Monday, June 7, 2010

Income Tax Refunds

I recently read an article in which the author suggested (correctly) that if you are due a tax refund, you should file your taxes as soon as possible after the beginning of the year. If you owed income taxes, you should wait until April 15th.

The premise reflects the time value of money. Why leave the money with Uncle Sam when you could be earning interest on it? This is correct as far as it goes, but it misses a larger point.

Why are you getting a refund in the first place? After all, a refund is the government giving you back a portion of the money you provided it as an interest free loan. Sometimes you end up with a refund because of a late-in-the-year event that you could not anticipate: both kids ended up needing braces the day after you fell off your skateboard showing the kids a cool trick and needed knee surgery to repair the damage to your ligaments. The additional out-of-pocket medical expenses gave you a larger tax deduction and as a result you ended up getting money back. (Repairing your pride is not tax-deductible.)

Assuming you have the willpower to keep money in a savings account untouched until April 15th, here’s a better way to handle your taxes.

Complete your taxes for the past year as early as possible (so if you do have a refund you can claim it) and at the same time estimate your taxes for the current year. If you expect them to be more than the previous year’s taxes, then arrange to withhold 100% of your taxes for the previous year. If your taxes for this year are going to be less than last year, make sure to withhold at least 90% of your expected taxes. If you withhold these amounts you will pay the minimum required during the year in order to avoid a penalty for underpayment.

Make sure to periodically add to your savings account the amount you will owe at the end of the year. For example, if your 2009 taxes were $10,000 and you estimate your 2010 taxes will be $12,000, set your withholding to assure you withhold at least $10,000 during the year (say $833.34 a month). To accumulate the $2,000 you will need to pay on April 15, 2011, save at the rate of $167.66 a month.

If you estimate your 2010 taxes at only $8,000, you could withhold as little as $7,200 (making sure to save the other $800 during the year). However, you need to be careful when you use the 90% rule that you don’t accidently underestimate your taxes. If it turns out you owe $8,100 and only withhold $7,200 you will be subject to an underpayment penalty.

If you are employed, you can specify a specific amount for your employer to withhold from each paycheck either by taking a greater or lesser number of exemptions than standard or through adding an additional amount each paycheck. Many HR employees don’t know you can do that, so you might have to educate them.

If, however, you are the kind of person who is tempted to spend the money you should be putting aside to pay for taxes (you know you can find the money later when the taxes are due) then please don’t follow my advice. Make sure to overwithhold your taxes and get the refund each year. You’ll be happier that way.

But if you are disciplined in handling your money, then change your way of thinking about tax refunds now. It hardly makes a difference with the very low short-term interest rates we now enjoy, but they won’t always be the norm. If you change your habits now, they’ll be in place when high interest rates return again.

~ Jim

Friday, June 4, 2010

Shining a Light on the Hidden Costs of Extraction Industries

Weeks into the oil spill in the Gulf of Mexico we still don’t have a handle on what the final cost of the BP disaster will be. Maybe BP is large enough and a strong enough company that it can pay for all the damage. Maybe not. It is clear to me is we need an upfront mechanism for the extraction industries to prefund the possible environmental costs of their extraction.

To take another example, which happens to be closer to my home, Rio Tinto (and their subsidiary Kennecott) plan to open a hard rock (sulfide) mining operation in the Yellow Dog Plains of Michigan’s Upper Peninsula. Kennecott claims they will not pollute the groundwater. Their opponents point to history; no completed hard rock mining operation has NOT polluted the groundwater.

Since the mine will in all likelihood proceed (and until I am willing to give up using the minerals they will extract I can’t in good faith object to mines in general) I think the government should require Rio Tinto to post a multi-billion dollar bond to clean up any and all groundwater or other environmental contamination. If X-years (not being an environmental scientist, I don’t know how long it will take for the pollution to show up) after the mine’s operation there is still no pollution, the government can release Rio Tinto of their bond obligations.

Implementing this program will increase the costs of extraction, which will cause the minerals or oil or gas or whatever to initially cost more. It shifts the burden of the costs to the current users of the extracted material. Under the current regulatory situation, environmental costs are shifted to us years later in the form of Superfund sites, polluted drinking water, ruined saltwater marshes and depleted seafood stock. We always pay for the damage, it is only a question of who and when. I think the costs should be recognized at the same time as the natural resource is utilized.

What if the bond price is too high for one company to afford? They’ll have to form consortia. Big companies develop consortia all the time to share other risks, why not for environmental risks?

If we recognize the environmental costs of extraction while the material is being removed from the earth, we will develop a fuller understanding of the true economic cost differences between (for example) oil versus solar farms. As long as we need to use the natural resources we get from drilling and mining we will have the resulting environmental damage. Let’s be honest about the costs and account for them in a proactive manner.

~ Jim

Wednesday, June 2, 2010

Shoot the Messenger (Germany style)

Haven’t we heard this before? The causes of the Greek debt crisis and the subsequent decline of the euro’s value are the actions of speculators – hedge fund operators, short-sellers and the like.

Folks, the causes of the Greek debt crisis are too much debt, too little income and few prospects of that changing. The euro took a beating because it is only as strong as its weakest member’s finances. To blame speculators for this mess is akin to chastising the little boy who called out, “The King has no clothes on.”

Should the euro fall as much as it has against the dollar? I have no clue; currency evaluation is beyond my ken. However, Germany’s response of banning naked short sales does not solve any problem and will perhaps cause more.

Short selling is the process of borrowing a security and then selling it. Legally, you must at some point buy it back, hopefully at a lower price. As the nineteenth century financier Daniel Drew is quoted as saying, “He who sells what isn’t his’n must buy it back or go to prison.” If you already own the security (but don’t want to or can’t, for whatever reason, sell it) and borrow shares from someone else to sell, that is called a covered short sale. Naked short selling occurs when you borrow and then sell a security you don't already own. The purported idea behind banning naked short selling is that those sales are putting undue pressure on the euro.

All Germany will accomplish is to drive the small percentage of European naked short-selling business transacted in Germany to London, where most is done already. Consequently, the German response will have little economic effect and is merely political grandstanding.

The problem is not short selling. Short sales can help make markets efficient since those who think current prices are too high have a mechanism of backing up their opinion with money. What governments should manage is the level of margin (or leverage) firms can use when they sell short. Leverage got the US investment banks in trouble, not per se the investments they made; they had too little capital when the markets went against them.

So too with short selling. If world-wide regulators set standard margin requirements to assure firms cannot become overly leveraged, we get the best of all worlds. The hedge funds can do what they claim to do best (find mispriced securities and take contrary positions), the markets remain liquid and efficient through multitudes of buyers and sellers and the rest of us are protected against financial calamities when firms take on too much risk.

The lesson governments and regulators should be learning from the most recent financial meltdown (and the one before that and the one before that, ad infinitum) is to manage risk levels. The German action to ban naked short sales does nothing of the kind. If the public lets them off the hook of addressing the real issues, it will only be a matter of time before we have another worldwide economic crises brought on by unmanaged risk.

~ Jim