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Fed's Small Fixes for a Growing Economic Problem

Economics / US Economy Jan 16, 2008 - 08:52 AM GMT

By: Paul_Petillo

Economics The economy has taken a serious turn since the first of the year. January has seen the Wilshire 5000 drop 4.9%, unemployment tick up, and write-downs and write-offs increase in size. Fortunately, the news is finally reaching the campaign trail. Problem is no one can quite agree on whether these problems are short-term or long, good or bad, recessionary or just simply the result of a poor calculation done months, perhaps years ago. So what happened when we turned the calendar?

If the Federal Reserve's stance is any indication, they are not the ones to ask. Fed Vice Chairman Donald Kohn has gone on the record with the following quote: “We cannot say more that we know and we should strive to avoid giving the impression that we know more than we do.” Okay. Mr. Bernanke was much more upfront with his view of the economy falling just this side of saying “I dunno know”. Now the markets are optimistically calling for a 750 basis point cut!

But it is an election year and despite the incredibly good television the candidates are providing, the economy has made itself an issue. John McCain claims to know little about the economy. Mike Huckabee has taken the cut taxes for the rich approach while giving the middle class some typical GOP lip service about it will benefit them. Mitt Romney simply says he's a better choice than the Democrats.

And the Dems, the party of the taxpayer see the economy as a much more complicated mechanism that needs to be fixed by reassuring the populace that A, it is not their fault and B, it can be fixed. Their focus has been on giving the states relief (John Edwards and Hillary Clinton), which sends a message to all Americans that the mess we are in will not be an easy fix to Barack Obama, who seems to have taken the GOP side – slash taxes and call it incentive.

While the candidates are still acting like moths to a porch light, chasing each voter's whim and many doing so without much more than generalizations, the economy swoons under the weight of bad-to-worse decisions.

Businesses, left to deal with their own poor mistakes have been crying for relief as well. Investors, who may have turned a blind eye to risk over the past year or two, reeling from the fallout are also standing in the same line. Everyone wants to be stimulated, revitalized, and rescued. Here's my plan.

I have read numerous proposals for economic stimulus. Most recently, the Wall Street Journal harkened back to a simpler time when the tax code was much less democratic and the economy was less global. When John Kennedy took office, this country was feeling much the same as it is today. Deficits were looming, an un-winnable war was being waged, unemployment was rising and the economy was not feeling the love or the benefits that only Washington could bestow.

The JKF Stimulus Plan or as it was referred to at the time, the New Frontier, offered the American people a more optimistic and hopeful look at a world. Many remember the New Frontier as little more than a promise to be the first in space rather than the economic stimulus package it actually was. Kennedy's plan focused on short-term stimulus, much like what is being discussed today but with much longer-range goals.

Question is can his ideas still work in this economy four decades removed. His focus on expensing was the right thing to do at the time. To many investors, the word expensing suggests an underhanded accounting technique used by more than a few large public corporations to hide compensation for its senior executives tucked away in stock options. But the idea of expensing, as it relates to equipment purchases has some solid footing among businesses, large and small.

For those that may not know how this works, expensing allows a business to write off the cost a buying a piece of equipment in the first year rather than deducting it from their taxes over the course of its usefulness (usually five years).

In 2002, the limits for expensing deductions in the first year of purchase was limited to $24,000. With the Small Business and Work Opportunity Tax Act of 2007, that amount was increased to $125,000 and was indexed for inflation until 2010. This is an incredibly deep discount for businesses that might be hesitant about making a major purchase. To a small business (depending on the owners tax bracket), this can amount to a savings of 25% or more on the cost of equipment. Purchased equipment creates jobs on both ends of the deal.

But as a short-term stimulus, it lacks teeth. Yes it does allow businesses to make forecasts further ahead than if such an accounting technique was not used but it also assumes that the business will still be “in business” five years down the road.

Expensing has a downside and this may make the very companies that might use it, think twice. If the equipment purchased today is no longer viable in the near future or the business sells, the IRS can recapture the savings from that first year depreciation and the tax savings will be given back.

While that penalty might be hiding under the surface and in the back of the minds of many businesses, some problems are much more clear. The ability to borrow money for these types of capital expenditures will be the most difficult hurdle for any business in the coming year. Not only will purchases be more difficult to finance, many companies are faced with the additional cost of refinancing current debt.

Additional ideas being floated by experts vary widely in whom they help and how much they will stimulate the economy. The cries for making permanent the tax cuts set to expire in 2010 have been raised a decibel or two. Political opportunists, who see this as the best kind of stimulus, rely on the psychological nature of those cuts. They didn't help much when they were first enacted and making them permanent will only serve to enrich the same folks that benefited from them previously.

Former Treasury Secretary Larry Summers has been touting the benefits of a Keynesian-type stimulus package. But it didn't work when the President tried it several years ago and it won't work now. Summer's idea might help the average taxpayer with this month's grocery bills or buy enough gas to get to and from work for a couple of weeks but the extended effects of such a move would be felt only briefly. One candidate has advocated a short-term bump. Hillary Clinton has offered heating relief package that would be spent, not saved but by the time she or anyone currently campaigning reach office, it will be too late.

To hear the current Treasury Secretary Henry Paulson speak about the economy leaves one with little hope that he has a bead on the right target. Not two months ago, Paulson was suggesting that the economy was strong enough to withstand some credit woes. Now, "There are risks to the downside" and, he is quick to add, because the Democrats now control the Congress, any potential help that the White House might suggest to fix the problem will be stalled due to partisanship.

I believe that three things can be done right now that would help get the economy out of the breakdown lane and back on the road. First: As I mentioned earlier, do away with the “give back” provision on all equipment depreciation. This would have the net effect of creating the potential for more jobs but it will not work as well without a much more lenient credit market.

As much as Ben Bernanke's swift rate cut stimulus might look good on paper and would definitely sound good for the media and the stock market, truth be told, lenders are still not convinced that borrowers can – or will, pay them back. Nor are they convinced that the loans they issue will be market-able. You can cut all you want Mr. Bernanke, the borrowers are just not there. Removing that provision might create enough of a risk/reward scenario that businesses might just jump.

Second: Reduce or eliminate the unemployment tax that businesses pay to the federal government. Let the states collect the taxes the way they currently do and allow them to make individual decisions on how long unemployment insurance should last based on their own economic needs.

The third and last suggestion – candidates, are you listening – involves making the some tax cuts permanent – just not the ones set to expire in 2010. I believe that if the following provisions were made to the tax bill, some are actually complimentary to the current relief bill, it would have the potential to provide enough stimuli to assure the right of taxpayers that the government is looking out for them.

Freeze the current income tax rates for 95% of the taxpayers. For some, this would be a tax increase but those taxpayers failed to provide the spending that would drive the economy and the job creation as was more or less promised they would do.

The government could lower corporate taxes for all businesses, which would have the net effect of making the US more competitive and could be done without removing important shareholder regulations. This particular move could be offset with a return to the 20% capital gains and dividend tax.

And lastly, eliminate portions of the Alternative Minimum Tax that would have the greatest impact on small businesses. Allow businesses to retain two portions of the current law: allow tax deductions to continue in states with the highest state and local taxes, including income, property, personal property and sales taxes and allow small businesses to take the miscellaneous itemized deductions that are so vital to cash flow.

By Paul Petillo
Managing Editor

Paul Petillo is the Managing Editor of the and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via:

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