how they’re thought of and that’s how they’re collected. And collect them according to one and only one tax code.

Allow Individuals To Defer Income Tax By (Re)investing Their Capital:

One thing that has always bothered me about the Capital Gains tax is that it amounts to a transaction tax on moving capital. That is stupid, and only impedes proper resource allocation across the economy.

Another thing that bothers me about the income tax is that it is based on income taken in one year. In a progressive income tax system, that means that you get taxed the highest rate when you’re at the end of your career. But that is unfair. One may have skimped out on income for years, slaving away in school, in order to get a high paying job later. That person’s lifetime income may be the same as someone who didn’t go to school, but they are penalized because they are making their money over a shorter number of years.

The obvious way to rectify these problems, while simultaneously encouraging people to put their money to work as invested capital, is to enable people to defer taxes on ANY income invested, and to allow any withdrawal from an investment to be deferred as income so long as the money is reinvested within a short amount of time, say 3 months. This way, individuals can save money up for retirement, school or whatever, and pay taxes only as the money is withdrawn and not re-invested. And they can do this without worrying about paying a transaction tax as they move money from one business to another, or one fund to another.

Oh, and one minor point, investment in land for business purposes would be shielded form taxation so long as the land is actually put to use for a legitimate business purpose, but investing in your primary residence would not be subject to any tax shield. That expenditure would be an after-tax use of cash.

Since I’ve kind of described the basics at this point, let me walk through two examples:

• Bob earns $150k/year, and socks $50k/year away in mutual funds. That is invested capital, so he’s only taxed at the appropriate rate for $100k/year. He reinvests any dividends he receives, and so he pays no tax on those. He owns a house, but receives no tax shield on mortgage interest, nor is his investment in his house viewed as an investment; it’s an expense. When Bob goes to retire, he withdraws $50k/year out of his mutual funds. At that time, he’s taxed as having an income of $50k. Thus his income is smoothed out. He pays taxes appropriate for his lifetime of earnings, and pays as he withdraws capital from the economy to be consumed.
• Jane is a trust fund child, and earns no money in the traditional way. She does not have a job, but spends her days attending sit-ins, rallys and the like. Jane has $5 million in an investment account, from which she withdraws $350k/year, or 7% of her principal. Jane pays tax on her $350k/year at the appropriate rate for that bracket. Instead of paying tax on transactions as her trust fund manager buys and sells investments, she simply pays money on the withdrawls she makes, whether or not there is a gain or loss. If her fund earns more than 7% in a year, she pays on $350k. If the fund earns less, she still pays on the $350k she withdraws. She can, of course, always withdraw less and thus keep her principal amount in check.

In effect, this plan would allow for infinite investing without taxation, so long as investments are not liquidated to be consumed. And that’s the idea: encourage as must investment in the economy as possible so as to generate a maximum amount of economic growth. In effect, we never tax the stock seed, only the crop that is to be consumed.

Eliminate Death and Inheritance Taxes:

Death and inheritance taxes force individuals to liquidate their investments when it would not necessarily make economic sense to do so. This fact alone makes the death tax disruptive to the economy. For this reason alone, it ought to be abolished.

The death tax constitutes a double tax as well. Under the current tax code, all assets being passed from one generation to the next have already been taxed at the time they’ve been earned. And under the Grand Plan system, they will be taxed at whatever point investments being passed down are liquidated (and not reinvested). So taxing the investment just because it’s being passed form one generation to the next constitutes a double tax as well.

The only impetus for an inheritance tax is envy. Envy is a bad reason for any public policy. Tax income once when it’s about to be consumed, and leave capital invested in the economy as long as its owners are willing to let it go to work. Interrupting invested capital amounts to eating stock seed, a foolish proposition in nearly any circumstance.

Eliminate ALL Deductions And Credits Other Than For Individuals And Dependents

This is pretty basic. Keep the tax code simple. Stop trying to influence behavior. Attempting to influence behavior is inconsistent with a belief in freedom, and just causes mis-allocation of resources in the marketplace. Give people a deduction for themselves and their dependents (only because we need successive generations to perpetuate the species and thus society) and leave the rest be.

Everyone Must Pay At Least $500/year

I know Ari Fleisher just wrote a piece on this (just as I was authoring this plank of the Grand Plan) but his justifications are all wrong. It’s not that the poor aren’t paying their fair share (though they may well not be). Rather, it’s just the principle that everyone benefits just from living in the United States, and therefore every able bodied adult ought to pay in a minimum amount, regardless of how the rest of their taxes come out.

Frankly, I don’t care if you don’t even earn any money. You still ought to incur a de minimus tax debt to the government every year. Paying a de mimimus amount makes everyone a stakeholder in society, and incurring the debt motivates one to get up and get to work. I don’t know if $500 is the right amount, that’s not really the point. The point is about social cohesion, and about caring how the government spend money.

Conclusion:

You will note here that I have said nothing about particular rates. That is because congress should manage rates on an annual basis, seeking to generate a small surplus when the country is in debt (namely, for the forseeable future) and otherwise do its best to break even. Whatever rates accomplish that feat are the rates that should be charged, no more, no less. Congress should feel free to manage rates, and refrain from generating an infinite number of exemptions, rebates, refunds and credits instead.

Another thing you may have noticed is that this plan is not functionally all that much different from a consumption tax. So why not just go for a consumption tax, you may ask? The answer is two-fold. Firstly, I fear creating a consumption tax and then having the income tax return, at which point we are burdened with double taxation on a whole new scale. But secondly, I do not think the country really wants a flat tax, as in one rate for everybody. So to reconcile that desire with a consumption tax would involve income tax like calculations anyway, and people applying for tax refunds from the government… in short it would be a mess. And it would be anything but simple for taxpayers. Better to let them withhold based on what they earn less what they plan to stash away, and leave it at that.

Instituting this tax plan would raise the savings rate of the country, make more capital available for investment generally, encourage people to save for retirement, eliminate complexity, reduce corruption on Capitol Hill, and radically reduce compliance costs across the country. It would be more fair than our current system, and be economically neutral, letting the economy allocate resources according to the collective wisdom of the market rather than the political pulls of Washington. The only people to lose out would be those in congress and those who have their ear.

And they deserve to lose out.

I’ve been meaning for some time to get this started, and I suppose there’s no better time than the present. Basically, no politician I’ve seen as of late has been proposing anything close to a coherent policy platform that makes an ounce of sense. The Republicans are off in never land, trying to be Diet-Democrats while Obama is turning into the worst caricature of a hardcore liberal that was imagined by his fiercest enemies before the election.

So I’ve decided to take it upon myself to outline my own policy proposals here on this blog. I’ll take it issue by issue at first, and when I’m all done, I’ll probably combine it all and put it on a page of its own. But for now, I’ll just put it all on this blog. I’ll tag everything as “Rob Sama Grand Plan” so you can follow along.

I should let you know that I am fully aware that none of these proposals have a chance in hell at passing. I’m mostly doing this as an exercise for me and for those who wish to follow along. Think of it as a message in a bottle. Even if the chance of it being found is one in a trillion, it’s worth it to try, given how bad things are going now.

So hop aboard and let me know what you think. I’ll start my first plank of the plan shortly.

UPDATE:

May as well make this page the table of contents for the Grand Plan:

1. Introduction
2. Taxation
3. Housing Crisis
4. Financial Regulation
5. Legal Reform
6. Health Care