Wednesday, December 27, 2006

Energy, Taxes and Expropriation

When I was back in the electricity industry there was a large movement to invest in assets overseas. The plan (on paper) was to invest in generation, transmission and distribution assets for electricity, gas and water around the world where infrastructure was poor and the local authorities didn't have enough money to make the necessary upgrades. Many of these countries lacked the rule of law and had weak capital markets, as well as uncertain political leadership. Some prime examples of this sort of investment include Dabhol in India by Enron and Endesa in South America.

These plans nearly brought the companies to ruin. Why? Because when you invest in "hard assets" overseas, you are at risk of Expropriation. What is Expropriation? The exact definition is disputed but what it typically means is that overseas investors have their local property taken over and aren't paid the market value for this property, or aren't paid anything at all. During a revolution assets are often expropriated. A key example is Cuba, where the dictatorship under Fidel Castro took over assets from their rightful owners, both companies and people. Ask any Cuban living in the US and you are likely to get a long discussion of how this worked.

Power assets are particularly susceptible to expropriation. Why is that? Because the assets physically sit on the ground and the local government usually requires that local labor be substantially involved with the construction and operations. Once the assets are sitting on the ground and operating, you can't just "pull up stakes" and leave, or the local country essentially just takes your investment for free.

Smarter countries can play games that essentially accomplish the same thing. If you have a power plant, it often has to sell power into the local grid. Instead of paying you in dollars, they can pay you in the local currency, which has depreciated in value significantly against the dollar. Russia recently accomplished this same goal in a semi-subtle manner with the huge investment that was made by Shell in Sakhalin by manipulating environmental claims against them and making Shell see the writing on the wall that they were going to control it no matter what Shell's contracts or negotiations with prior governments had indicated. In some ways Russia and Sakhalin represents a double-expropriation - first the Russians took this from Japan during the waning days of WW2 (no peace treaty was ever signed on this topic) and then they took the investment away from Shell (de-facto).

Now that I have gone through what expropriation means, the question arises - what does this have to do with taxes?

If you look at tax literature in the US the common assumption is that it is better to defer taxes paid to the government to some future date. The theory behind the 401(k) plan is that you put aside money today that is NOT taxed and it is able to grow tax-free for years and years. When you take this money OUT of your 401(k) it is taxed as income in the year you pull out the money, and the assumptions are 1) that your tax rate will be lower because you will be retired and making less current salary income 2) that all the tax free growth compounded for years and years provides significant growth.

However, this math works assuming future tax rates are stable. On the other hand, if the US is running significant deficits, there is nothing to stop the US government from raising taxes on 401(k) assets right when you need them, at retirement. The government would look at all these "captive" 401(k) assets sitting there as a giant honey-pot; let's say that you are a Democrat and for the most part (aside from Hollywood) your electoral voters are poor. Since the Republicans already hate you, you have nothing to lose politically by slapping a big tax on 401(k) withdrawals above a certain limit, maybe the limit that YOUR voters receive from social security. This is a pain-free method of the Democrats redistributing your wealth to their voters. And what could you do about this? NOTHING. Because your assets, just like the power assets overseas, are trapped; at some point you have to "blink" and withdraw your assets for retirement or they are useless to you; thus the government knows that it can out-wait you.

The Republicans, in one of their few pro-business moves, created the Roth IRA. The Roth IRA works in reverse; you pay taxes NOW and then it grows tax free forever, as long as you meet certain rules (waiting until you retire or using it for specified purposes). Unfortunately the Roth IRA is crippled with low income rules meaning that it is not usable by higher income individuals, the same individuals that would be most liable for expropriation. The Roth IRA shields you from tax rate creep; however, the government could still implement a "windfall" tax on Roth IRA's like they threaten to do on oil companies from time to time.

It is a bad assumption to make that future tax rates will be lower than current tax rates. Capital gain taxes are now low; for assets held for years the rate is only 15% while the ordinary income rate can be 28% or 33%. If you have an investment (i.e. land in Arizona) and it has appreciated, you may want to seriously consider selling the asset and taking the tax hit if it appears likely that the Democrats will abolish the capital gains tax breaks and treat it as ordinary income. The tax hit today means 1) money out of pocket 2) lack of future growth in the asset. However, the difference between growth and a 33% tax rate is very significant when you compare it to no growth and a 15% tax rate. For example, if you bought something for $100,000 and sell it for $200,000 at a 15% tax rate, your gain is $100,000 and your tax liability is $15,000, for a net gain of $85,000 after tax. If you buy that same asset for $100,000 but hold it longer so it is worth $230,000 and sell it for a gain of $130,000 but pay at a 33% tax rate you pay $42,900 in taxes and have a net gain of $87,100 so it is about the same. This is not to say that you should make "economic" decisions based solely on tax consequences; but if you are on the edge of a decision (i.e. to keep an asset or sell it) and you think that a tax change is coming that will be for the worse, it should factor into your decision.

I do see articles from time to time talking about the immense tax increases that will have to be imposed by both the states, local municipalities and the Federal government when you factor in their pension and medical promises for employees as well as social security for everyone. However, I rarely see the other side of this advice, which is that deferring taxes indefinitely and then hoping that rates will be lower in the future may not be a sound plan.

I don't have the certain advice but do believe that it is a consideration that should exist in your mind. Ultimately the "solution" for tax expropriation is to move money offshore and out of the reach of tax authorities; I abhor this solution because it is expensive and contains many risks of its own, as well as being unpatriotic. However, with the rise of world markets and tax free havens around the world it will be a growing consideration for more and more Americans. Sadly, the remaining burden will fall upon those that stay, which will make the problem worse.

In the grand scheme, the solution is growth, whether it is new investment, immigration, or productivity. This is the only plan that can save our finances. Waiting for the governments at all levels to "fix" their fiscal problems is pure folly. As a taxpayer, you need to watch for this and think about the total economic picture. Deferring may ultimately equal expropriation...

1 comment:

Carl from Chicago said...

From today's WSJ... Goldman is about the smartest company around. Note how they are primarily investing in the US and Europe to avoid the topic of this post... I guess if you need infrastructure and you live in a poor country you are screwed...

Goldman Sachs Group Inc. closed its first GS Infrastructure Partners fund with more than $6.5 billion in committed capital.

The New York-based global-investment company said the fund is dedicated to making global infrastructure investments.

The company said the fund will seek investments in traditional infrastructure sectors – such as toll roads, airports and ports as well as regulated gas, water and electrical utilities -- and expects the primary opportunities to be located in Europe and North America.