Steven Engelhardt

Previously, I performed a “big picture” overview of the Federal Government’s reported FY 2006 budget results. Today I would like to look at Federal receipts in more detail. All numbers are from the U.S. Treasury Preliminary Statement of Budget Results for Fiscal Year 2006.

As a reminder, total Federal tax receipts increase from $2,153.3 billion in FY 2005 to $2,406.7 billion in FY 2006. This broke down as follows:

Therefore, the three largest increases in revenue in percentage terms were from miscellaneous receipts (whatever those are), corporate income taxes, and individual income taxes, respectively. The three largest increases in revenue in dollar terms were from individual income taxes, corporate income taxes, and employment and general retirement taxes, respectively.

Whether these revenue increases are one-time events or sustainable trends remains to be seen.

I read a number of stories about the decrease in the U.S. Deficit today, such as this and this ($), and I decided to bypass the imperfect filter of the news media and go directly to the source: the U.S. Treasury Preliminary Statement of Budget Results for Fiscal Year 2006. I decided to ignore any budgetary estimates and deal only with the final numbers. Here’s what I found:

In short, since total receipts went up by $253.4 billion while total outlays went up by $182.3 billion (all figures in nominal dollars), the total federal budget deficit shrank by about $71 billion. Therefore, an impressive surge in total revenues significantly outpaced the growth of total spending, which was still up a fair amount.

While the total federal budget deficit is an important figure, as it tells us how much money the Federal Government must borrow through the sale of Treasury bonds to the public, it is only part of the larger picture. A number of programs (currently, the Social Security Trust Fund and the U.S. Post Office) are separated into their own entity which isn’t considered part of the official federal budget. These programs are called “off-budget”, and the remaining programs are called “on-budget”. There are legitimate reasons for these entities to be put off-budget, and both the on-budget and off-budget budgets (heh) should independently be in balance over the long term. Let’s see what the numbers look like now:

Therefore, $60 billion out of the $71 billion (or approximately 85%) of the improvement in the federal deficit is attributable to an improvement in the state of the on-budget budget. However, the off-budget programs are still subsidizing the on-budget ones to a remarkably large degree. The off-budget surplus is, of course, by design — most of the surplus is from Social Security tax overpayment in an effort to prefund the retirement benefits of Baby Boomers, with the expectation that the on-budget budget will “pay the money back”. To do this, the on-budget budget must transition from the current, $434 billion deficit to a significant (probably around $200 billion) surplus.

In short, the FY 2006 budget news is a welcome improvement largely due to an unexpected increase in on-budget receipts, but there is a very long way to go.

More analysis of the FY 2006 budget to come.

LONDON, Sept. 29 — Politics and worries about oil supplies may have caused gasoline prices to go up at the pump earlier this year, but one big investment bank quietly helped their rapid drop in recent weeks, according to some economists, traders and analysts.

Goldman Sachs, which runs the largest commodity index, the G.S.C.I., said in early August that it was reducing the index’s weighting in gasoline futures significantly. The announcement did not make big headlines, but it has reverberated through the markets in the weeks since and some other investors who had been betting that gasoline would rise followed suit on their weightings.

“They started unwinding their positions, and those other longs also rushed to the door at the same time,� said Lawrence J. Goldstein, president of the Petroleum Industry Research Foundation.

Wholesale prices for New York Harbor unleaded gasoline, the major gasoline contract traded on the New York Mercantile Exchange, dropped 18 cents a gallon on Aug. 10, to $1.9889 a gallon, a decline of more than 8 percent, and they have dropped further since then. In New York on Friday, gasoline futures for October delivery rose 4.81 cents, or 3.2 percent, to $1.5492 a gallon. Prices have fallen 9.4 percent this year.

…

Unleaded gasoline made up 8.72 percent of Goldman’s commodity index as of June 30, but it is just 2.3 percent now, representing a sell-off of more than $6 billion in futures contract weighting.

Timmons, Heather. “Change in Goldman Index Played Role in Gasoline Price Drop.” The New York Times 30 September 2006.

In short: changing the definition of an index (the G.S.C.I.) had significant effects upon the overall market, in that it contributed (at least in part) to the fall in national gasoline prices. (By the way, I can’t help but note that Henry “Hank” Paulson, the current Secretary of the Treasury, was formerly the Chairman and CEO of Goldman Sachs. Then again, so was Robert Rubin.)

While I am a big fan of index investing, this article reminds me of some of my concerns about the strategy.

First, the definition of an index is controlled by a third party, and this third party may make changes to the index at their leisure. Index funds respond to changes in the index definition by reallocating their assets and other investors adjust accordingly. As this article illustrates, changing the index definition has the power to move markets — an enormous power to entrust to anyone.

Second, there is great potential to profit off the market movement which ensues after a index redefinition. Imagine if the third party which controls the index decided to exploit this profit-making potential.

Third, mutual funds (including index funds) essentially force one to abandon their rights as a shareholder, including the important duty of electing the Board of Directors. A multimillionaire mutual fund manager may have a very different idea of what makes a good Board member than do his middle class investors.

Update 2006-10-02 9:52 AM: Reworded a few paragraphs to try to be a little more balanced and have more sensible inter-paragraph transitions.

The rise in popularity of 401(k) plans has revealed that Americans, by and large, fundamentally don’t know how to invest for retirement. People don’t save enough; they’re too conservative (or too aggressive) with their investment choices; they’re too concentrated in a particular asset (or asset class); they leave their 401(k) asset allocation as the default (typically 100% low-yielding money market accounts); they chase performance, etc.

To help people avoid these mistakes, financial companies have developed an alternative: the managed 401(k).

New research shows signs that a recent addition to some 401(k) plans — known as “managed accounts” — can provide a significant boost to workers’ retirement savings.

These programs are based on computer models that automatically manage portfolios tailored to match an investor’s age and appetite for risk. They also take into account any other retirement income they can expect — such as a pension, Social Security earnings, even a spouse’s portfolio.

…

Traditionally, investors in 401(k) savings plans were responsible for making their own investment decisions. But studies have found that too many people do a poor job of it — putting their own retirement at risk. The new managed-account programs are an attempt to fix that by using sophisticated models to make investment decisions on behalf of retirement-plan participants.

…

At American International Group Inc.’s AIG Valic, which has been offering managed accounts based on models developed by Morningstar Inc.’s Ibbotson Associates since 2003, the changes are translating into better returns for investors.

AIG found that for 12 months ended June 30, the average managed account gained 9.35% compared with a 5.36% return on nonmanaged accounts. In part that is because many of their clients can count on pensions, so the managed account puts more-aggressive stock holdings into their 401(k) plan.

Lauricella, Tom. “The 401(k) That Fixes Itself.” The Wall Street Journal 19 Aug 2006: B1.

Setting aside minor concerns about implemention details, this is a very good idea. These managed 401(k) plans provide, in essence, access to a professional money manager — something most Americans sorely need — while allowing the more sophisticated investor the ability to opt out.

Better defined-contribution plan defaults will do much to bulk up the physique of Americans’ scrawny retirement savings.

Many people don’t fully understand the difference between marginal and effective tax rates, which often leads them to incorrect conclusions. News stories almost always discuss the marginal tax rate — the rate one pays on each additional dollar of income. For example:

WASHINGTON — Prospects improved for a major overhaul of the federal estate tax, as key senators moved toward compromise yesterday, and Senate Majority Leader Bill Frist, with one eye on the November elections, said he wants to settle the issue this year.

The likely basis for discussions of a deal would be a proposal unveiled by Sen. Jon Kyl (R., Ariz.) that would exempt the first $5 million of a person’s estate, or $10 million per couple. The remainder would be taxed at two rates. Estates valued at less than $30 million would be taxed at the capital gains rate, currently 15%; anything over $30 million faces a 30% tax.

Republicans enacted a law in 2001 to temporarily phase out the tax. Under current law, $2 million worth of an estate is exempted from the tax, and the remainder is taxed at rates as high as 46%. In 2011, the law expires and the rate snaps back to 55%.

Mullins, Brody. “Estate-Tax Overhaul Gains Ground” The Wall Street Journal. 8 June 2006.

Based on these numbers, one might conclude that while the proposal significantly reduces the tax rate, it doesn’t even cut the top rate in half, so revenues from the estate tax should still be at least half what they were before. This conclusion is, however, almost certainly incorrect. The problem is that marginal tax rates aren’t directly comparable due to the presence of deductions and tax brackets. The effective tax rate — total taxes paid divided by tax base (e.g. income or estate size) — should always be used for comparisons, either on an individual or group basis.

To better illustrate how the two can diverge, consider the following calculation of effective tax rates based on estate size E:

Or, graphically:

As the estate size increases, the effective tax rate asymptotically approaches the top marginal tax rate, and the decrease in effective tax rate approaches the original assumption. However, there is a significant portion of the graph where the drop in effective estate tax rate is far more than 50%. Consider, for example, the drop in effective estate tax rate from 36.8% to 7.5% for estates of size $10 million.

Therefore, depending on the size of the average American estate, the cost to the Treasury of Kyl’s proposal may be far more than one might naïvely presume, due to the divergence of marginal and effective tax rates.

Finally moved to action by a comment on QandO, I decided to go through the history of the Social Security Trustees’ Reports to plot the year that the combined Social Security OASDI trust fund is predicted to expire vs. the year the prediction was made. Here is the resulting graph:

Here are the files I used to generate the plot:

• oasdi-exhaustion.dat: The raw data (created by scanning through past Social Security trustees’ report summaries)
• oasdi-exhaustion.plot: The gnuplot input file which generates the graph

It appears that the Social Security trust fund has been predicted to run out in “about 30 years” for over 10 years straight.

(Yes, I am familiar with the arguments that the Social Security trust fund, isn’t.)

I keep seeing statements such as the following pop up in the news:

And taking general inflation into account, it is slightly cheaper than what motorists paid in March 1981 in the aftermath of the Iran hostage crisis. Then, gas cost $1.41 a gallon, or $3.12 in 2005 dollars.

Hebert, H. Josef. “Q&A: Less oil, costly ethanol; that’s trouble” The Modesto Bee. 26 April 2006.

My immediate observation was that gas prices themselves are a part of the inflation calculation, and this may influence the comparison. I set about to explore this in more detail, and my findings are below.

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