One More Wealth-Skimming Consequence of Boom-Bust

When it comes to inflation – the monopoly-enabled money-printing / credit-creating type – there are many benefits to those receiving on the front end (politicians, bankers, crony-capitalists, etc.), and many costs to those receiving on the back end…wait, that didn’t come out right…although it paints the proper picture.  I think you get my meaning.

I will comment on an aspect that gets little, if any, attention – at least within the universe of what I have read on the topic: the tax benefits to the state.  I will take this in two forms – one somewhat more obvious, and another that may not be so.

First, to the more obvious (and at least somewhat more commented on): inflation stimulates (or attempts to stimulate) economic activity more than otherwise would occur.  On the back of this false, boom activity rides tax receipts – real wealth taken from the productive sector to the government sector.  That this will be partially offset (and certainly reduced) in the subsequent and certain bust is somewhat irrelevant; all politicians in elected democracies live for today.

Second, perhaps the less obvious: tax-loss carry-forwards in various forms.  Some examples and definitions will help:

Tax Loss Carry-Forward:

A tax loss carryforward takes place where a business or individual reports losses on a tax return up to seven years after the loss occurred. Frequently the logic behind this is to reduce tax liability during a year where the income or profits are high if losses were experienced previously. The tax loss carryforward reduces the overall tax liability during the high-earning year by incorporating the earlier loss as a reduction to taxable income.

In the boom, artificially high profits were earned.  Tax is paid on these in the immediate year earned.  In the bust, lower profits and, inherently, losses are incurred.  These losses do not result in a refund of prior years’ taxes paid (paid due to the boom that will always result in the bust); the losses do not result in a payment from the treasury to the taxpayer at the marginal (negative) tax rate in the current year.  Instead, the taxpayer must carry-forward the loss, helpful only in future years and only if a profit is achieved in the future.  So, on a timing basis, the treasury comes out ahead.

Consider; the boom ensures a subsequent bust: condition precedent is the boom; condition subsequent is the bust.  But the logic of the tax code is the opposite: the losses associated with the bust cannot be retroactively applied to the taxes paid during the preceding (and causing) boom.  Instead, they must be carried forward – to a boom not associated with the current bust.

Of course, if the business goes bankrupt in the bust, there is no profit in the future against which to apply the loss.  The treasury comes out net ahead.

Net Operating Loss:

A period in which a company's allowable tax deductions are greater than its taxable income, resulting in a negative taxable income. This generally occurs when a company has incurred more expenses than revenues during the period.

The net operating loss for the company can generally be used to recover past tax payments or reduce future tax payments.

The terms of the tax relief and how it can be applied varies by jurisdiction but usually the NOL can be applied to the past few years (two to three) and much more to the future (seven to 10) years.

Similar in concept to a tax-loss carry-forward.  Note that the retroactive period is much shorter than the prospective period.  I often hear of businesses that carry as an asset a tax loss.  This suggests that the prior 2-3 years where not useful in recovery, and that the hope is for the future ten years to offer the possibility of application.

Once again, the treasury is paid taxes on income, while the taxpayer has to wait to gain benefit from losses.

Writing off Investment Losses.  Note: this is taken from an article at the end of 2008 – a year of significant investment losses for many, and a bust period following a significant boom (similar to the dot-com bust several years earlier):

The IRS allows a taxpayer to use up to $3,000 in net capital losses to offset ordinary income. Capital losses of more than $3,000 ($1,500 if married, filing separately) must be carried over to the next year, though they can be carried over indefinitely.

Take the example of someone with $500,000 in capital gains and $1 million in capital losses. After subtracting the gains from losses, he has $500,000 in excess capital loss. He can use only $3,000 of that loss to offset ordinary income, such as salary, that year.

The taxpayer, having previously enjoyed the gains from the boom (and paid taxes for the privilege), now faces substantial capital losses due to the inevitable bust following the preceding boom.  Can he go back to the returns of the boom years and apply these losses to the earlier periods?  No.  They can only be applied to future years, and only up to the amount of the future capital gains plus $3000 per year.

So, the poor sap in the above example must either dive back into the market and hope for the best (the next boom), or wait 167 years to recover.

These are just a few examples.  Different jurisdictions have different rules.  Sometimes the losses can survive a bankruptcy, sometimes not.  But most, if not all, tax laws are skewed in favor of the treasury – leveraging the inevitable bust following the boom to the benefit of the state.

To summarize: the bust is tied to the preceding boom, yet the tax benefits (if you will) of the bust must wait for the next boom (if any benefits are even realized; often, the benefits can die unused for various reasons) – the treasury is always one cycle (if not permanently) ahead.