Why I like tax-free internal compounding, and why you might (and might not)

Last month I wrote about a range of available non-retirement investment accounts and broke down some advantages and disadvantages of each. When it came to 529 college savings accounts, reader flyernick had some objections to my math:

"On one hand, you’re arguing that at withdrawal, you get to exempt $12000 in gains because of the std. deduction. Then you compare that, 'In a taxable account, meanwhile, you’d owe taxes annually on every dividend and capital gain distribution'. But, you get that same $12000 exemption every year on annual distributions. And of course, 'taxes on the sale of the asset itself' would only apply to (un-distributed) cap gains. Your example here fails to convince me that paying an additional 10% tax 20+ years down the road is a useful strategy."

I want to address flyernick's specific objection and also expand on my logic to show why I think tax-free internal compounding is valuable enough that it's worth paying some amount for under the right circumstances.

529 accounts are uniquely valuable because of the option of tax-free withdrawals

I know my readers have heard this a thousand times already, but let's do a quick rundown of the benefits of 529 plans again:

1. limited, state-dependent tax benefits;
2. unlimited tax-free internal compounding;
3. unlimited tax-free qualified withdrawals.

The state tax benefits are typically not very interesting, but high-income folks in high-tax states should certainly maximize their home-state benefits before contributing to a low-cost plan like Utah's My529 (formerly UESP) or Vanguard's Nevada-based plan.The tax-free internal compounding is a feature shared by 401(k)'s, 403(b)'s, IRA's, and even variable annuities — more on this in a moment.But the ability to make tax-free qualified withdrawals of both your contributions and your earnings turns 529 plans into super-charged Roth accounts for anyone who may ever spend money on anyone's higher education expenses: they have preposterously high contribution limits, no income limits, tax-free dividends and capital gains, and tax-free withdrawals.This is a crime against the American taxpayer, but as long as the crime is being committed for the benefit of the wealthiest people in the country, it would be irresponsible for the rest of us not to join in.

What is the value of tax-free internal compounding?

With that out of the way, we can focus on nickflyer's specific question: what is the value of tax-free internal compounding, and how much should you be willing to pay for it? Let's take two stylized, but true, historical examples.

• Between July 1, 2009, and June 30, 2018, Vanguard Total Stock Market Investor Shares had a price appreciation of about 200%: $100,000 invested at the beginning of the period would have turned into $301,900 at the end of the period, and this appreciation would be tax free under any circumstances, as long as you held your shares for the entire period, since we don't tax capital gains until they're realized. But you also would have received $32,212 in dividends and capital gains distributions, and those would have been taxed along the way. Capital gains tax rates have bounced around a little bit but if you were in the highest capital gains tax bracket (23.8%) for the entire period, you would have owed a total of $7,667 in taxes over the 10-year period. In the lowest long-term capital gains tax brackets, you would have owed nothing on those distributions.
• Between July 1, 2000 and June 30, 2009, Vanguard Total Stock Market Investor Shares had a price appreciation of negative 32%: $100,000 invested at the beginning of the period would have turned into $68,639 at the end of the period. During the same period, you would have received $12,349 in dividends and capital gains distributions, and paid a top federal tax rate of 20%, or $2,470.

Importantly, in these examples it doesn't matter if you reinvest your dividends and capital gains; the taxes are owed no matter what you do with the money.Using the same two time periods, with the same $100,000 invested in the same mutual fund, but with dividends and capital gains reinvested and allowed to compound tax-free, the corresponding final values would be $356,174 and $79,522, respectively. With the investment made in a 529 plan or other account with tax-free internal compounding, the investor has so far saved $7,667 or $2,470 in federal taxes owed, plus whatever rate their state levies on capital gains and dividends.What happens when we try to get the money out of the 529 plan? For the 2000-2009 investor, this is not a problem at all: they're allowed to withdraw their entire balance, including dividends and including capital gains, tax- and penalty-free, because the amount of the withdrawal is lower than the amount of their contribution. The 529 plan "wrapper" has saved them $2,470 in federal taxes with no downside at all (except the opportunity to harvest capital losses). Obviously they'd prefer if their decade of investing had a positive, instead of a negative, return, but that's what you get when you invest at the peak of a stock market bubble and sell at the bottom of a global financial crisis.What about the investor who put $100,000 to work in July, 2009? Sure, they've saved $7,667 in taxes along the way, but now they're facing an account balance that is 72% gains ($256,174 of their $356,174 balance). For simplicity, say they convert their Vanguard Total Stock Market Investor Shares to cash at the end of the period, so they'll face a total of $25,617 in penalties whenever they withdraw that balance: 10% of the gains on the account, plus of course their ordinary income tax rate on the share of the gains they withdraw.Based on our stylized example, we can now easily see four possible outcomes:

• The account falls in value, and non-qualified withdrawals are completely tax- and penalty-free;
• The account maintains its value, and withdrawals are completely tax- and penalty-free regardless of whether they are qualified or non-qualified;
• The account increases in value, and non-qualified withdrawals are taxed and penalized;
• The account increases in value, and qualified withdrawals are tax- and penalty-free.

Only in one of the four cases, where you have an appreciated account with non-qualified withdrawals, does the 529 account have any downside compared to the same investment in a taxable account. In the case of accounts that fall in value or maintain their value, withdrawals remain tax- and penalty-free while dividends and capital gains compound internally tax-free, and in appreciated accounts used for qualifying expenses dividends, capital gains, and price appreciation are permanently tax-free.

Conclusion

I've assembled these facts not to give nickflyer a definitive answer to his question, but to reframe it slightly.A person who has certain knowledge about the future trajectory of the stock market should invest in the stocks that are going to go up the most. In that case, tax loss harvesting, tax-deferred accounts, and other opportunities to game the tax code are a sideshow compared to the business of buying the stocks that are going to go up and selling the ones that are going to go down.But if you have no idea which stocks are going to go up and which are going to go down, then 529 plans give you the opportunity to make lop-sided bets: if they go down, you're allowed to withdraw your principle, your dividends, and your capital gains tax-free. If they go up, you only have to pay taxes and penalties on your earnings, and only for non-qualified distributions. And if you're able to make qualified distributions, your earnings, dividends, and capital gains are permanently tax-free.The 10% penalty and ordinary income taxes levied on non-qualified distributions has to be weighted by the likelihood and magnitude of non-qualified distributions of gains. And as I mentioned in the original post, you can make those odds even more lop-sided by opening multiple accounts and horse-racing them against each other: make qualified withdrawals from the most appreciated accounts, and non-qualified withdrawals from accounts that have fallen in value, maintained their value, or appreciated the least, while all your accounts compound internally tax-free.

Differences between non-retirement investment options

If you're in the right mood, there's something a little bit depressing about the subject of investing: how boring it is. An easy way to think about this is that if you make the maximum contribution to a 401(k) and IRA every year, for 20 years, at the end of that 20 years, you'll be rich. How rich you'll be depends on a lot of factors, but the fact you'll be rich doesn't depend on anything except the steadiness of your contributions and the amount of time they're allowed to compound.$24,000 in annual contributions for 20 years turns into a million dollars at 6.6% APY. If you can only manage 6% APY, it takes a year longer, and at 7% APY a few months less. But all anyone has to do to become a millionaire is max out their 401(k) and IRA contributions for around 20 years.I don't mean to say that's easy. You can't contribute more than 100% of your income to a 401(k) or IRA, so if you make less than $18,500 you can't maximize that contribution (although you can contribute your first $5,500 in income towards both accounts). I'm just saying it's boring. Max out your contributions, wait 20 years, and you'll fall somewhere in the top 10% of households by net worth.The flip side of that fact is that as long as you make your retirement accounts as boring as possible (my solo 401(k) is invested in a single Vanguard mutual fund), you can do almost anything you like with the rest of your money without posing much if any risk to your chances of ending up rich. I've written a lot in separate posts about different kinds of non-retirement investments, so I thought I'd pull those different pieces together in one place.

Taxable brokerage accounts

Pros: no withdrawal penalties, opportunities to manipulate income, cheap or free, $11.2 million estate tax exemption and stepped-up basisCons: taxable (at preferential rates), may affect financial aid eligibility, limited control over dividends and capital gains distributionsTaxable brokerage accounts have two huge advantages and a slew of disadvantages.On the plus side, you can access your money at any time for any reason. It's true you may owe taxes on any appreciated assets, but as I like to say, if you're afraid of paying taxes you're afraid of making money — you only owe capital gains taxes on capital gains, after all. Additionally, simply having a bunch of uncorrelated assets in a taxable account is a tool for managing your tax liability, since you're able to top up your income with long term capital gains in low-income years ("capital gain harvesting"), and sell losers in high-income years to reduce your taxable income by up to $3,000 in losses per year ("capital loss harvesting").The disadvantages are important to consider, however: mutual funds that are forced to pass along capital gains can trigger tax bills even if you don't sell your own shares. Unpredictable dividends can make it difficult to dial in your income precisely, for example if you intend to qualify for premium subsidies on the Affordable Care Act exchanges. If you or your kids are applying for federal financial aid using the FAFSA, you don't need to report qualified retirement savings, while assets in taxable brokerage accounts will reduce your assessed financial need (under some circumstances).One other thing taxable brokerage accounts are perfect for is gambling. If you walk into a Vegas casino and lose $500 playing roulette, you're out $500. If you buy $500 of Enron stock and it drops to $0, you might be out as little as $250, depending on your federal and state income tax situation.

Variable Annuities

Pros: tax-free internal compounding, asset protectionCons: gains taxable as ordinary income, inherited assets fully taxable, very expensive, early withdrawal penaltyI wrote relatively recently about variable annuities so I won't belabor the point here, but one point that reader Justin brought up in the comments to that post is that depending on your precise situation, annuity assets may be protected from creditors in a civil judgment or bankruptcy filing. This is, obviously, not protection afforded to taxable brokerage assets, and I think in certain circumstances an annuity might be worth considering for this reason alone.However, if your primary goal is asset protection, you should first consider shopping around for an umbrella insurance policy, since the management fees and tax consequences of a variable annuity might be substantially higher than the annual cost of comprehensive liability insurance. However, this would not apply if you're contemplating bankruptcy in a state that protects annuity assets from creditors.

529 College Savings Plans

Pros: low-cost, state-dependent tax benefits, tax-free internal compounding, flexible beneficiary designation, tax-free qualified withdrawalsCons: non-qualified withdrawal penalty, contribution limitsLong-time readers know that 529 plans are a crime committed in broad daylight against the American people. But that doesn't mean they can't still be useful. It's useful to think of 529 plans in two ways:

• qualified withdrawals are completely tax-free;
• pro-rated gains on non-qualified withdrawals are taxed as ordinary income with a 10% penalty.

While my main problem with 529 plans is the tax-free transmission of wealth between generations, it's trivial to conceive of an even simpler hack to achieve both tax-free internal compounding and tax-free withdrawals. Since 529 plan beneficiaries can be changed without any tax consequence to immediate (and not-so-immediate) relatives of the current beneficiary, who does not need to be related to the account owner, all you need to do is find a family with a bunch of kids and designate the oldest (or smartest) as the beneficiary of the account.Whenever they have any qualified educational expenses (which, thanks to Zodiac Killer and Republican Senator Ted Cruz, now include up to $10,000 in private and religious K-12 expenses per year), you can issue a qualified, tax-free distribution to the school and be reimbursed by whoever would otherwise pay their tuition.To be clear, this is completely illegal. But if you think that's stopping our plutocrats from doing it, I've got a tax-advantaged infrastructure investment in Brooklyn to sell you.The other reason to consider 529 plans as an alternative savings vehicle is that the penalty on non-qualified withdrawals just isn't that harsh. Here's an example using the 20-year investment horizon I described earlier:

1. Contribute $100,000 to the Vanguard Total Stock Market Portfolio in Vanguard's (Nevada-sponsored) 529 plan;
2. Using a 5% APY average return after fees, in 20 years the account's value will be about $265,000, representing $165,000 in gains, or roughly 62% of the account's value.
3. Assuming a standard deduction of $12,000, you can withdraw $19,354 per year without owing any income tax: 62% of the withdrawal will be taxable as ordinary income and 38% will be a tax- and penalty-free withdrawal of your original contribution. You will, however, owe a 10% penalty on the gains, or $1,200.

In a taxable account, meanwhile, you'd owe taxes annually on every dividend and capital gain distribution as well as taxes on the sale of the asset itself. Under the right circumstances, the 10% "penalty" can be lower than the taxes you've avoided on internal compounding, and over even longer time horizons that's even more likely to be the case.In other words, over long enough time horizons, 529 college savings plans function like variable annuities with substantially lower management fees and expenses, and the opportunity for completely tax-free withdrawals. In Vanguard's case, compare the 0.18% all-in fee for their 529 Total Stock Market Portfolio to the 0.42% for the same portfolio in their variable annuity product. The key point is that the higher management fees and expenses are charged on the entire variable annuity portfolio, while the 10% withdrawal penalty is only charged on the gains in the 529 portfolio.This technique even allows you to replicate the old "horse race" strategy of IRA recharacterizations. Since the gains in each 529 account are calculated separately for the purpose of non-qualified withdrawals, you could open one Vanguard 529 plan invested entirely in the Total Stock Market Portfolio, and one My529 plan invested entirely in the Vanguard Total International Stock Index Fund (and another state's plan invested in the domestic bond market, and another state's plan invested in the international bond market, etc.). Since non-qualified distributions are taxed and penalized on an individual account basis, you would always have the option of making non-qualified withdrawals from the account with the most (or least) gains, depending on your tax situation in a given year.And this, unlike the "sell your 529 plan assets" strategy mentioned earlier, is 100% legal. Hell, it's practically encouraged.

Non-traded investment scams

Pros: high "expected returns"Cons: expensive, illiquid, obviously doomedToday there are a million crowd-funded investment options, from old-school players like Prosper and LendingClub to newfangled bill brokers like Kickfurther. But the investment that most naturally lends itself to crowdfunding is real estate. Real estate is expensive (so you can raise a lot of money), it's illiquid (so you can lock investors' money up for years), and it's opaque (so no one has any idea if you're getting a "good" or "bad" price on the real estate you acquire or the management fees you charge).I have a lot of respect for these scams. They charge huge upfront fees and huge management fees for an investment they have no control over the performance of. Fundrise is one of my favorite examples: one thing you could do if you identified a promising piece of real estate is to take out a loan and buy it. Alternately, you could raise money from a group of investors who would then share ownership of it. But Fundrise has an even better idea: collect money from strangers, issue them unsecured claims on a future stream of revenue, charge your expenses against that stream of revenue, then return their money minus your own healthy share of any eventual profit.If you want to invest in a mutual fund, you ought to invest in a mutual fund. If you want to invest in real estate, you ought to invest in real estate. But if you want to get ripped off by some Silicon Valley dweebs who paid $300 for a graphic artist to design a sleek website, Fundrise is for you.

Rental real estate

Pros: generous tax treatment, stepped-up basisCons: expensive, illiquid, volatileAs a leveraged bet on the cost of housing, owning rental real estate doesn't have any advantages over simply buying a residential REIT on margin. You have all the risks of declining real estate prices, rising vacancy rates, and property damage, and none of the benefits of spreading that risk across hundreds or thousands of properties.All the advantages come from the special tax treatment real estate receives. While you own a rental property, you're allowed to deduct the interest on any mortgage you took out to buy it. You're allowed to deduct the property's depreciation. And you're allowed to sell the property and make a "like-kind" exchange for another property (in the US) without triggering taxes on the sale. Finally, like other taxable assets, your heirs will receive the property with a stepped-up basis, meaning they won't owe taxes on the appreciation of the property during your lifetime.This is especially valuable in the case of real estate if the original owner was deducting depreciation and reducing their own basis in the property: a property purchased for $200,000 whose owner deducted $100,000 in depreciation, but is worth $400,000 when inherited and sold, avoids capital gains taxes on $300,000 that would have been owed if sold during the original owner's lifetime.

Collectibles

Pros: interesting conversation piecesCons: losing all your moneySome people think the problem with "greater fool" assets, whether it's bitcoin, Beanie Babies, or Hummel figurines, is that you'll run out of fools, but I don't think that's quite right. If you try hard enough, you'll likely always be able to find someone, at some price, to take your junk off your hands. The problem isn't finding a fool, it's finding a greater fool — someone willing to pay more for your trinkets than you did.Note that there are strict rules on the tax treatment of hobby losses, so consult a lawyer and/or CPA  (again, I am neither) before starting to gamble in any of this stuff.

Start a business

Pros: preposterous tax advantages, higher Social Security benefits, larger 401(k) contributionsCons: unknownI'm here to promote entrepreneurs and entrepreneurship, so obviously I'm a bit biased. Nonetheless, the advantages of starting a business are undeniable, whether or not you also work as an employee elsewhere.First, if you don't hit the Social Security earnings cap through any other work you do, self-employment allows you to raise your annual contribution and increase the old age and disability payments you're entitled to. For folks who spent a long time unemployed or in higher education due to the late-2000's breakdown in global capitalism, the only way to make up for those missing years is higher contributions during the remaining years before retirement.Second, while your voluntary employee-side 401(k) contributions are capped at $18,500 in 2018 across all your employers and your self-employment, each employer — including yourself — has a separate cap on the amount they're able to contribute to an employer-side 401(k). That means you can take advantage of any employer matching program at your day job and make additional employer-side contributions into a solo 401(k) subject to a totally separate cap.Finally, the 2017 Republican tax heist added an additional 20% discount on the taxable income of many small businesses. This is an extremely confusing topic so, again, consult a CPA if you have any questions about whether your small business qualifies, since certain industries and legal structures are excluded under certain circumstances.

The rhetorical confusion between the administrative and regulatory states

On the occasion of a new Federalist Society nominee to the Supreme Court, I thought it'd be worth explaining a set of issues that are going to repeatedly come before the Court in the coming decades, and explain a confusing set of terms that arises from those issues.

The "Administrative" Procedure Act is about regulation, not administration

The Administrative Procedure Act lays out the rules executive agencies have to follow when creating new, legally binding regulations. So, for example, Congress might pass a law saying the EPA has to regulate pollution of the air and water, and to create corresponding regulations. The Administrative Procedure Act sets the rules by which the EPA is allowed to create those rules.This is, manifestly, a terrible way to run a regulatory state. The EPA has to pretend to collect "input" from anyone and everyone, then they have to pretend to judge the input, then they get to enact the regulation they wanted to enact in the first place.Then the people affected by the regulation get to sue and spend years working their way through the courts arguing that the EPA didn't properly take their input into consideration, or that Congress didn't have the EPA's regulation in mind when they passed the law, or that the head of the EPA wasn't properly confirmed by the Senate, or whatever else the Federalist Society comes up with next week.

Congress ought to pass more, better laws

The Administrative Procedure Act has let Congress off the hook for decades. For example, the entire legal doctrine of sexual harassment has arisen from one sentence in Title VII of the Civil Rights Act of 1964. Instead of passing additional laws specifying what kind of behavior constitutes sexual harassment and what the consequences of it should be, Congress has been happy to let the courts and the Justice Department wander all over the place, interpreting the law however they please.But we know there's a better way. When the Supreme Court threw out Lilly Ledbetter's sex discrimination claim, Nancy Pelosi led Congress in passing the Lilly Ledbetter Fair Pay Act that simply spelled out the legal framework Congress had in mind for assessing sex discrimination claims. If a future Congress wants to assess sex discrimination claims differently, they can pass another law, but it's no longer up to the Department of Labor or the Supreme Court to fantasize about Congress's intentions.

We (still) need a well-functioning administrative state

This brings me to the rhetorical confusion I mentioned above: the Administrative Procedure Act is bad, and in my opinion should simply be repealed, but a regulatory state that is explicitly designed and endorsed by Congress will still require administration.If, instead of the EPA, in consultation with scientists, activists, and lead manufacturers, determining the level of lead that's acceptable in municipal drinking water, Congress determines and sets into law the level of lead that's acceptable in municipal drinking water, people will still have to be employed to administer the law: they'll have to take testing equipment out to Flint, fill up some test tubes, run some tests, and report whether Flint is in compliance or not.Likewise, the so-called "carried interest loophole" is not a product of any congressional action, it's the product of the IRS's interpretation of certain terms within the laws passed by Congress. But even if Congress finally passed a law specifying whether hedge fund management fees should, or should not, be treated as capital gains, the law would still have to be administered by an army of auditors swarming across the nation's hedge funds making sure they complied.

Don't leave it up to the judges

In college I fenced in the foil weapon category, which leaves a lot of discretion to referees. They're asked to determine, in real time, who initiated an offensive action, where on the weapon a defensive move lands, and whether a counteroffensive move is a riposte or a counter-attack. This, naturally, leads to a lot of hurt feelings when you feel the judges don't give your efforts enough credit.But my coach, an ornery old Russian lady, never let me mope about the judges. She told me, "don't leave it up to them." If you leave it up to the judges, you may as well be flipping a coin. If you want to win, make sure there's nothing left for the judges to decide.

The worst equilibrium is a dysfunctional Congress and an amateur judiciary

In the Supreme Court's 2012 hearing over the constitutionality of the Affordable Care Act's individual mandate, the original amateur justice, Antonin Scalia, drew laughs from the usually staid audience when he suggested that Congress should simply pass another law fixing the defects in the original Act.Of course, at that point Republicans had taken control of the House of Representatives, so striking down the Affordable Care Act would have meant another generation of Americans without access to affordable health care.That is, of course, the situation we're being set up for today: a Congress that is so deeply gerrymandered that it's incapable of representing the popular will, and a Supreme Court that stands ready to strike down any legislation that is able to pass through Congress.You don't need to be a Democrat, or a liberal, or a leftist, to appreciate that a country congenitally unable to pass laws governing itself, that turns itself over to executive agencies and then resigns itself to years or decades of court battles over the slightest minutiae of statecraft, is not a country well-suited to addressing the challenges of this or any other century.

Thinking about Vanguard's no-transaction-fee ETF announcement

The finance blogosphere has been ablaze the last week with Vanguard's announcement that they'll be eliminating trading fees on an enormous swathe of ETF's that currently cost $7 to buy and sell. Reducing transaction fees is an unalloyed good for investors, but I think there are some interesting additional consequences of the change to think about.

What's happening

On July 2, Vanguard announced that "nearly 1,800" ETF's would be offered with no transaction fees through the Vanguard platform, beginning "in August."Vanguard already offered its own ETF's commission-free, so this seems like an attempt by Vanguard to move more non-Vanguard ETF trading onto their own platform; folks who used Vanguard to trade Vanguard ETF's, but used a Fidelity or Merrill Edge account to trade non-Vanguard ETF's, like iShares and SPDR's, may be tempted to move more of their assets into a single Vanguard brokerage account.

Aside: Why ETF's?

People who invest in taxable accounts sometimes prefer ETF's to mutual funds because when mutual funds see investor redemptions they're sometimes forced to sell their underlying holdings and pass along any accrued capital gains tax liability to the remaining shareholders, while ETF's use a financial engineering process called "creation and redemption" to avoid passing along capital gains to shareholders. I don't think this is very interesting but people who distribute ETF's think it's incredibly interesting, so I want to make sure you're aware of it.

This could be a Robinhood-killer

I like using the Robinhood iPhone app to trade individual shares of stocks and ETF's without commissions. But with commission-free ETF's through Vanguard, there's no reason to use Robinhood to buy and sell those shares, so Robinhood will get a smaller percentage of my recreational trading business [Disclosure: I own one share each of WisdomTree's DHS, iShares' QAT, ERUS, and TUR, and two shares of Cambria's TAIL].Robinhood has two key problems as an investment platform: it only offers taxable brokerage accounts, and it doesn't offer the benefits of a full-service taxable brokerage account. While Vanguard allows you to easily identify specific shares for sale, making it possible to harvest capital losses in some years, gains in others, or both to offset each other, Robinhood just doesn't have that functionality, at least not yet.On the flip side, while Vanguard's full-service taxable brokerage platform makes it easy to maximize the tax benefits of price fluctuations, they also charge transaction fees for non-Vanguard ETF's, meaning every time you harvest a loss or gain, or simply make a periodic contribution to a non-Vanguard ETF, you're surrendering some of the benefit of the platform back in transaction fees.

Using Vanguard as your primary taxable brokerage account is going to make more sense

While Vanguard offers a wide range of ETF's, understandably they don't offer very many overlapping, tightly correlated ETF's, which is one of the fundamental principles of tax-loss harvesting.When you sell an asset in a taxable account that has declined in value, if you want to maintain exposure to the asset class, you need to find a not-substantially-identical asset to buy in order to avoid the "wash sale" rule. But within a single fund family, those are relatively rare. Vanguard offers VTI (Total Stock Market) and VOO (Vanguard S&P 500), for example, but they don't offer a foreign total-market and foreign large-cap ETF, or emerging market total-market and emerging market large-cap ETF.What the addition of no-transaction-fee non-Vanguard ETF's brings is the ability to do far more such matching trades in taxable brokerage accounts. For example, the Vanguard FTSE Emerging Markets ETF (VWO), as you'd expect, tracks the FTSE emerging markets index, while the iShares MSCI Emerging Markets Index (EEM) tracks the MSCI index. The main difference is the exclusion of South Korea in the former and its inclusion in the latter. Since they're not substantially identical (South Korea's a big country!), they make a great tax loss harvesting trade.I don't think taxes are that interesting so I don't think you should spend too much time obsessing over this stuff, but for those who are willing to put in the work these fee-free transactions potentially offer a lot of opportunities to harvest losses during choppy markets without the friction of transaction fees.

Vanguard doesn't offer custodial services to advisors

One reason folks in the finance world have been spilling so much ink over Vanguard's announcement is that Vanguard doesn't have a full-service custodial platform for financial advisors, which creates a dilemma: in order to take advantage of opportunities to harvest losses and rebalance portfolios, advisors want to have a full-service trading platform, but in order to best serve their clients, they also want to have a low-cost trading platform.There's no one right solution to this problem, but hopefully Vanguard's aggressive move will encourage the existing custodial platforms to lower or eliminate trading fees for ETF's on their own platforms.

No-transaction-fee ETF's in qualified retirement accounts

So far I've been talking about the tax benefits of access to more no-transaction-fee ETF's in taxable brokerage accounts, but of course most people have the majority of their financial assets in qualified retirement accounts where things like capital gains distributions and tax loss harvesting are irrelevant.In those accounts I think there's opportunity for both mischief and profit. If no-transaction-fee ETF's cause people to buy too many, too-expensive ETF's from too many issuers, they're going to end up with something that looks a lot like the market's performance, minus the additional expenses paid to their menagerie of funds.On the other hand, if investors want to pursue a specific investment thesis, or execute a specific hedge, in their retirement accounts then being able to do so without the friction of transaction fees could save them tens or hundreds of dollars per year.

Conclusion

To be clear, lower transaction fees are an unalloyed good, for the obvious reason that transaction fees cost money, and the more money you spend on transaction fees, the less money you have left afterwards.But whether you, in particular, should be jumping all over no-transaction-fee ETF's starting in August instead of making steady contributions to a portfolio of low-cost mutual funds depends on your specific situation.In other words, just because you can trade for free doesn't mean you should trade for free.

Distinguishing between falsifiable and non-falsifiable claims

Right-wing troll Ben Shapiro has a cliché he deploys whenever he's confronted by someone who disagrees with his particular brand of snarky malevolence: "facts don't care about your feelings." Of course, what Ben means is that his feelings don't care about your facts. If Ben feels you're wrong, then you're wrong regardless of the evidence you provide, and if Ben feels he's right (he usually feels he's right) then he doesn't need to provide any evidence at all.I think a related, but far more productive, distinction is that between falsifiable and non-falsifiable claims.

A falsifiable claim is not a fact, but it's fact-curious

There are lots of kinds of falsifiable claims, but what they have in common is that there is some piece of information that you can more or less objectively determine in advance would make the claim false:

• If you had only ever seen trees that lose their leaves in the winter, you might claim "all trees lose their leaves in the winter." This is falsifiable because discovering a tree that does not lose its leaves in the winter would make the claim false. After encountering a pine tree, you might adapt your claim to "all leafy trees lose their leaves in the winter." After encountering a palm tree, you might adapt it further to "some leafy trees lose their leaves in the winter; others do not." Even if you never encounter an evergreen tree, however, you can acknowledge that the existence of an evergreen tree would disprove your initial claim. The falsifiability is an intrinsic feature of the claim, separate from its truth value.
• Famously, the claim that "all swans are white" is falsifiable because you know in advance that the existence of a black swan will render the claim false — whether or not you ever find out black swans exist.
• The claim that immigrants to the United States are violent criminals is falsifiable because you can collect data on the number of crimes committed by immigrants and see if that data shows immigrants commit fewer crimes than native-born Americans, or that communities with high populations of non-native-born residents have lower crime rates than communities with low populations of immigrants. Again, the falsifiability of the claim is not dependent on whether it is false or not, but rather that there is some piece of evidence that you can acknowledge, if it existed, would prove the claim false.

Non-falsifiable claims are the ones that really motivate people

Ben Shapiro's formulation juxtaposing "facts" and "feelings" sounds reassuring, but there's a fundamental problem: while falsifiable claims have a sturdy scientific logic to them, falsifiable claims don't, in fact, motivate anyone's actions. That's because at the bottom of most falsifiable claims is a non-falsifiable claim that no evidence can cause a person to reject or modify. Global warming denialism follows this pattern:

1. the Earth isn't warming (falsifiable);
2. the Earth is warming, but it's not the result of human activity (falsifiable);
3. the Earth is warming due to human activity, but it's actually good (falsifiable);
4. the Earth is warming due to human activity, it's bad, but there's nothing we can do to stop it (falsifiable);
5. even if we could stop it, I don't want to (non-falsifiable).

In this case it's obvious that the more time is spent arguing over the details of #1 through #4, the less time is spent dealing with the core, non-falsifiable claim in #5.

Engaging non-falsifiable claims can lead to meaningful solutions

To come around full circle to our friend Ben Shapiro, a particular obsession of his is with the existence of "biological genders." Now, people who study these things for a living will tell you that "biological gender" is an oxymoron, since gender, like race, is a social construct. Even worse, biological sex isn't even binary!But this is making a fundamental mistake, confusing falsifiable claims ("there are two biological sexes") with the non-falsifiable claims that actually motivate Shapiro: "I feel threatened by the increasing visibility of non-cisgender-people." This is illustrated in possibly one of the greatest Shapiro tweets of all time:"If you whip out your female penis next to my small daughter in a ladies' room, I don't care what you think you are."What's going on here? Does Ben Shapiro understand how restrooms work? The idea of treating this as a falsifiable claim is making a basic category error. The grievance has nothing to do with bathroom logistics, it has to do with Shapiro's fundamental insecurity in a world he doesn't recognize or understand (I don't mean this as a defense, Ben Shapiro isn't even two years older than me and I'm not a transphobe so I don't know what his excuse is).Recognizing people's claims as non-falsifiable is treated by ideologues like Shapiro as a way of dismissing them ("feelings"). Unfortunately, we often don't have that luxury in a country we have to share with one another. Once you recognize that you don't have to change people's minds to reach compromise, however, you can sometimes identify solutions acceptable to everyone.For example, the frenzy in certain conservative circles over restroom access for trans people can't be resolved by convincing conservatives of the dignity of trans people. But (as any late bloomer can tell you) you'd find support among liberals and conservatives alike for replacing open changing rooms with private changing and showering cabins at American middle schools and high schools.Likewise, equalizing federal treatment of highway and public transit funding doesn't require convincing anyone to believe in anthropogenic global warming, but would do an enormous amount to reduce US greenhouse gas emissions.This approach doesn't require anyone to admit they were wrong, which of course is a drawback to conservatives who want to destroy human civilization in order to own the libs and to leftists who want conservatives to acknowledge the dignity of their fellow man. But it has the advantage of sidestepping the non-falsifiable claims each side holds dear.

People rightly put values above facts

You can disparage non-falsifiable claims as "feelings," but it's much more accurate to describe them as values. Values are the things that motivate us in the complete absence of evidence. Fox host John Stossel thought he had a pretty good stunt dressing up in a fake beard and begging for money on the street to prove that #actually panhandlers have it pretty good. And indeed, what does cause a person to give money to a panhandler without insisting on seeing audited tax returns for the previous 5 years?Well, values do. And when values are really, fundamentally in conflict, we should have long, drawn-out, bitter battles over our values. If you think immigration causes crime, we can talk about the evidence. If you think immigration lowers wages, we can talk about the evidence. But if you think the United States is and ought to remain a white ethnostate, immigration is an issue we'll never agree or compromise on.

Conclusion

I find this framework helpful, so I thought I'd pass it along. A lot of public disagreements take place at the superficial level of falsifiable claims: how many Pinocchios does this or that Trump tweet get? But people, rightly, mostly don't care about the truth of their falsifiable claims. They care about the truth of their non-falsifiable claims — their values.Shall we preserve the habitability of the Earth for future generations? Shall we spare immigrants the cruelty of family separation? Shall we honor Confederate as well as Union generals? Shall we privilege religious objections to non-discrimination laws above racist objections to non-discrimination laws?These are not questions that have answers you can find if you just dig deep enough into the scientific literature. They're questions about how a person should be. There are opportunities to finesse some of these controversies, while others must be engaged to the best of our ability, not in the interest of convincing those who don't share our values, but for the sake of activating the consciences of those who do.

What if low US labor force participation is driven by low US labor standards?

There is no cliché more beloved by chin-stroking observers of The West than the "sclerotic" labor markets of Western Europe.

• France is of course the most notoriously sclerotic labor market;
• but Spain hasn't dodged sclerosis either;
• and even our Anglo-Saxon brethren in the United Kingdom have a certain sclerotic tendency.

There is a problem with this diagnosis, unfortunately: all three countries have higher labor force participation rates than the United States.

Sclerosis is a stiff metaphor for high labor standards

Sclerosis is such a weird metaphor that I won't belabor its exact definition, except to say that it primarily means labor protections in excess of those in the United States, which is the only example ever used of a "non-sclerotic" labor market among industrialized countries. So, the United States:

• has a minimum wage that is a lower percentage of the median wage (35%) than any other OECD country;
• has no guarantee of paid sick, parental, or vacation leave for the vast majority of workers;
• has a workforce primarily composed of "at-will" employees who can be fired for any reason, or no reason at all;
• has an extremely low level of private sector collective bargaining;
• and allows employers to force employees into private arbitration to settle workplace disputes.

In other words, any country with a generous minimum wage, paid leave, restrictions on terminating employees, high levels of unionization, and a vigorous enforcement of workplace protections, by definition has a more "sclerotic" labor market than the one in the United States.

What keeps people out of the labor market?

It's possible, of course, that the higher labor force participation of the French, Spanish, and British populations is a result of some national characteristic so powerful that it overcomes the sclerosis of their labor market and causes people to seek work despite the labor market's shortcomings.But an alternate explanation I'd like to advance is that the high, uniform labor standards of Western Europe encourage labor force participation because of their height and uniformity.There are a few reasons this might be the case. First, due to our workplace-based benefits system, it's genuinely unclear to workers in the United States whether they'll be better or worse off if they move from our federal single-payer Medicaid program for low-income households to a workplace-based health insurance plan with co-payments and deductibles or to a state-based Affordable Care Act exchange. It's not just rational, it's correct for a low-income person with expensive health care needs to stay out of the labor market in order to avoid accidentally falling into a vastly more expensive health care plan.Likewise, the strict eligibility conditions built into the federal Family and Medical Leave Act mean that a person who is pregnant or planning to become pregnant is perfectly rational in staying out of the labor market, knowing that there's no chance they'll be eligible for (unpaid) family leave after giving birth.

What if people who are confident of fair treatment are more likely to join the labor force?

Media coverage of the US labor market is confusing because there are two equally confident, contradictory assertions made about it:

• there is a critical shortage of unskilled labor;
• and there is a critical shortage of skilled labor.

You could imagine each of these conditions being true. It might be that too many people are learning too many specialized skills that make them unwilling to perform unskilled labor. It also might be that not enough people are learning enough specialized skills, making them unable to perform skilled labor.But the fact that the labor force participation rate in Spain, France, and the United Kingdom are 5-6 percentage points higher than those in the United States makes me think a much simpler process is at work: people who expect to receive fair treatment at their places of work are more likely to seek out work than people who are certain they'll be mistreated at their places of work.

Conclusion

Whenever I read about a business owner complaining they "can't" find employees, I'm always the first to ask whether they've tried paying more, and I think it's a good and right question to ask any employer who thinks they're being held back by some force outside their control instead of the force directly within their control: the wage they pay.But if there is any truth to the claim of "labor shortages," that truth lies squarely in the fact that the United States has made labor conditions so miserable, so unappetizing, that plenty of people who might work under more appropriate conditions simply have no interest in working under the conditions that actually exist in the United States.They have smartphones in France, they have video games in Britain, they have pornography in Spain, but all those countries have somehow managed to entice much more of their working-age population into the workforce.That makes me think it might be time to introduce a bit of sclerosis here, as well.

Means-testing and the real marriage penalties (wonkish)

For decades (at least as long as I've been alive), people have used the expressions "marriage bonus" and "marriage penalty" to describe what happens to the income tax liability of a couple before and after they formally wed. But focusing attention on changes in income tax liability has resulted in a totally inadequate amount of attention being paid to the actual marriage penalties faced by low-income people considering marriage.

The classic marriage "bonus"

Consider two people, one of whom has an IRS form 1040 line 22 total income of $100,000 and one of whom has a line 22 total income of $0. With no other adjustments, in 2018, their combined income tax liability would be $15,410: the high-earner would pay income taxes on an adjusted gross income of $88,000 (after her $12,000 standard deduction), and the low-earner would pay $0 on his $0 income.Now consider if the same two people wed before the end of the calendar year, and file their taxes jointly. The same $100,000 in total income would be reduced by the new $24,000 standard deduction, and they would owe $8,739 on the remaining $76,000. The difference between the $15,410 owed when unmarried and $8,739 owed after marriage is a marriage "bonus" of $6,671.Now consider two people, each of whom has a form 1040 line 22 total income of $50,000 in 2018. Each of them would pay $4,370 on $38,000 in taxable income. If they wed before the end of the year, they'll end up paying $8,739 on their combined $76,000 in taxable income.In this stylized example, when two people with taxable income wed, their total income tax bill remains unchanged, while when a person with taxable income weds a person without taxable income, the government pays them $6,671 in reduced income tax liability.

Means-testing creates enormous marriage penalties

I am not, in general, concerned with the effects of marriage on income tax liability. I think the "marriage bonus" described above is pretty absurd, and we'd be much better off eliminating the standard deduction entirely and replacing it with a universal basic income, but that's beside the point of today's post.The real marriage penalty doesn't appear in the income tax tables, it appears in the multiplicity of ways marriage can affect people's eligibility for means-tested benefits. Let's look at a few stylized examples.

• Health Insurance. In a Medicaid-expansion state, a person earning $16,753 is entitled to premium-free Medicaid coverage and a person earning $48,560 is entitled to premium tax credits that limit the cost of coverage on the Affordable Care Act exchanges to 9.6% of their income ($4,662). If the two people wed, their income will still be slightly under 400% of the federal poverty line, but 9.6% of that amount will now be $6,270, a marriage penalty of $1,608. Meanwhile, they receive a marriage "bonus" of just $95, leaving them $1,513 worse off, assuming they require no medical treatment whatsoever. If they do require medical treatment, the marriage penalty balloons further since, unlike Medicaid, Affordable Cart Act plans also include substantial deductibles and co-payments for treatment.
• Earned Income Credit. Often described as one of the most effective programs embedded in the tax code, beloved by Democrats (anti-poverty) and Republicans (pro-work) alike, the Earned Income Credit also features an enormous marriage penalty: a single filer with $6,700 in earned income is eligible for the maximum refundable earned income credit of $510. Two such workers, each with $6,700 in earned income, when filing jointly are eligible for a refundable earned income credit of $510, resulting in a marriage penalty of $510.
• Retirement Savings Contribution Credit. The RSCC is based on adjusted gross income, so it can get extremely complicated depending on your ability to game your AGI, but let's again use a stylized example to illustrate how marriage penalties work in practice. In 2018, one single filer with an AGI of $19,000 ($31,000 in total income) and one single filer with an AGI of $19,001 ($31,001 in total income) would be able to claim a RSCC of $1,000 and $400, respectively, for a total credit of $1,400. If wed, their credit would be just $800, resulting in a $600 marriage penalty.

Means-testing is an assault on the family

All forms of means-testing involve a certain incoherence, even if that incoherence is at times fashionable. The earned income credit, for example, is widely praised by economists for phasing in quickly and phasing out slowly, since economists believe that marginal incentives drive behavior. But if marginal incentives drive behavior, why should the earned income credit be phased out at all? And why should it be halved on the occasion of your wedding day (let alone retroactively to the first day of the year you wed)?An incoherent view towards the family and towards poverty is at the very heart of the conservative movement in the United States:

• if marriage is the best way out of poverty, then you might want to eliminate the financial penalties for marriage I described above, in order to encourage more people to wed;
• but if anti-poverty programs are keeping people from getting married, then you might want to eliminate benefits for the poor in order to cast them deeper into poverty and encourage them to marry solely to escape it.

Thankfully, I'm not a conservative, so I don't have to try to resolve the contradictions inherent in this worldview, but merely point them out.

Conclusion

I do not believe that the American family is "in crisis," but the more seriously you take the institution of the family in American life, the more seriously you should take the very real attacks on family formation built into our welfare state and tax code. A $510 penalty here, $610 there, and even $1,513 over there won't on their own destroy the institution of the family. But if you take that institution seriously, you ought to fight to eliminate those penalties wherever they arise.

3 questions about Americans and money

It's a slow, rainy Sunday around here, which is as good an occasion as any to contemplate the mysteries of life. In that spirit, here are three questions I genuinely don't know the answers to about Americans and their financial habits.

Why don't Americans save in other currencies?

I'm fascinated by currency risk and have written before about exposure to currency risk in the context of long-term investing. But even outside the context of long-term investing, as far as I can tell Americans have no easy access non-dollar-denominated accounts, and even less interest in them.Why would you want to save in euros, pounds, or yen? Well, because you plan to spend euros, pounds, or yen! If you're planning a trip to the United Kingdom in June, 2019, you know for a fact that you'll have to spend pounds for your accommodations, meals, transportation, and souvenirs. What you don't know is what the exchange rate will be in June, 2019, so you have no idea how many dollars you'll need to cover those expenses.The sensible solution is to save not in dollars, but in pounds. This is perfectly legal, and it's even possible, but only at great cost and inconvenience. For example, a nearby mall has a Travelex currency exchange booth where they'll happily sell you pounds in exchange for dollars. But what then? You've got a stack of pounds you've got to do something with, and your bank doesn't accept pound-denominated deposits.The main thing I want to stress is how unusual this is. Every bank I know of in Russia allows customers to open accounts denominated in US dollars, euros, or Russian rubles. In Poland people took out home mortgages denominated in Swiss francs. There's no technical or administrative barrier to denominating assets and liabilities in any currency you please; it's a purely cultural barrier.In principle I understand that it "feels" riskier to save in a different currency. You might lose money if the exchange rate moves against the currency you're saving! But you might also end up having to take a shorter vacation, eat worse meals, and buy fewer souvenirs if the dollar drops against the currency in your destination. Ordinarily, that's the kind of risk it makes sense to hedge against, and Americans don't have a convenient way to do so.As a travel hacker in my day job, I feel compelled to point out that it's travel hackers and miles-and-points enthusiasts who really do "save" in a currency besides their home currency. The relative "stickiness" of hotel pricing in each hotel chain's loyalty currency means you can relatively predictably know how many points a stay will cost: if the destination currency moves higher against your home currency, it's unlikely the price in points will immediately react, while if the destination currency falls in value, you can pay with dollars instead (of course, "relatively" is doing a lot of work here; hotels move around in redemption cost all the time).

Why do Americans debt-finance everything?

This morning I came across a very strange story in the Washington Post, titled "The latest blow to struggling family farms: Rising interest rates."Broadly speaking, there are three ways to finance a business:

• raise money with debt;
• raise money with equity;
• and reinvest retained earnings.

There are of course variations on these themes, like mutual aid societies, Islamic finance, or rotating savings clubs, but the general idea is that you can either pay a fixed rate of interest for access to money, you can sell a share of your future profits, or you can reinvest the business's profits instead of withdrawing them to spend.While there is a theorem in economics that capital structure is "irrelevant" we know this is not true in the real world, and for obvious reasons: a firm that is certain of its success is likely to use debt financing in order to preserve as much profit as possible for its owners, while a speculative enterprise is more likely to use equity in order to put as little of the founders' capital at risk as possible.What is baffling to me, and what the Washington Post article above illustrates clearly, is that Americans are way, way too reliant on debt financing.This is not entirely irrational. For example, under conditions of accelerating tuition and decreasing state support for higher education, debt financing ("student loans") is a sensible response, since college students don't typically have any prior earnings they could use to pay tuition, and the extremely wide distribution of incomes in American society means they would have to sign over an unacceptably high percentage of their lifetime income to raise equity financing.Likewise equity financing of car purchases makes little sense, since virtually all cars are used for the same morning and evening hours so few people would want to share ownership of a depreciating asset (although there's no reason coworkers couldn't share ownership of a vehicle they are all able to carpool to work in).All of this brings me back to the plight of the family farmers in today's Washington Post. It seems obvious to me that they've made a simple mistake: they used debt financing instead of equity financing for an incredibly speculative enterprise. They thought they would be able to buy seed and equipment, and pay their farmhands, using borrowed money, then repay the borrowed amount with interest while turning enough of a profit on the sale of their crops to make withdrawals that meet their own personal spending needs.Why did they think this? I have no idea.Farming is a complex enterprise, forcing farmers to deal with a multitude of factors, but the one thing that isn't complex about it is that commodity prices fluctuate, meaning each growing season's profits is entirely out of the farmer's hands. In other words, it's a perfect candidate for equity financing, or financing out of retained earnings.Someone who raises equity financing and promises to pay out profits in proportion to the ownership stake of their investors never needs to worry about rising interest rates. Someone who saves their profits in profitable years never needs to worry about lower commodity prices or rising interest rates, as long as their savings hold out.Maybe the savings won't hold out! But that's a consequence of your inability to run a profitable business, which is obviously not something that rises to the level of national emergency.

Why do Americans take financial advice from commissioned salespeople?

In a whole range of commercial activities, Americans are some of the most skeptical people on the planet. We know used car salesmen are con artists, we know "extended warranties" are scams, we know "travel insurance" is a racket, we know rental car insurance is a joke.But when it comes to financial advice, Americans are still rubes. Of course it's not as bad today as when you would call up "your" stockbroker and ask what he (and it was almost always a he) thought was going up and what he thought was going down, send him your money, and cross your fingers.But it hasn't gotten a whole lot better.Part of the problem is surely the famous "fear of missing out," which means people are reluctant to "merely" earn the market rate of return on their savings as long they're reading every day about bitcoin millionaires, venture capitalists, and private equity.But it's nonetheless true that smart, educated, professional people (the only people these days who have any excess income to invest) fall for the most preposterous scams imaginable, whether it's variable annuities, actively-managed mutual funds, or whole life insurance policies. And I don't have a good answer why our natural skepticism breaks down when confronted with a sufficiently analgesic Powerpoint presentation.When it comes to insurance Americans at least have the excuse that it's literally illegal to sell policies on anything but a commission basis. But that does nothing to explain the love affair of American investors with stock brokers who are paid to rip them off.

"Suicide of the West" is not a very good book

Last week I got into a discussion on Twitter with a long-time conservative reader who was upset about something he called "tribalism." We went back and forth for a while but I couldn't figure out what he was talking about, and then I remembered that I had recently heard the National Review "The Editors" podcast endorse a book by an NRO staffer named Jonah Goldberg called "Suicide of the West: How the Rebirth of Tribalism, Populism, Nationalism, and Identity Politics is Destroying American Democracy."I figured that rather than bug my reader on Twitter for answers he couldn't give me, I'd go right to the source. If anyone could explain tribalism to me, it would be the guy who wrote the book on it! I was wrong.

A book about big eternal ideas that's relentlessly, tiresomely focused on the present

Goldberg is a conservative ideologue, but his ideology is based entirely on the conservative grievances of late 2017. A few examples:

"Barack Obama said in his Farewell Address:"'Our Constitution is a remarkable, beautiful gift. But it's really just a piece of parchment. It has no power on its own. We, the people, give it power—with our participation, and the choices we make. Whether or not we stand up for our freedoms. Whether or not we respect and enforce the rule of law. America is no fragile thing. But the gains of our long journey to freedom are not assured.'"Many of my fellow conservatives were angered by this, and given Barack Obama's remarkable, yoga master-like flexibility in interpreting constitutional text, I can understand why" (p. 97).

Taken on its face this is a remarkable confession of motivated reasoning.

"The question almost surely was intended to be rhetorical in the same way the organizers of an essay competition at Oberlin asking 'Has diversity made us stronger?' would simply assume the contest was over who would most creatively—or loyally—answer 'Yes'" (p. 135).

How did the big scary liberal arts college in Ohio hurt you, Jonah?

"I've tried to avoid making explicitly partisan arguments, but attention must be paid to the insidious and incestuous relationship between the Democratic Party and government unions. It is no accident that the National Treasury Employees Union, which represents the IRS, gave about 96 percent of its political donations during the 2016 election cycle to Democratic candidates" (pp. 196-197).

This one is particularly incoherent because the book is a paean to the role of non-state organizations in giving life meaning. Then he just hangs a huge asterisk on his thesis that reads: "except unions."

Does the Constitution "work?"

There is a version of the history of American civilization that goes like this: the Declaration of Independence, Constitution, and Bill of Rights embody a set of universal ideals that the Founders fell far short of. However, those shortcomings have been addressed one-by-one by subsequent generations, which have used the universal promise of the founding ideals to correct injustice after injustice to better bring America in line with her values.This is a story with obvious appeal. It means the genocide of the native population of North America, slavery, lynching, Jim Crow, restriction of the franchise to men, Chinese exclusion, Japanese-American internment, segregation, poll taxes, grandfather clauses, redlining, police violence, the war on drugs, mass incarceration, stop-and-frisk, purges of the voter rolls, gerrymandering, are not features of our constitutional order, but violations of it or even attacks on it.And this is more or less the story Goldberg tells, although he would not put it in exactly these words: we have a Constitution of ideals, which each generation seeks to make more imminent in the lives of the people.There is a problem with this story, however, and that is the fact that at each turning point in this story, those fighting to fulfill the ideals of the Constitution have been confronted by those who insist the true meaning of the Constitution lies is the status quo or a reversion to an earlier, less just order.

Why The South Must Prevail

In 1957, William F. Buckley, a father of the modern conservative movement and the founder of National Review (Jonah Goldberg's employer), published a short column which is worth reading in full, headlined "Why The South Must Prevail." He wrote:

"The central question that emerges-and it is not a parliamentary question or a question that isanswered by merely consulting a catalogue of the rights of American citizens, born Equal-is whether the White community in the South is entitled to take such measures as are necessary to prevail, politically and culturally, in areas in which it does not predominate numerically? The sobering answer is Yes-the White community is so entitled because, for the time being, it is the advanced race."

Jonah Goldberg is many vile things (an apologist for torture not least of them), but I don't know if he's a racist or not, and am not trying to imply that writing for a magazine founded by a racist that spouted racist vitriol for decades makes you a racist by association. That inference is left to the reader.What I am saying is that it has always been the business of conservatives to insist that whatever progress has just been achieved in fulfilling the ideals of the Constitution is the last work that needed to be done, and all further work should be abandoned.It has become unfashionable to remember that George W. Bush ran for reelection in 2004 on a campaign of amending the Constitution to ban marriages, nationwide, between people of the same gender. Today, with the right to marry the person of your choice upheld by the Supreme Court, the very same people insist that the work of equality is done. "This far and no further" is always the order of the day.

The coincidence theory of conservative politics

All this feeds into what I call the "coincidence theory" of conservative politics, which takes two main forms:

• The coincidence of timing says that whatever era a conservative is born into happens to have finally settled once and for all every important issue, or might have gone a bit too far.
• The coincidence of reason says that when you apply logic and reason to a problem, you happen to arrive at exactly the conservative's preferred policy.

I discussed the coincidence of timing above, but Goldberg also illustrates the coincidence of reason in his attack on the minimum wage:

"At least in the medieval guilds it was understood that giving an inexperienced worker an apprenticeship—i.e., a shot at learning a trade—was something of great value. The wage, if there even was one, was trivial compared to the opportunity to learn how to be a blacksmith, mason, or tanner. That was the path to prosperity. First jobs, particularly for unskilled non-college-educated young workers, play the same role. If you work hard and learn the business at, say, McDonald's, you will likely be promoted to assistant manager before the year is out. That is invaluable experience. Raising the minimum wage above what employers can bear or to the level where hiring an iPad makes more sense is immoral, because it is tantamount to taxing entry-level jobs. If there is anything more settled in economics than the proposition that taxing an activity reduces that activity, I don't know what it is. To say that the minimum wage should be a 'living wage' is to tell employers they must pay inexperienced workers above their value, and that is unsustainable" (p. 204).

It's irrelevant to me whether you agree with Goldberg that it's "immoral" to raise the minimum wage, or if you agree with me that if we are to require people work to survive, we must pay them enough to survive.What's obvious is that our policy beliefs are upstream of our political beliefs. You can see by Goldberg's story about the minimum wage that he did not start with a set of beliefs about the medieval guild system and then deduce his view on the minimum wage from that; he started with a belief about the minimum wage and then worked backwards from that to a just-so story about medieval guilds.The coincidence of reason is not unique to conservatives, but in my experience they are uniquely incapable of acknowledging it. Leftists who want to raise the minimum wage do not pretend to start with an elaborate just-so story about "returns to capital being above their historical norm and government intervention being necessary to recalibrate the economy-wide return to capital and labor." They start with a story about the need to raise the minimum wage, and then explain how capital can afford to pay for it because of the enormous profits capital is currently earning.Everyone is entitled to marshal the most convincing available arguments for their preferred policy views. But if you find someone who believes those arguments caused their policy views, or that their policy views are the inevitable or necessary consequence of some external feature of the world, you are dealing with someone who does not, or is pretending not to, understand how political beliefs are actually formed.

Unfortunately, I didn't learn anything about "tribalism"

I was excited, 200 pages into "Suicide of the West," to arrive at Chapter 10, "Tribalism Today: Nationalism, Populism, and Identity Politics." Finally, I thought, I'd get some answers about what this "tribalism" business is all about and what's so horrible about it.I did not, but to explain why not, it's worth quoting the core of Goldberg's thesis, as near as I can identify it:

"We still believe that the government shouldn't exclude some groups based upon arbitrary prejudices. But the rest of the melting-pot formula is breaking down in three ways. First, we are now taught that the government should give special preferences to some groups. Second, as a cultural imperative, we are increasingly told that we should judge people based upon the group they belong to. Assimilation is now considered a dirty word. And last, we are taught that there is no escaping from our group identity" (p. 211).

I think Goldberg's formulation is useful because a slight reformulation puts it in direct contrast with the actual beliefs of progressives in America today:

1. First, the government gives special preferences to some groups. Redlining, for example, is a practice that prevented the residents of predominantly black neighborhoods from receiving federally backed mortgages and accumulating housing wealth. FHA loans were a special preference given to the white residents of white neighborhoods.
2. Second, people are judged based on the group they belong or are perceived to belong to. Race science, as practiced by Charles Murray and his acolytes, who are quoted extensively throughout "Suicide of the West," is a systematic, comprehensive, negative judgment on the value of African-American culture and civilization, and elevation of white European culture and civilization. 
3. Last, we are not allowed to escape from our group identity. State violence against ethnic minorities, whether Japanese-Americans, Hispanic residents of Maricopa County, or black Montgomery bus riders, was based on an inescapable identity assigned by the organs of state power.

We are not taught these things. These things are true, and we have the choice whether to learn them or not. If we choose to learn them, we have the choice whether to act on them or not.And when we do learn them, and when we do act on them, we can count on facing opposition from the Jonah Goldbergs of the world at every turn.

Cumulative losses as the psychic cost of investing

I was playing around with a pretty cool tool called Portfolio Visualizer and got to thinking about the difference between how finance professionals and ordinary people talk about investing.For finance types, an asset or a portfolio has an expected return, which might be calculated using historical returns or a forward-looking rule like Jack Bogle's "reasonable expectations" formula, and then it experiences volatility, typically expressed as a standard deviation around that average return. So the stock market has higher expected returns than bonds, which are supposed to compensate for their higher volatility, which financiers also sometimes confusingly call "risk."But ordinary people aren't concerned with volatility; they're concerned with losses, and to a lesser extent gains. No civilian would say "I'm worried because I was expecting an 8% return but instead received a 20% return; this asset is too risky." Nor would they say "I was expecting a 1% return but instead lost 0.5% thanks to the asset's low risk."But it's even worse than that! Even when financiers describe an asset or portfolio's falling price, they express it in percentage terms, while ordinary people describe their gains and losses in dollar terms. Losing $20,000 in a $100,000 portfolio may hurt more than losing $10,000 in a $20,000 portfolio, despite the decline being 60% smaller in percentage terms.While pondering this, I thought of a simple way of describing how risky a portfolio would be experienced by an actual investor.

The pain ratio

The pain ratio looks not at average annualized returns, but instead dollar returns, which means it takes into account the fact that smaller percentage declines in a larger portfolio can be more painful than larger percentage declines in a smaller portfolio. To calculate it, I plugged three simple portfolios into Portfolio Visualizer, a 40/60, 60/40, and a 90/10 stock/bond portfolio, and looked at dollar returns over a 30-year time horizon from 1987 to 2017.Over this period, as you'd expect, the 90/10 portfolio outperformed the 60/40 portfolio, which outperformed the 40/60 portfolio, and was also much more volatile, with an average annualized return of 10.04% and standard deviation of 13.51%, compared to the 40/60 portfolio's return of 8.19% and standard deviation of 6.56%, respectively.Over 30 years, that means $10,000 invested in the 90/10 portfolio in 1987 returned a net of $184,117 compared to the $104,671 returned by the 40/60 portfolio. However, that net return is composed of two figures: the total gains experienced by the portfolio and the total losses. In the same 30 years, the 40/60 portfolio experienced just $10,273 in losses in just 3 down years, while the 90/10 portfolio lost $51,917 in 6 down years (meaning it also experienced $236,034 in gross gains).You can find all the raw data I used and my calculations here.

Sequence of return risk and the pain ratio

When people refer to "sequence of return" risk they often mean the risk that a retiree will experience large losses early in retirement and that withdrawals from that lower base will permanently impair their ability to meet their needs in retirement.But the pain ratio illustrates a different kind of sequence of return risk: that large dollar losses late in an investor's accumulating years will permanently scare them into lower-returning assets, locking in both a lower asset value and lower future returns.It seems to me that the answer is for investors and their advisors to look at expected returns and potential losses not just in percentage terms, but in dollar terms as well, and to consider moving into less risky assets before a relatively small percentage decline in a large enough portfolio scares them into locking in permanent underperformance.Note that this is totally distinct from moving into less risky assets as you approach or enter retirement; it's solely a function of the size of your portfolio and how you'll subjectively experience the conversion of even small percentage declines into concrete dollar losses. This is just as risky for a young investor as an older one, since the pain ratio is based exclusively on the dollar size of the portfolio.

What a culture of entrepreneurs and entrepreneurship would look like

I write a lot about entrepreneurship. This is not because I think everyone should be an entrepreneur. For one thing, not everyone wants to be an entrepreneur, and part of having an economy that works for everyone means making room for folks who just want to show up at work and do their job.The problem with our current system of social and economic organization is that we've swung too far in the other direction: entrepreneurship is so maddeningly difficult that folks who would be better off starting their own business remain as employees, both occupying jobs that would be better filled by folks who want jobs, while also not pursuing their own goals.But it's easy to complain. Instead, I want to share my actual, concrete, actionable vision for what a culture of entrepreneurs and entrepreneurship would look like.

Simplify the tax code

Self-employed people and entrepreneurs don't talk as much as they should about the complexity of the tax code because once you're self-employed you've almost by definition figured out the tax code. It takes me perhaps half an hour to do my taxes these days, because they're basically the same every year.That's unfortunate, because it means people aren't talking about the initial hurdle of figuring out how the tax code applies to entrepreneurs. The half hour my taxes take me today is the product of hundreds of hours of poring through tax schedules to figure out how all the pieces fit together.Fortunately, the answer's simple:

• tax capital gains as ordinary income;
• eliminate the floor and ceiling on FICA taxes;
• eliminate the 20% pass-through income deduction introduced in the smash-and-grab tax reform bill of 2017.

Obviously running a business will never be exactly the same as being an employee. But if you use the basic idea of adding up all your income each year and paying taxes on the resulting number as the core principle of the tax code, we can demolish an enormous hurdle to entrepreneurship.

Eliminate (tax preferences for) workplace health and retirement benefits

I've never pretended to have all the answers; I don't know how much money people should be able to shield in tax-advantaged retirement accounts. My gut feeling says the number should be $0, but whatever amount you think they should be able to shield in tax-advantaged retirement accounts, there's obviously no reason that number should depend on their employer.

• If the number is $5,500 (the limit on individual retirement account contributions), then the number should be $5,500 for everyone.
• If the number is $24,000 ($5,500 in IRA contributions and $18,500 in employee-side 401(k) contributions), then the number should be $24,000 for everyone.
• And if the number is a full $60,500 ($5,500 in IRA contributions, $18,500 in employee 401(k) contributions, and $36,500 in employer 401(k) contributions), then the number should be $60,500 for everyone.

To be clear, since this is an area where people tend to develop some very strange ideas, your employer's contribution to your workplace retirement plan is part of your labor income; it's not a gift and it's not done from the generosity of their heart. Even if you believe that there should be tax advantages to contributing to investment accounts that can only be tapped penalty-free in old age, there's no reason to believe that the investment management company, investment options, and fees should be determined by your employer, instead of by you.Meanwhile, eliminating the exclusion from personal income of workplace health insurance benefits would almost immediately end the disastrous American experiment with employer health insurance plans, and keep every business in America from having to run a small, terrible health insurance company on the side.

Make hiring easy

There was a period in the late 90's when it was fashionable to attack and vilify political candidates who hired landscapers, housekeepers, or nannies "under the table," the idea being that they were either facilitating undocumented immigration or saving money on the taxes they'd owe if they were operating on the level.This is bullshit. It is not, in fact, possible to hire someone to work legally in the United States. Don't believe me? Just try it!I've written before about E-Verify, which doesn't work, but E-Verify isn't mandatory, so set that aside.It's impossible to comply with US and state employment laws. Now, it's true that you can pay someone to handle payroll for you, but that means the hurdle to hiring an employee is not "is this employee going to produce more value than they cost?" but rather "is this employee going to produce more value than they cost plus the cost of hiring them?" The lower we can make that extra drag, the easier businesses will find it to expand and hire.The obvious way to deal with the information asymmetry between employers and the IRS is for the IRS to design a single interface that calculates federal, state, and FICA tax withholding and accepts payment for those taxes.The fact that we haven't done so is the most striking proof that we don't take entrepreneurship seriously.

Eliminate means testing and (paper)work requirements

A non-exhaustive list of big national welfare benefits:

• the Earned Income Credit
• the Retirement Savings Contribution Credit
• the Child Tax Credit
• Supplemental Nutrition Assistance Program
• Women, Infants, and Children
• Medicaid
• Low-income Heating Energy Assistance Program

These programs all have different requirements, each of which has to be documented, and which can push in different directions.

• They all require you to have a low income. What qualifies as a low income depends on the program, however: in Medicaid-expansion states "low-income" means up to 138% of the poverty line, or $16,146. Meanwhile, the EIC is phased out completely at $15,000 in earned income, and the CTC at $240,000 in adjusted gross income.
• But not too low! The same programs also have minimum income requirements. SNAP requires recipients to work 20 hours per week; the RSCC can only be credited against taxes owed, meaning recipients have to have more income than their standard deduction; and only $1,400 of the new CTC is refundable, so $600 of the credit is reserved for folks with income high enough to owe at least that amount in tax (but less than the phaseout amount, remember).

This means someone's disposable income is dependent on their income from work, but not in a coherent or dependable way. It's impossible to guess whether an additional dollar of income will actually raise your disposable income, or whether it will reduce your welfare benefits by more than a dollar.The obvious answer is to replace all the cash-like welfare programs with a universal basic income (per adult) and child allowance (per child), and pay for the higher costs with higher marginal tax rates on higher incomes. This would act as the same "phase-out" the designers of welfare programs are so enamored with, but through the simple mechanism of a progressive income tax instead of having to calculate the phase-in and phase-out points of dozens of different benefits.In this way, earning a dollar of extra income will still not increase your disposable income by a dollar, since it will be reduced by the taxes owed, but it won't be reduced again by the loss of eligibility for multiple interlocking welfare programs.

Conclusion

One of the most destructive, counterproductive tendencies in American life is to talk about entrepreneurship as something other people do. Whether it's venture capitalists in Silicon Valley or restauranteurs in Brooklyn, we hear that it takes a special kind of person, willing to work 20 hour days, spend Christmas at the office, and never see their family in order to finally hit the jackpot when their vision is realized.But when I say "entrepreneur," I mean the stay-at-home dad who screenprints t-shirts when the kids are napping. I don't care if he ever turns the business into a global conglomerate, I just want to make his life as easy as possible so he can get back to work on the t-shirts.We were not put on Earth to fill out paperwork.

Wrapping my head around variable annuities

I've written before about indexed annuities, one of the most expensive, abusive, unnecessary financial products known to man, but I've recently had a couple occasions to learn more about variable annuities, the confusingly-similarly-named product offered at lower cost by more reputable firms, like Vanguard and Fidelity.

Variable annuities are expensive

There are two expenses that go into a variable annuity: the wrap fee and the fee for the underlying funds your money is invested in.For example, Vanguard charges 0.29% in annual administrative and "mortality and expense risk" fees, plus investment portfolio expense ratios ranging from 0.11% (Total International Stock Market Index Portfolio) to 0.42% (Growth Portfolio).Meanwhile, Fidelity charges 0.25% in fees plus portfolio expense ratios between 0.10% (Fidelity VIP Index 500) and 1.54% (PIMCO VIT CommodityRealReturn Strategy).Since you're a sophisticated investor, say you combine the best of both worlds and invest only in the cheapest fund with each provider. You'll pay 0.4% annually to invest in the total international stock market with Vanguard, and 0.35% annually to invest in the S&P 500 with Fidelity.Is that a lot? Well, it's over 3 times more expensive than buying Vanguard's Total International Stock Index Fund Admiral Shares and almost 9 times more expensive than buying Vanguard 500 Admiral shares, but it's not objectively very expensive, so if variable annuities offered tangible benefits, they wouldn't have to be very valuable to make back that difference.So, do they offer tangible benefits?

Variable annuities are not tax efficient

The first problem with variable annuities is they swap the extremely favorable tax treatment of capital gains and qualified dividends for the extremely unfavorable treatment of ordinary income. This happens in a fairly complicated way that I still don't fully understand, but essentially withdrawals from variable annuities are done against an after-tax contribution portion (which is untaxed on withdrawal) and an earnings portion which is taxed as ordinary income, a bit like how non-qualified withdrawals from 529 plans work (except more complicated).The advantage of this trade (capital gains for ordinary income) is theoretically that you can defer capital gains taxes during your high-earning years, when you might pay up to 23.8% on them, and then make withdrawals during your low-earning retirement years, when your marginal tax rate on ordinary income is lower.If capital gains were taxed as ordinary income (as I would prefer), this argument would be airtight, and variable annuities would be a commonsense way to smooth your tax burden over a lifetime. People would use variable annuities instead of taxable brokerage accounts for all their savings in excess of qualified retirement accounts, paying less in capital gains taxes during their working years and more in ordinary income taxes during retirement.The problem is that capital gains aren't taxed as ordinary income: they're taxed at preferential rates, and those preferential rates extend high up the income scale. The 23.8% rate I mentioned above is the highest rate paid on capital gains, while taxable income in excess of $82,500 is taxed at 24%, and rates only climb from there.Between Social Security old age benefits and required minimum distributions from IRA's and 401(k)'s, taking taxable withdrawals from a variable annuity can easily put someone's taxable income in the range where they're actually paying more on their gains than they would have if they'd simply held their investments in a taxable account and benefited from preferential capital gains tax treatment.

Variable annuities are terrible estate planning

When the owner of a taxable investment account dies, their heirs inherit their assets with a "stepped up" basis: the owner's unrealized, untaxed capital gains receive a new, higher cost basis and those capital gains will never be taxed.When a variable annuity is inherited, the account retains the distinction between contributions and earnings, and earnings will still be taxed on withdrawal at the heir's ordinary income tax rate.Heirs can either take a lump sum distribution of the account's balance (potentially paying up to 37% of the earnings in taxes), or spread the distribution out over 5 years. In either case, rather than the owner saving money on taxes in retirement, the account's gains are taxed at the likely higher tax rate of the inheritor.

The best case for variable annuities

I gather that I come across as a bit of a scold in this post, but I always try to find the good in everyone and in every financial product, so after a little bit of thinking, I came up with a perfectly reasonable use case for variable annuities.Consider a high earner who knows she wants to retire early. Because she's a high earner during her working years, she exclusively uses traditional IRA's and 401(k)'s to reduce her taxable income. Likewise because she's a high earner, she'll pay 23.8% in taxes on any dividends and capital gains distributions during her working years for assets held in taxable accounts.Instead, he contributes to variable annuities, perhaps splitting his contributions 50/50 between the lowest cost options at Vanguard and Fidelity (I don't know why Fidelity doesn't have a low-cost international stock portfolio. Or, rather, I do know why).If she contributes, say, $50,000 per year to her variable annuities, compounding at 5% annually over 20 years, she'll end up with $1.736 million, of which $1 million will be contributions and $736,000 will be earnings.At age 59 1/2 (when variable annuity withdrawals become penalty-free), he gives two weeks notice and start withdrawing 9.1% of the balance per year, or $158,000, of which $91,000 will be tax-free contributions and $67,000 will be earnings taxed as ordinary income (this is not exactly how it works, but close enough). Assuming no other taxable income, he'd owe a nominal amount of tax on that amount.Then, at age 70 she would file for her much higher Social Security old age benefit and at age 70 1/2 start collecting required minimum distributions from her traditional IRA and 401(k) accounts.In other words, since delaying filing for Social Security is so lucrative, even someone retiring early should find a way to delay claiming their Social Security old age benefit as long as possible. If they have no earned income in retirement, then the relatively unfavorable tax treatment of variable annuity withdrawals is irrelevant, as long as their total taxes paid on withdrawals is lower than the capital gains tax payments they would have owed during their working years had the assets been held in a taxable account.

Employers have forgotten how to hire. But they'll learn

I've written before about what I called the high-employment generation, which I use to describe people entering the workforce today who have no memory of the long, grinding recession which destroyed countless American communities in the aftermath of the global financial crisis of 2007-2008.Four pieces have come across my desk in the last few weeks which highlight the consequences of high employment in different ways:

• Why a white town paid for a class called ‘Hispanics 101’
• How Bad Is the Labor Shortage? Cities Will Pay You to Move There
• Crab crisis: Maryland seafood industry loses 40 percent of work force in visa lottery
• A Fast-Food Problem: Where Have All the Teenagers Gone?

These articles are almost universally written from the perspective of employers, rather than employees, and there's no surprise there: it's a lot easier to get the owner of a Subway sandwich shop to speak on the record than it is to get a quote from the employee making $10.93 an hour and who depends on their job for survival.

Learning to hire is hard, but I believe employers can be taught

During the low-employment generation which I belong to, employers had the dual luxury of being able to hire relatively-well-educated workers (high school and college graduates) for relatively low wages. The cliche about PhD's working as baristas was commonly used as a dig against the value of PhD's, but from a workforce perspective coffeeshops were lucky to be able to hire easily-trained PhD's to make coffee due to the abundance of slack in the labor market.It's fashionable to respond to employer complaints of difficulty hiring by saying they should raise wages, and indeed, they'll find it's necessary to raise wages. But you can see from the articles above that employers already see the outline of a much larger problem: in the context of an entire economy of steadily rising wages, employers will need to not only match competitors' wage increases, but outbid them if they want to retain workers or expand their workforce. And that's the process that we're not yet seeing take place.

How bad is the labor shortage?

The best illustration of this process is the WSJ article "How Bad Is the Labor Shortage? Cities Will Pay You to Move There." Here are the specific examples given in the article for the drastic measures cities are taking to respond to what they consider extreme labor shortages:

• "A local community foundation opened applications for 11 scholarships—$5,000 toward student loans of people in engineering, technology, science or the arts, if they agree to live for two years in downtown Hamilton, about 45 minutes from Cincinnati."
• "The Community Foundation of St. Clair County has awarded eight grants from among 40 applicants and recently raised its award to $15,000 from $10,000, targeting local young people who have moved away."
• "In Grant County, Ind., the economic development office offers $5,000 toward a home for people moving to the area. The requirements are a job and advanced training or a college degree. The money must be repaid if recipients leave within five years."
• "The chamber of commerce is developing a $9,000 scholarship program to help repay student loans."
• "A local committee in Marne offers newcomers free land to build a house...The town’s free-lots program—funded by donations—began before the recession. So far, though, only one home has been built."
• "The North Platte, Neb., chamber of commerce last year started offering up to $10,000 to move into town for a job...The first grant went to Audrey Bellew, a 25-year-old law school graduate. She grew up nearby and had planned to return home. The money helped pay for her move and provided support while she studied for the bar exam and prepared for a job at a local law firm....The town has landed a second newcomer, a physical therapist who moved from Colorado with her husband."

These efforts are, not to be rude to the people of North Platte, Nebraska, ridiculous. They have identified an issue that they consider of sufficient important to organize a community initiative around, and their community initiative is utterly inadequate to address the problem. $9,000 to repay student loans? How will that attract people who don't have student loans? Free land to build a house? Who wants to build a house? $5,000 "towards a home?" What does that even mean?This might lead one to despair that we're doomed to dumb employers and dumb communities proposing dumb initiatives doomed to failure.

Stunts calibrated to the scale of the problem work great

The University of California, Irvine, opened a law school that admitted its first students for classes in the fall semester of 2009. That first class had all 3 years of tuition paid for through a private scholarship program (the next two classes had their tuition by the same scholarship covered at a lower rate). The goal was to attract the nation's top law students to a program that had just sprung into existence.And it worked. The UC Irvine School of Law is ranked 21st in the latest U.S. News and World Report rankings of US law schools — a school that has been open for barely a decade!

Relocation stunts are the beginning, not the end, of these experiments

As I said, the stupidity of the relocation stunts I linked to above (merengue classes?) might lead some folks to despair. Maybe employers and communities really can't muster up sufficiently bold initiatives to solve the problems of falling populations and unfilled jobs. Maybe their brains have atrophied so much in the face of a decade of low employment and cheap labor that hysteresis will extract decades of subpar wage and employment growth.But I do not despair, and I think the UC Irvine stunt illustrates that we haven't entirely lost our capacity for ingenuity. I think when the relocation initiatives I mentioned continue to fail, bigger and bolder initiatives will be developed.Of course, they'll be developed unevenly, just as the existing initiatives offer different incentives in different places. Maybe Branson, Missouri, will figure out how to attract workers before Grant County, Indiana, and Branson will thrive while Grant County continues to decline.In hyper-local industries like the Eastern Shore of Maryland's crab-picking firms, they may not adapt fast enough to stay in business and jumbo lump crab meat might disappear from mid-Atlantic diets entirely, or appear only as the occasional delicacy. But if this occurs, it will not be a failure of immigration policy, it will be a failure of imagination.And I'm not yet prepared to bet against the American imagination.

There are no work requirements, only paperwork requirements

Paul Ryan, having decided that his services will no longer be needed by the American people come January, is taking one last bite at the apple of welfare reform by proposing onerous restrictions on who is eligible to receive SNAP benefits, the only remaining near-cash welfare benefit available to low-income Americans.I do not have a very high opinion of work as an occupation, but I'm not here to convince you that poor Americans "should" or "shouldn't" work. My objection to so-called "work requirements" is much simpler.

There is no such thing as a work requirement

In order to receive SNAP benefits more than 3 months out of every 36, recipients are already "required" to work 20 hours per week.This is the 32-page application Texas uses for SNAP (and other income-dependent programs). Here's California's 18-page application.I want to give an honorary mention to Texas's 2-page form "Report of Pregnancy," which reads in part "THE DEPARTMENT CANNOT PAY YOU FOR COMPLETING THIS FORM. Thank you for your assistance."But while these forms are required, "work" is not required.

All work requirements are actually paperwork requirements

Before desktop publishing became a reality, I assume paystubs had to be manually typeset at great expense by trained professionals. But since we live in the 21st, not 19th, century, I would invite you to pull out or download your last paystub and actually look at it.A paystub is an Excel spreadsheet with a bunch of merged cells and some light math.Anybody born after 1980 can produce a paystub showing any number of hours worked, at any wage, in about 20 minutes (if they can keep from being distracted by Twitter for that long).And of course anyone claiming to earn income through self-employment doesn't even need to do that.

Means-testing is an expensive, vicious mistake

As should be obvious at this point, the problem is not the amount of time low-income Americans spend working, it's the amount of time low-income Americans spend navigating the welfare bureaucracy.I truly do not care if an hour saved filling out Texas's 32-page form is spend at work or if it is spent catching up on the latest scandal. I only want it to not be spent filling out a 32-page form.At an American Enterprise Institute event on work requirements last year, the entire panel literally did not understand my question about the paperwork requirements they were proposing subjecting low-income Americans to.But as I attempted to painstakingly explain to them, any so-called "work requirement" has two separate costs:

• the cost of being denied benefits to those who are unable to meet the paperwork requirements;
• and the cost of attempting to the meet the paperwork requirement whether using "genuine" documents or a little time in Excel.

It's important to understand that the latter cost is even more serious than the former, since it's imposed on everyone whether or not they in fact meet the work requirement.In other words, even if you are fine with onerous paperwork requirements being imposed on people who are ineligible for benefits, you should strenuously oppose onerous paperwork requirements on people who are eligible for benefits. And since it's impossible to know in advance which is which, the obvious solution is to end paperwork requirements for everyone.

The solution: universal benefits, progressive income taxes

Americans often pretend to be upset about the idea of universal welfare benefits, presumably because they don't realize they're already receiving them. A free public school is a universal welfare benefit. Streetlights, roads, and busses are all universal welfare benefits. In-state tuition at public universities is a universal welfare benefit. Police, firefighters, judges, and clerks of the court are all universal welfare benefits.And even universal welfare benefits paid for through property taxes are paid for disproportionately by those occupying the most expensive homes, a kind of primitive progressive taxation (depending on local restrictions on property assessments).I did not think very much of the personal exemption, and am glad it was eliminated in the 2017 tax reform law. But it did unintentionally contain an essential truth: people need money to live, everyone should receive enough money to live, and then once everyone has enough money to live, the surplus should be split up in the most efficient way possible.Paul Ryan's project appears to be something like the opposite: destroy the ability of people to meet their essential needs, consign them to unending poverty, and see if you can wring any productive labor out of them before they die, miserable and alone.

The relationship between cost and confidence

A longtime reader asked me the other day, "how do you convince someone that actively managed funds are worse than passive?" I think it's a good question, not because it's possible to convince someone that actively managed funds are worse than passive funds (it's not possible to convince people of anything, in my experience), but because answering the question highlights one of the most important relationships in investing: the relationship between cost and confidence.

All active investors get the market's return

When you buy a mutual fund or exchange-traded fund linked to a market-capitalization-weighted index, you've decided to "settle" for the market's return. Your investment will rise and fall along with the index, since the fund's holdings are linked to the market capitalization of the index's components.If all passive investors get the market return, then by definition all active investors also get the market return, minus trading costs, since active investors are trading against each other: each active investor's winning bet is another active investor's losing bet, minus trading costs on each side.

Good active management is cheap at any price

If you knew your active fund manager was going to beat the market indices by as little as 1% per year, after taxes and fees, you should be willing to pay virtually any amount for their services. Over long enough time horizons, even modestly higher investment returns result in enormous increases in the final value of an investment.

I know of no way to identify good active management in advance

After the fact, all the people who selected "good" active managers will end up much richer than all the people who selected "bad" active managers. But as an investor, your task is not to identify who outperformed in the previous 10, 20, or 30 years, which you can easily look up online, but who will outperform in the next 10, 20, or 30 years.As if that weren't unfair enough, over the course of their careers active managers move from fund to fund, and eventually leave the business, one way or the other, so the benefits of correctly identifying the best active manager have a built in time limit, whether it's retirement or the grave.

How many times do you have to be right?

Passive, market-capitalization-weighted index funds don't absolve you of the responsibility, or consequences, of investing your money well. If you invest in Vanguard's Total Stock Market Index Fund instead of the Vanguard Total International Stock Index Fund, and the latter outperforms the former, then you made the wrong choice and performed worse than someone who made the opposite choice.But when you pay an active mutual fund manager to decide, over and over again, which stocks to buy and which to sell, you're not just counting on that person to be a better stock picker than you are. You're counting on that person to be enough better a stock picker than you are to make up for the management fees you have to pay them whether or not they outperform.When you know, by definition, that all investors in actively managed funds will underperform all investors in passively indexed funds, due to the higher fees charged by actively managed funds, the core question becomes clear: no matter how good you are at picking active managers, how many times do you have to be right to make up for all the fees you have to pay whether you're right or wrong?When you're wrong, you pay higher management fees and underperform. When you're right, you pay higher management fees and outperform. How sure are you that your excess returns will exceed your excess losses? It appears to me that there is no evidence whatsoever that individual investors have any capacity to select skilled active managers even once, let alone over and over again throughout an investing lifetime.So I choose to invest in passive funds, because I think the amount I save in management fees is greater than the amount I could realistically squeeze out of a lifetime of hopping from one expensive actively managed fund to another.But if a Wall Street Journal from 2048 fell into my lap, I'd happily change my mind!

What can the police do but arrest them?

I read with interest the essay of National Review columnist Kyle Smith about the response of the Starbucks coffee drink company to reports that one of their employees summoned Philadelphia's municipal law enforcement authorities in response to the presence of two men at one of their Rittenhouse Square coffee drink locations. He writes:

"We can all easily imagine circumstances in which a manager of a coffee shop or restaurant might properly call the police to ask them to remove loiterers. These are places of business. There’s nothing wrong in principle with calling the cops on non-customers who are taking up space. And there’s nothing wrong with police asking people to leave private property where they aren’t welcome, given that trespassing is a crime. When such people refuse, that’s unfortunate, but what can the police do but arrest them?"

I am glad Mr. Smith asked this question, because it's precisely the question people on both the left and the right should be asking about how we should be expected to deal with one another.

An Anecdote

In my late 20's, I was a graduate student in Providence, Rhode Island. Without expressing any unwarranted prejudice against the people of Rhode Island, it is a den of villainy. Nowhere was this more perfectly expressed than in the taxi industry, which was populated exclusively with the worst people in Rhode Island, and perhaps in all of New England.If you're from Rhode Island, then I suppose you get pretty used to the way your taxi drivers abuse their passengers, but if you're not from Rhode Island, it gets very old, very fast.One day, I flew into T. F. Green International Airport (named, hilariously, after the guy President Johnson is intimidating in the famous picture of his manhood), and taxis were in short supply. The taxi jockey at the airport insisted on putting multiple people into the same cab in order to move the line along. I was seated with a fellow going to the Providence Marriott, perhaps a half mile from my apartment. After dropping off the first passenger, and being paid by him, the driver continued to my apartment, where I handed him the difference between the final fare and the fare as of the first passenger's arrival at the Marriott.The driver was not amused. He insisted that I owed him half the fare to the Marriott, plus the additional distance he'd driven me. When I told him I wasn't paying him that, he said he'd call the police, and I told him I'd wait up in my apartment.He really did call the police! And when the police car finally pulled up 20-30 minutes later, I went downstairs and explained the situation to him. The cop patiently listened to us both, and understood both sides:

• On the one hand, why should I pay for somebody else's trip to the Providence Marriott, which took me out of my way home?
• On the other hand, why should I get a free trip downtown from the airport and only pay for the last half-mile of the trip?

But you know what the cop did? Nothing. He listened to both sides, he understood what both of us were saying, and he didn't arrest anybody at all.

The police don't have to arrest anybody

Was I "stealing" from my taxi driver by not paying what he thought I should for my share of my ride from the airport? Maybe!Were the two Philadelphia Starbucks patrons "trespassing" by sitting at a table for a few minutes before the manager called the police? Maybe!We can use whatever legalisms we want to describe particular situations, whether it's theft, trespassing, vandalism, loitering, or jaywalking, without insisting that the police have no choice but to arrest us, incarcerate us, and immiserate us.They always have a choice, and best of all, they work for us. Which means, like it or not, that it's up to us to do something about it.

Consumption smoothing is the best-theorized, least-implemented idea in economics

Given the prestige economics holds as a profession under late capitalism, it's somewhat odd how little attention is paid to the genuine theoretical innovations of the economics profession. I was reminded of this most recently by George Will's recent column in the Washington Post, which I'll quote at length:

"The recent bipartisan budget agreement, which signals that 12-digit deficits are acceptable to both parties even when the economy is robust, indicates government’s future. So does government’s pregnancy, which was announced nine months ago by this tweet from Sen. Marco Rubio (R-Fla.): 'In America, no family should be forced to put off having children due to economic insecurity.'"The phrase 'due to economic insecurity' is a way to avoid saying 'until they can afford them.' Evidently it is now retrograde to expect family planning to involve families making plans that fit their resources. Which brings us to the approaching birth of a new entitlement: paid family leave after the birth or adoption of a child. This arrival will coincide with gargantuan deficits produced primarily by existing entitlements."

I think it's worth thanking George Will for making explicit what is often implicit in criticism of reproductive decision-making, since it allows us to ask the question: shall our human biology be subservient to the economics of late capitalism, or shall we forge a political and economic system that encourages human thriving as we actually exist in the world?

What does it mean to afford a child?

We can crudely identify a variety of (non-exhaustive) costs that childbearing creates:

1. Prenatal, delivery, and neonatal medical care. Whether you think childbirth should be as "medicalized" as it is in the United States, even our hippies usually want a few ultrasounds, a clean room to give birth in, and somebody to check in on their newborn. A fully-medicalized birth, of course, costs far more, and if a C-section is required (or "required") the amounts involved can easily reach the high tens of thousands.
2. Early childhood maintenance. During a child's youngest years, they demand attention throughout the day and night. This care can either be performed professionally, or by an unpaid amateur who foregoes paid work, but in either case the work performed by the caregiver is a cost created by the presence of the additional human being.
3. Living expenses. In addition to the costs of childhood maintenance, human beings also have nutritional requirements, and rapidly-growing children often have unexpectedly high nutritional requirements. Under conditions of multiple children living in the same home, it's also frequently found necessary to acquire a larger living space to accommodate the additional people.
4. Educational expenses. Parents often enroll their children in schools, where professional teachers provide instruction in a range of subjects the children may find useful.

No one can afford a child

Looking at the list above, it should be obvious that virtually no one can afford a child, and no one tries.Most working-age people in the United States have medical insurance provided by their employer or the employer of a partner or parent, so that the medical costs created by pregnancy and birth are spread throughout a pool of people, not all of whom are delivering children at the same time, and some of whom will never deliver children.Most school-age children in the United States attend public schools paid for with taxes levied on their entire community, some of whom have many children, and some none at all.George Will would never be stupid enough to ask that people not give birth until they can prove to their obstetrician that their $40,000 check will clear, or until they can afford the services of a professional schoolteacher to educate their child, because George Will is a well-insured columnist living in a leafy Washington suburb with good public schools.

Consumption smoothing is basic economics

What about food, shelter, and supervision? Aren't those expenses parents should be expected to personally pay for out of current income?Upon even a moment's reflection, the answer is obviously not. When a child is enrolled in kindergarten, their childcare is suddenly paid for collectively by everyone who pays taxes in the city, county, or state in question. But the child doesn't undergo a transfiguration making them worthy of state-provided childcare, they are simply newly eligible for childcare and education provided collectively by their fellow citizens, instead of directly by their parents. There's nothing "natural" about privatizing the costs of childcare for the first few years of a child's life and socializing them thereafter.Of course, the community does this not because they're deeply committed to the concept of socialized childcare, but because well-educated children are a boon to the community.But well-fed, well-sheltered children are also a boon to the community, and privatizing the provision of those needs makes no more sense than privatizing the provision of education.

We don't take consumption smoothing seriously, but we should

All of this comes back to the theoretical innovation I mentioned earlier: consumption smoothing. Throughout history, the vast majority of people have tended to live, reproduce, and die, relying solely on their current income. Under the radical material constraints of feudalism and early capitalism, this often took the form of simply malnourishing, murdering or abandoning to exposure children who required too many resources given the current year's harvest. In other words, when George Will takes about "affording" children, for most of human history he was talking about infanticide.But even under late capitalism, the problem is no less obvious: since people's income tends to rise as they gain experience and education, they have less money than they need early in life and more money than they need later in life. But humans are also more fertile early in life than they are later in life! The logical response to these conditions is for people to consume more than they earn in their younger years, and less than they earn in their older years, "smoothing" their consumption from year to year so they aren't constantly changing their lifestyle due to income fluctuations, whatever the cause.

Intergenerational consumption smoothing is even more justified

Smoothing consumption across a single human lifespan is a tricky proposition: you would want to start with a fairly accurate estimate of a person's lifetime, inflation-adjusted income, build in a margin of safety, then divide by the person's expected lifespan. Then you'd need to find someone to loan them the money in their early years at a low-enough interest rate that they'd completely repay the loan in their higher-earning years without reducing real, inflation-adjusted consumption below the desired baseline.But intergenerational consumption smoothing is easy! Since the United States is organized as a perpetual entity, all we have to do to is issue debt today that will repaid by our much-richer descendants. Assuming a modest 2% average real growth in GDP over the next 75 years, our descendants will have $4.42 of real resources available to repay each dollar we borrow today.That's not to say debt-financing long-term investments is always, or even usually, the best course of action. When interest rates are especially high, debt-financed spending may reduce future consumption to below the level it raises current consumption to, reducing overall consumption instead of merely smoothing it. Under those circumstances, tax-financed spending may be more justified. And of course, there's no reason to commit to a single option: since growth rates are necessarily uncertain, tax-financed and debt-financed spending are two great tastes that taste great together.But whenever anyone tells you that your children, grandchildren, or great-grandchildren "will get the bill," insist on sending it COD — your great-grandchildren will thank you in between their vacations to the moon.

Idiosyncratic bets on real estate: homeownership or mutual funds?

I've written before about the ways homeownership in the United States is heavily subsidized by the federal government, at the expense of current and future taxpayers:

• preferential tax treatment of capital gains on primary residences, with $250,000 or $500,000 (depending on filing status) of a home's appreciated value being completely tax free;
• the tax deductibility of mortgage interest (on the first $750,000 of a home's value for new mortgages);
• a federally backed system of securitization which ensures liquidity for mortgage backed securities and encourages banks to issue mortgages while taking on virtually no risk themselves;
• and the exclusion from taxable income of "imputed rent," the amount of value a homeowner receives by occupying a dwelling they also own, instead of paying (taxable) rent to someone else.

Different policy makers, journalists, and think tanks focus on different elements of this system, but I don't want to litigate any one piece of this policy puzzle. I'm merely pointing out that these policies create an enormous federal tax and regulatory subsidy for owner-occupied housing of all kinds.What is missed in criticism (much of which I agree with) of this system is that it exists in order to encourage Americans to make a totally idiosyncratic bet, not on the value of land in the United States, or the trajectory of residential housing prices in the United States, but on the value of a specific parcel of land, structure, or condominium unit.No matter how sure you are in a stock pick, commodity bet, or options strategy, you wouldn't put 80-100% of your net worth into one of them without a significant amount of downside protection. Since we decided homeownership was an important goal of American economic policy, we decided to create an enormous subsidy to encourage people to make what would be, under any other circumstances, an extremely unfavorable bet.

Comparing idiosyncratic bets on real estate

I started to wonder: if you wanted to make an idiosyncratic bet on US real estate, and have somewhere to live, would you be better off buying a house and living rent-free in it, or buying the Vanguard Real Estate Index Fund (VGSIX) and paying your rent with distributions from the fund?Both vehicles should provide access to the US real estate market and a stream of income. The mutual fund provides access to a diversified portfolio of US real estate investment companies and periodic dividend distributions, while the single-property option is a concentrated bet on a particular parcel and income in the form of imputed rent you're (not) paying yourself.To answer this question, first I pulled the price and distribution data of VGSIX back to January, 1997, and compared it to the Median Sales Price of Houses Sold for the United States (MSPUS) data available through the St. Louis Federal Reserve's FRED project. Since the median sales price in January, 1997, was $145,000, I used that as the starting value of the mutual fund investment as well.The two numbers we're interested in are capital appreciation (the market value of the mutual fund or the house) and income distributions (the annual income received by owning the asset). Once you have those numbers, you can slice and dice them in a variety of interesting ways.

Why a real estate mutual fund?

Before I get into the numbers, you might be asking, why would you want to get your rent from a real estate mutual fund, instead of a diversified portfolio of stocks and bonds? Isn't that an awfully concentrated bet on a particular sector, and wouldn't it be better to diversify?The answer is yes, which is precisely the point of this analysis: if you think a large sector-specific bet on real estate is too much concentration in your investment portfolio, you should be even more skeptical about a bet not just on the real estate sector, but on a particular unit in a particular building on a particular plot of land.

VGSIX and median home prices do track each other over long time periods

The first question we can ask is simple: over the entire time period, does the Vanguard Real Estate Index Fund actually provide access to the same asset class as individual homeownership?An investment of $145,000 in the median US home in 1997 would be worth $305,125 in 2016, while the same investment in VGSIX would be worth roughly $309,474 (the average of the starting and ending balance in 2016). The maximum deviation was in 2009, when REIT prices bottomed out, while the median home price was more resilient.

VGSIX is much more volatile than median home prices

During the 20-year period I looked at, VGSIX experienced 3 minor and 2 major decreases in market value:

• Between January and December 2002, between January and December 2013, and between January 2015 and December 2015, VGSIX dropped up to 3%.
• Between January 1998 and December 1999, the investment in VGSIX dropped 22%.
• And between January 2007 and December 2008, VGSIX dropped over 52%

Meanwhile, the median home price only fell once, between 2007 and 2009, when it dropped from $244,950 to $215,650, a decline of 12%.

VGSIX distributions fall more often, but by less

Remember, the point of this comparison is to look at the possibility of using real estate distributions to pay rent. That means the volatility of mutual fund distributions matters more than the volatility of the fund's price. During the 20 years I looked at, VGSIX distributions fell in 8 years. However, the peak-to-trough drawdowns were relatively modest, except during the global financial crisis.

• Between 1998 and 1999, distributions fell 4% before recovering in 2000 to above their 1998 level;
• Between 2000 and 2002, distributions fell 7%;
• Between 2005 and 2010, distributions fell a total of 48%, with year-on-year drops between 3% and 35%.

The risk of the strategy, then, comes from experiencing a large decline in distributions after anchoring your expectations to a particular value. Given that VGSIX has experienced a peak-to-trough fall in distributions of 48% in just the last 20 years, you should be prepared to withstand a drawdown of at least that much in the money you have available to pay rent.

Case study: what will the median home price buy you today?

In 2017 VGSIX paid out $1.13 per share in distributions (including dividends and return of capital).In the 4th quarter of 2016, the median home price was $310,900, which would have bought 11,305 shares of VGSIX, distributing (in 2017) $12,775, or about $1,065 per month.Were that to be reduced by 48% to just 59 cents per share, however, you would only left with $556 per month to pay your landlord. Of course, renters also have the luxury of following prices down, so if radical cuts to dividend distributions reduce your spending power, as a renter you'd have the option of moving to a more affordable unit or location, or renegotiating your rent. Likewise as distributions increased you'd have more money available to move to a more expensive location.

Taxes, liquidity, distribution, leverage, and timing

There are some limitations and nuances to this kind of analysis, so let's take a quick look at them, if for no other reason than to abbreviate the arguments in the comments section.First of all, the issue of taxes. The United States has a fairly curious system of taxation whereby the owners, rather than the occupants, of real estate pay taxes on it. I call this curious because it means a homeowner has to personally cut a check to the city or state every year, while a renter usually has no idea what portion of their rent is going to their landlord as income and which portion is going to pay property taxes. In states with limits on property tax increases, two tenants paying the same amount in rent may have totally different allocations of that rent between their landlord and the state, depending on how long the landlord has owned the property.Meanwhile, a tenant paying rent with mutual fund distributions pays capital gains taxes, decreasing the amount of taxable distributions that can be spent on rent, while an owner-occupant receives the imputed rent of the property tax-free. This is an important nuance to be aware of, but is too dependent on local tax policy for me to provide any general insight. I suspect the value of tax-free imputed rent is somewhat higher than any potential benefit to a tenant of avoiding property taxes, but that's an empirical question I don't know the answer to.Second, the issue of liquidity cuts strongly in favor of the mutual fund owner. I used market values in this analysis but the term "market value" means something very different in the two cases: in the case of the mutual fund, it's the actual amount you would receive for selling your shares on any day the stock markets are open. In the case of the median home, it's the price that home sold for after days, weeks, or months sitting on the market and before paying fees to one or more real estate brokers.Third, that brings me to the question of the distribution of home prices. I used the median home price in each year, which is the price above which and below which 50% of homes sold at. That is not, however, the price of the same house, because the distribution of property values shifts over time around the country. While the median home price in 1997 was $145,000, and the median home price in 2016 was $305,125, the median house in the first case might be in Illinois and in the second in Arizona. VGSIX did a good job of tracking median home prices over the 20-year period, but your particular home is virtually certain to deviate from the median by more than VGSIX did — either by appreciating more than the median, or failing to keep up with it.Fourth, leverage is another area where the homebuyer has a key advantage: due to the federal system of subsidies, you can buy $145,000 in housing for just $29,000. It's true you could also use leverage to buy VGSIX (or, more easily, VNQ, the exchange-traded version of the fund), but you'd find yourself paying higher, non-deductible interest rates, and be subject to margin calls should the fund's value drop enough to leave you underwater. By contrast, as long as you keep making your mortgage payments, you can stay in an underwater home for as long as you'd like.Finally, there's the issue of timing. The key feature of the mutual fund strategy is that you can move without selling. Just take your rent budget and spend it somewhere else. Homeownership means that in order to liberate the imputed rent you've been using to live on, you have to sell your home entirely, at whatever price you're able to get, and then make the decision whether to rent or buy all over again.

Conclusion

In the absence of the enormously expensive regime of subsidies provided to owner-occupied housing, I believe the financial advantages of mutual fund investing would swamp those of homeownership:

• if imputed rent were taxed as ordinary income the way other rents are, then homeowners would have to more carefully consider if they're getting as much value from their homes as a potential renter would;
• if mortgage interest were not tax deductible, after-tax mortgage interest rates would be more closely aligned with rates charged on other kinds of secured loans, making leveraged housing purchases less attractive compared to other kinds of debt;
• if a federally-backed system of securitization didn't exist, banks would be less willing to make mortgage loans to marginal buyers, requiring shorter terms, variable interest rates, or higher down payments;
• if capital gains on residences were taxed the same as gains on other capital assets, there would be less incentive to use housing as a form of tax-advantaged savings account.

Without those benefits, the idea of making a leveraged bet on residential real estate in a particular time and place would make as much sense as making a leveraged bet on the price of Apple stock, pork bellies, or bitcoin.However, given the existence of those benefits, the picture becomes much murkier and almost completely contingent on the specific buyer, location, and property.

Why do so few people use non-conflicted financial advisors?

I was listening to the latest episode of the "Animal Spirits" podcast with Michael Batnick and Ben Carlson, and they mentioned a statistic in this (paywalled) Wall Street Journal article: just 2% of the 285,000 professionals giving financial advice in the United States are fee-only financial advisors, who are held to a fiduciary standard that requires them to put the interests of their clients first.An ocean of digital ink has already been spilled over the Department of Labor's aborted fiduciary rule requiring advisors on retirement accounts to act as fiduciaries, and the SEC's decade-long refusal to impose a similar rule on all financial advisors, so I'm not going to repeat that history here.Instead, I think it's worth considering why so few investors who, in principle, are the ones that should be most interested in ensuring their assets are invested with their best interests in mind, use fee-only financial advisors. No one would go to a doctor they knew was being paid by a pharmaceutical company to prescribe a certain drug, or a lawyer they knew was being paid to file in a certain jurisdiction, so why do investors go to financial advisors being paid to work contrary to their interests?

There aren't very many fiduciaries

Unless you stop to think about it, you might not notice just how many "financial advisors" are out there.I didn't think about it until I recently drove through a struggling area of central Illinois, and even in a town with blocks of empty storefronts, burned-out buildings, and crumbling houses, there was an Edward Jones office offering "retirement" services. Of course the only "retirement" services they offer are high-cost, variable fixed income annuities with big commissions for the agent who closes the deal.How is the average investor in central Illinois supposed to even find out how abusive these products are, and that there are financial advisors who put the investor's interest first? Google? All they'll find there are another thousand agents trying to sell variable indexed annuities!Almost every Chase, Bank of America, Citi, US Bank, and Wells Fargo branch in the country has a desk with a little sign next to it saying "financial advisor." That's what financial advice means to the overwhelming majority of individual investors.

They're not accepting new clients

My buddy George Papadopoulos (not that one, the other one) is a fee-only planner in Michigan. He seems skilled and conscientious, and his clients seem satisfied with his work. And he hasn't accepted new clients since 2017.It's not his fault: providing skilled, conscientious, fiduciary advice is hard work. Why would anybody do any more of it than they absolutely have to?By contrast, nobody's ever been turned away from a Chase branch because the branch "has enough clients already." Make an appointment (or don't!) and somebody will be able to see you the same day, they'll have all the forms ready for you to move your assets over, and you'll be on your way in no time.

They have transparent fees

The most common argument made by the non-fiduciary crowd is that sure, they might churn accounts a little bit than they should, they might buy and sell securities that aren't strictly speaking in the best interest of the client, but if they weren't allowed to do that, then investors wouldn't get any advice at all because investors aren't willing to pay for it.And anyway, the products still have to be "suitable," and maybe sometimes they'll even outperform the market!Compare that to a fee-only financial advisor who gets paid directly by the client, instead of through commissions, marketing fees and sales charges. It's a lot less fun to pay a fee you're billed directly than one that's extracted one trade at a time whenever your broker has a hot new investment idea.I think unbiased financial advice is worth paying for (if you're willing to take it), but it never feels good to pay for something, especially when down at the bank they're telling you that all of their fees are "included."

They're boring

Since the correct thing to do with your investments in 99.9% of circumstances is nothing, the client of a fee-only advisor often finds herself in the bizarre situation of paying someone to tell her not to do anything, and that everything will be fine.Meanwhile, a commission-based advisor can't wait until the next big market downturn, or upturn, or increase in volatility, or decrease in volatility, so they can tell you the market environment has completely shifted and it's time to incur another batch of trading commissions.Yield curve flattening? Better do something. Dollar weakening? Better do something.But a fiduciary who puts your interests first should know better than to chase performance, overtrade, and overpay for active management that's almost certain to underperform low-cost mutual funds (and ETF's, if you're so inclined) over the medium and longer terms.

Quality is tough to measure

A fee-only advisor acting as a fiduciary can't accept the legalized bribes that non-fiduciary advisors accept. But it's not enough for a doctor to free of conflicts with the pharmaceutical industry, you'd also like them to be a skilled medical professional. It's not enough for a lawyer to be unconflicted, you'd also like them to win your case.Likewise, a financial advisor without any conflicts at all can still give bad advice, and for someone without any investing experience bad advice sounds pretty much the same as good advice.Just like buying socks, toothpaste, or contact lenses, if you don't know how to distinguish good products from bad products in advance, you can either buy the more expensive version (hoping that price does the work for you) or the cheapest (hoping that you save more in cost than you lose in quality).Unfortunately, when it comes to financial advice, the question of whether it's good or bad depends just as much on you as it does on the person doing the advising. A fee-only, fiduciary financial advisor is perfectly free to advise a strategy of building a highly-leveraged real estate empire, a fleet of lobster boats off the coast of Maine, or a pile of gold in a safe deposit box in Switzerland. They just can't be paid by anyone else to suggest it.If you don't know what kind of investor you are (or want to be), it's almost impossible to identify a financial advisor that's able to help you meet your goals."Fee-only" is used as a kind of talisman by the financial planning industry, but you should think of it as a necessary, not sufficient, requirement for your financial advisor.

Basics of IRA recharacterizations

Like aircraft flying at very low altitudes, the US tax code does strange things when very low incomes are involved. Most people know about, or have at least heard of, the earned income credit, which phases in quickly as "earned income" (which includes wage and self-employment income) rises, then phases out somewhat more slowly.I think that's bad program design, since it creates a weird higher marginal tax rate in the phase-out range, which then drops again when the credit is fully phased out, and I think the tax code should feature steadily rising marginal tax rates, not ones that bounce around all over the place, but economists like these "phase-outs" and the economists won.If the earned income credit has an unfortunate design, it's nothing compared to the retirement savings contributions credit, which has two abrupt adjusted gross income thresholds that reduce the value of the credit by 60% and 50% at $18,501 and $20,001, respectively, for single filers, before being eliminated completely at $31,001 in adjusted gross income. Those cutoffs have no economic rationale, but presumably they reduce the cost of the program since low-income folks tend to have more volatile income and will bounce around between the income bands.These cutoffs mean fine-tuning your adjusted gross income can make an enormous difference to your total tax liability, and IRA recharacterizations are a great way to fine-tune your adjusted gross income.

The 2017 tax reform did not affect recharacterizations

This gets a bit confusing, since there was a change in the 2017 tax bill that affected a particular tax planning strategy involving IRA's. That strategy involved transferring a tax-deductible traditional IRA balance into an after-tax Roth account, then reversing the transaction if the account fell in value before the tax filing deadline, a sort of heads-I-win-tails-I-win method of managing current and future income tax liability.That strategy was eliminated by Congress in the 2017 tax reform bill by stipulating that Roth conversions cannot be reversed: if you convert a traditional IRA to a Roth IRA, you are liable for income taxes on the amount of the conversion whether the Roth account rises or falls in value.All of this is made even more confusing by the fact that people use the terms "conversion" and "recharacterization" interchangeably. In this post I'm calling converting an existing traditional IRA balance into a Roth IRA account a "conversion" and redirecting an IRA contribution to a different account type a "recharacterization."And there was no change to the ability to recharacterize contributions, which can be done in either direction: contributions to a Roth IRA can be recharacterized as contributions to a traditional IRA, and vice versa (subject to Roth IRA income limits).

Recharacterizations were intended for high-income taxpayers

Since Roth IRA contributions can only be made by taxpayers with modified adjusted gross incomes below a relatively low limit ($133,000 for single filers in 2017), but many people (in my view, rightly) make weekly, biweekly, or monthly contributions throughout the year, there needed to be some mechanism for taxpayers whose income turned out to be above the contribution threshold to correct their mistake.That mechanism is the recharacterization, whereby a contribution (legal or illegal) can be recharacterized from one account type to the other. In a recharacterization, both the original contribution and any earnings or losses on the contribution are transferred, meaning it's irrelevant which account type you contribute to during the year: whether it gains or loses value, in a recharacterization everything is calculated as if you had made the contribution to the other account type in the first place.

Recharacterizations are great for fine-tuning low incomes

Low-income workers are the biggest beneficiaries of Roth IRA's, since the "post-tax" contributions they make to them are generally "post" a tax of $0. That means they feature the enormous benefit of tax-free contributions, tax-free internal compounding, and tax-free withdrawals. A good deal!But due to the "ground effects" of the retirement savings contribution credit I described above, it can be extraordinarily valuable to fine-tune the income of low-income workers, since the difference of a dollar in adjusted gross income can mean the difference between a credit that covers your entire tax liability and one that leaves you owing $418!That means a low-income worker's "core" retirement savings account should be a Roth account, but with a traditional IRA on the side to fine-tune their AGI before filing their taxes each year.

My 10-minute recharacterization call with Vanguard

I made very slightly more money in 2017 than I did in 2016, and when I plugged my numbers into Free File Fillable Forms my adjusted gross income was about $4,900 over the $18,500 threshold needed to claim the maximum retirement savings contribution credit.This was a purely unforced error. I have a solo 401(k) for my self-employment activities, into which I split contributions 50/50 between the pre-tax and Roth subaccounts. If I had made only traditional contributions, I would have been just a few bucks away from the $18,500 target and could have just topped up the traditional account with retroactive contributions, which is what I've done in previous years.But five grand is a lot of money, and I'm poor, so it was time to learn about recharacterizations.Once I'd identified the precise dollar amount I needed to recharacterize, I called Vanguard, where my Roth IRA is held. After the security questions, I told the agent what I needed to do and he immediately understood. Since I didn't have a traditional IRA with Vanguard, he told me to open one online while he waited. After I reached the confirmation screen, he refreshed his view and saw the account.After I told him the amount of the 2017 contribution I needed to recharacterize, he plugged it into his computer and immediately returned with the amount of earnings on that amount (2017 was a good year).Note that you have the option to identify specific contributions to recharacterize. I had 52 (give or take) contributions in 2017 so didn't bother with specific identification, but it's an option that's available if you want to recharacterize only the most-appreciated or least-appreciated contributions (most-appreciated if you're recharacterizing to Roth, least-appreciated if you're recharacterizing to traditional).Then he asked me which securities in my Roth IRA I wanted to move. Vanguard moves securities in-kind internally, so you don't have to sell to cash before recharacterizing. I told him to move all my TIPS and take the remainder from my Vanguard 500 holdings.Since I held Admiral shares of the Vanguard 500, he warned me that Vanguard would eventually downgrade them to higher-cost Investor shares unless I topped up the balance to the $10,000 minimum.The entire call, including opening a new traditional IRA account, took 10 minutes.

Conclusion

As I'm fond of saying, the overwhelming majority of financial advice is targeted at people who can afford it and don't need it, rather than people who need it and can't afford it.The retirement savings contribution credit is the major tax benefit available to filers who make too much to qualify for the earned income credit, and claiming the maximum benefit is the easiest way most low-income filers have to increase the amount of their federal income tax withholding returned to them as a refund each year.IRA contribution recharacterizations are an easy way to maximize the amount of your retirement savings permanently shielded from taxes, while also giving your savings as much time as possible to work in the markets.