Trick or Treat

Location Date: 
October 20, 2011

October could well go down as the cruelest month, and not just for wild swings in the stock market.  Zero Hedge reported yesterday that October 31, yes Halloween, could be the date that government debt to GDP exceeds 100%.  In terms of round numbers, that is $15 trillion of debt!

Trying to navigate all of the extremely large numbers can be daunting.  So enter Mike MacBain of East Coast Fund Management to simplify things for you.  At our Arrow advisor presentation a few weeks ago, Mike condensed the U.S. federal balance sheet and income statement into a “household” format – just take out 8 “zeros,” round-off a few digits, and here is what you get:


Family Income Statement


Annual Family Revenue


$ 21,700


Annual Family Expenditures




Net Family Income/Loss




Proposed Budget Cuts:


$ 385



Family Balance Sheet


Outstanding Family Debt




New Debt on Credit Card




Total Debt




Now if you were the bank, would you lend to this family? 

Of course we have not put in the fact that the U.S. does have substantial assets that it could “sell” and it has the power to increase taxes or cut expenditures (i.e. it can change its balance sheet and income statement if it wishes to do so).  We could also say thanks to the FED for historically-low interest rates so that our debt service costs are extremely low today.  But the big question is, when will it get around to “fixing” things?  If it waits too long, will it foster a real crisis of confidence? 

On that front, there is endless debate inside and outside of Washington as to how best to get the job done.  The American people will be given a choice so that by January 2013, we will have to have a “solution” to the twin structural deficits – one that explicitly discusses how social security and healthcare benefits are cut.  As many have pointed out, social security is reasonably “easy” – raise the retirement age and provide it only for those who truly need it.  Health care is much tougher to reform. 

The short-term annual deficits will also need to be tackled.  This is where many are suggesting a policy of taxing the “rich” as a way to solve our problems.  One of my great fears is the debate will lead to America descending into class warfare – where the “rich” (1%) are pinned against the poor (99%).  Robert Sanborn, a fund manager based in Chicago and one for which we have a great deal of respect, recently penned his 3rd quarter letter which contained a rather scathing critique of Warren Buffet – not of his investment acumen but rather his politics.  Mr. Sanborn is a brave soul for chastising the Oracle of Omaha!  I find myself very sympathetic to Mr. Sanborn’s views.  Here is, with permission, the text of his commentary.

Warren, I Hardly Know Thee

Warren Buffett, outside of a couple personal friends, is the professional investor I most respect. His record is long-term and outstanding and, more important, it has been achieved with a logical and disciplined approach that he describes in his annual letters with rare clarity. My TV set is programmed to TIVO him whenever he is on CBNC, and I watch every minute.

Which is why I am so disappointed with him over his recent forays into the political world. If he applied the same logic to his investing that he applies to his political views on the economy, his fund would have blown up ages ago. There are two main reasons I am disappointed, first, the towering hypocrisy, and, second, that he is being used to help mis-inform the American people in order to agitate them.

First, the hypocrisy. This begins with the meaning of the word “rich”. President Obama has always used this term in a misleading way, as he defines “rich” as any household with $250,000 in taxable income. Now, say, is a married pair of doctors, finally earning good money at age 35 and with perhaps $500,000 in debt, living in New York or Boston, and earning $250,000 “rich”? Of course not. On the other hand, is someone with no earned income and a $100 million muni-bond portfolio “rich”? Well, not in Obama’s world, but definitely in the real world.

The so-called “Buffett rule” would ensure that middle-income earners pay lower average tax rates than people making over $1 million per year. Buffett allegedly came up with this idea when he discovered that he pays a lower tax rate than his secretary. On his $100,000 in salary and $63 million in adjusted gross income and $40 million in taxable income, most of which presumably were in the form of capital gains, he paid $7 million in taxes, a lower rate than his $60,000 per year secretary.

The hypocrisy is multiple. Relative to his WEALTH, Buffett may be the lightest-taxed American in history. He pays a relative pittance in taxes relative to his vast wealth. Moreover, he has structured his business life------with a low salary, a trust that holds most of his assets, and huge un-realized gains-----to minimize the taxes he pays. He could voluntarily pay more to the Treasury if he wanted, but by all accounts has not chosen to do so.

Moreover, Buffett has campaigned in favor of the estate tax, but----lo!, and behold----he will pay very little there too, as the vast bulk of his estate will go to the Bill and Melinda Gates Foundation, and thus escape the death tax. Moreover, Buffett leads a group that urges his fellow billionaires to give at least half of their estates to charity. Now, most of these billionaires are those whose wealth, like Buffett’s, is in the form of un-realized gains. So-----and, kind reader, please dwell on this to contemplate the enormity of this nonsense----Buffett, on the one hand, thinks his fellow billionaires (at least those with “low” taxable income and , thus, “low” tax rates) pay insufficient taxes while, on the other hand, he advises the same people to take steps that will further allow them to escape taxation.

Second, and even more pernicious, is Buffett’s role in mis-educating the masses. It would be far more consistent if Buffett were to argue that people like him should pay taxes on their un-realized gains, or a minimum estate tax, or, God forbid, a wealth tax. Those WOULD hit him.

However, Obama is using Buffett to argue that “the rich” (ie., those making $250,000 and up) should pay more taxes, and Buffett surely knows this. As I write this, the “Occupy Wall Street” groups are holding their protests, which focus on the protestors’ view that the “rich” are screwing them and everyone else. As an aside, I have tried to engage some of these people here in Chicago in a dialogue, but got nowhere. Based on these attempts at discussion, I safely conclude that 99% of these protestors do not get the distinctions between capital gains, earned income, etc. They sure seem angry, though, and sure have “passion”. I must say, I found it humorous that some hold signs such as “Down with the Corpocracy” and “Corporations aren’t Persons” while they wear Abercrombie + Fitch shirts and Nike shoes, communicate on Apple devices through the Verizon network, get transported on oil delivered by Exxon, drink Diet Pepsi, meet at Starbucks, and so forth. Somehow, I do not think the protestors appreciate the irony. The problem is, the facts are that “the rich” pay the vast majority of taxes, and almost all income taxes. The top 10% pay a staggering 71% of all income taxes. The guy at the middle, the 50% percentile, pays very little if any income taxes. However, this rhetoric coming from Obama and Buffett, gives those that do not know any better the impression that the “rich” are getting a free ride, paying no taxes (or at least at a lower rate than the average person), and screwing the middle class.

The facts are clear. According to the Tax Policy Center (affiliated with the left-of-center Brookings Institution), effective federal tax rates for the top 0.1% in 2010 was 30.4% and for the top 1% was 28.0%. The next top 4% pay 25.8%. On the other hand, the middle quintile pays an effective tax of 14.1%, most of which is from both sides of the Social Security tax. The lowest quintile pays 1.6%, and the second-lowest quintile pays 7.3%.

Any fair person looking at this data must conclude the US has a very progressive tax system, and that arguing that “the rich” pay less than the guy in the middle is pure poppycock. Yet Buffett is a huge part of this deception, which is very corrosive to the social ties that bind us. It is one thing to have a political point of view supported by the facts, but to willfully distort the facts or to ignore the facts to advance a political view shows a lack of integrity.

So, Warren, I will still pay careful attention to your investment views. Your political views? You’ve lost me.

Robert J. Sanborn

October 17, 2011

Of course, we will be posting further thoughts on this difficult situation in the future.  The important issue for readers is that confidence will return to markets and businesses when policy debate is turned into decisive, clear and thoughtful action.

Jim McGovern