Unintended Consequences: Case Study

Gripping stuff from the dismal science here – but you might want to understand it, if you, for example, vote. Or it may cure insomnia. Even I get drowsy thinking of it:

Arbitrage: Buying and selling the same thing at the same time in two different markets at two different prices. Say I have a buyer for something – pork bellies, crude oil, default risk on a consumer mortgage portfolio, whatever. I don’t own what the buyer wants to buy, but I know how to get it. I shop for a price that’s lower than the buyer will pay. I execute the purchase from the seller at the same moment I sell to the buyer. I never see the pork bellies or crude oil – the seller and buyer make whatever arrangements they want. The difference is profit. I earn the profit by being more aware of the markets for the goods I’m arbitraging than the buyer or seller are. The buyer could, in theory, shop for himself and maybe uncover the same deal I found. But this is often difficult in practice.

The market* (there’s that market, again) is strongly inclined to eliminate arbitrage. When arbitragers report huge profits, the buyers tend to want to keep that profit, which, after all, came out of their pockets (or out of the pockets of the sellers who clearly undercharged – right? Whose bull got gored, and all that). Sometimes, the arbitrage is just too ingenious, involving buying bundles of things where the parts are sold to people uninterested in the bundle as a whole, and bought from people uninterested in breaking up the bundle. There are people who while away their lives watching, for example, index funds versus the stocks supposedly in them, to make sure it all adds up *perfectly*. If not, there may be an angle. When the knowledge of the buyers and sellers is both good and widely know, arbitrage doesn’t happen.

Hold this thought. 

When corporations are taxed, they are compelled by the market (again!)** to try to control that expense – anything the corporation has to pay is an expense, if it’s taxes or rent or payroll or pencils. Many a company has been driven into bankruptcy by failure to control expenses.

So, if taxes are an expense, and I must try to control them, what do I do? Here we will consider income taxes only. The rule in the United States is: Every year, a company must pay taxes as a certain percentage of all the taxable income it earns. The terms are defined, and the mechanisms by which the amounts to be paid are determined, are lovingly spelled out in thousands of pages of contradictory, baffling and largely incoherent tax code. Even with scads of highly educated and compensated lawyers and accountants involved, there’s still enough gray involved that, were it paint, one could put a couple coats of gray on all the ships in all the world’s navies.***

Warning: the following is grossly simplified, but illustrated the basic operational premise.

So, let’s say I run a highly profitable business – doing my job creates loads of taxable income. Every year, I write fat checks to the government. Logic, and the market (us, again!) demand that I take a look at that. In fact, I don’t have to – my highly trained and compensated tax department has come to me with a plan to save us some money, which is why they are paid so well:

An asset. Not yet fully depreciated in the real world, assuming it still works.

This plan involves buying assets in order to use the depreciation of those assets to offset taxable income.

Taxable income is, generally, gross income over the year less expenses over the year (as determined, of course, by IRS rules). One expense is depreciation – that’s the change in value of assets the business owns. For example, I buy a bulldozer, say, for $100,000. I have to junk it after 5 years, and get another one. The bulldozers value starts out at $100k when I buy it, and ends up at $0 (or whatever its worth as scrap – keeping it simple, here) after 5 years. The decrease in value of the asset (bulldozer) each year is its depreciation.

First unintended consequence of taxing corporations on their income: My tax team points out to me that, were the company to buy a bunch of depreciable assets, the IRS rules allow us to subtract that depreciation from our taxable income – we’d pay less in taxes! But of course, to make this work, we’d end up buying assets that our company doesn’t actually need. We’d have to do something with those assets…

There are at least 3 ways to view depreciation:

1. The difference between what you paid up front and what, at any point, somebody will pay you for that asset. This is called ‘Fair Market Value’, and is determined by – wait for it! – The Market! That’s us again! Or at least, those of us who buy used bulldozers. Subtract the fair market value at any point from what you you paid, and that’s the change in value of the asset, which is by definition its depreciation.

2. Book depreciation. Accountants, who are appropriately NOT considered as a group to be among the most creative people in the world, use a very simple principle to calculate depreciation: how many years do you plan to own that bulldozer? How much did it cost? How much is it worth at the end? Subtract the amount it’s worth at the end from how much you paid for it, divide that number by the number of years you plan to own it and Voila! There’s your annual book depreciation!

This has the advantages of being very tidy and calculable by a properly-trained pigeon. It has nothing to do with the real world, but accountants will just true it up at the end, like they always do, and look at you funny if you question them. I get looked at funny a lot, and chose this explanation over others that might uncharitably spring to mind.

3. TAX DEPRECIATION. If you by now expect depreciation as calculated according to IRS rules to be complicated and divorced from reality – you win!**** Here’s the second unintended consequence: instead of just buying whatever assets a company needs to do its business, companies have to consider the tax implications of that purchase.

Third unintended consequence: all this complexity means that lots of pretty smart people will need to dedicate their lives to figuring all this out instead of doing anything useful.

So, here’s the plan your tax team has come up with: why don’t we buy a ton of equipment so that we can take the tax depreciation on it, and then lease the equipment to the people and companies that actually need it?

You, having been smart enough to get to run a company that makes enough money to hire these tax people in the first place, have got to go: What? Why would somebody lease equipment from us instead of somebody else, or just borrow money from the bank and buy it themselves?

Ah! You tax people share knowing glances – tax arbitrage! Not only will tax arbitrage make it so that some people and companies will want to lease equipment from us, it just sounds so darn sexy!

Here’s how it works: I pay taxes on my income. On a cash basis, depreciation is almost as good as getting a check from the government: say I anticipate having $100K in taxable income this year. I pay 35% in taxes, so I expect to pay $35K in income taxes. BUT: I buy a $100K bulldozer, which, according to IRS rules, gets, say, $50k in depreciation in the first year. Subtracting $50K from my $100k in taxable income leaves me with only $50K in taxable income, and only $17.5K in taxes! WooHoo!

Problem: I’m still out $100K. All the depreciation is doing is letting me reduce my taxes by $35K over the life of the bulldozer (you get to depreciate  the entire $100K over some number of years as determined by the IRS) – so, on this deal, I’d still loose $65k! What the heck? BUT: I lease the bulldozer to Joe’s Level Best Grading for $1,700 a month for 5 years – that’s enough to recover the $100K, and a little more! Now we’re talking!

Trouble is, how’s this a good deal for Joe’s Level Best? Turns out, Joe’s doesn’t make any taxable income – after he pays himself and the rest of his team and all the bills, that’s it – nothing left over. Joe makes a good living, and pays personal income taxes, but the company is not a taxpayer.

So, there are two ‘markets’ for that depreciation deduction: in Joe’s market, it is worth exactly nothing – if his company buys the bulldozer, he cannot use the depreciation to offset his taxable income, because he has no taxable income. But it is worth $17.5K (in the first year – it gets much more complicate after that) to my company.

So here’s what we do: we burn up some of that $17.5K in the form of a lower rent to Joe than he could get from a bank or elsewhere. We still make out good (and, hey, as long as there’s any benefit to us, we can just keep duplicating this process over and over to as many leasing customers we can find until our tax depreciation totally eliminates our tax bill!)

So, by leasing Joe the bulldozer, we buy and sell the tax advantage in two ‘markets’ at once: we ‘buy’ from Joe, paying in the form of reduced rent, and ‘sell’ to the IRS in the form of reduced net taxes. In practice, the equipment is purchase only once the renter is identified and committed – my company never sees the bulldozer, it goes directly to Joe. Even though my company ‘owns’ the equipment for tax reasons, I never set sight on it.

The unintended consequences of corporate taxes + the IRS’s convoluted depreciation rules: tax paying companies in the US are highly motivated to set up leasing companies to arbitrage the tax benefits of asset depreciation. This is not theory: AIG, for example, an insurance company, started a leasing company years ago for just this purpose; GE has a leasing company that was so good at its job that Congress wrote special laws – Alternative Minimum Tax (AMT) – just so GE would pay SOMETHING on its billions of profits. Otherwise, it would merely lease enough equipment to entirely offset its tax liability.

To sum up: US leasing companies created solely to arbitrage tax advantages are a relatively innocuous unintended consequence, as far as market distortions go, as long as you don’t count all the wasted intelligence and energy of all the people paid to make sure it works.

And AMT has its own set of unintended consequences.

* ‘The market’ is just shorthand for ‘people in their capacity to buy and sell things’. Nothing mysterious or dead-handy about it, really. In this context, just ask yourself: if I could buy the same thing for $4 here that costs me $5 there, all things being equal, would I not buy it here rather than there? You, saving a buck, is the market driving out an arbitrage opportunity. Enough people do this, and the $5 price is lowered, or the $4 price is raised – either way, the prices converge until the arbitrage opportunity goes away.

** in this case, the market – that’s just you and me, again – acts in a couple ways that strongly motivate companies to control expenses: keeping it very simple, when we shop for lowest price on a car or a head of broccoli, and we buy the cheaper one, the company that sells it to us has to pay all its bills on the difference between what it cost to get that car or broccoli to you and what you are willing to pay for it. That’s called ‘gross margin’. If, after I pay the salesman, the utility company, the night watchman, the cleaning crew, the sign maker, my taxes, and on and on, if, after all that, there’s money left – that’s the profit, the reason I’m doing all this work and taking all this risk instead of getting a government job. The only two ways to increase this profit is to 1) raise prices – can’t do that very much, because shoppers like you and me will only pay so much for a car or head of broccoli; or 2) CONTROL EXPENSES – make sure I’m paying as little as I can for all the stuff I got to pay for.

Next, in a slightly more complicated fashion, almost all companies finance their day to day business with money they borrow through banks or bond sales – same thing, pretty much, in practice for our purposes here. If a company’s expenses are out of control – if its gross margins are comparatively tiny, or – Adam Smith forbid! – negative, it can’t borrow any money. So it can’t pay its bills.  And nobody will buy its stock: I and millions of others, maybe even you, with our 401(k) or pension plan would (eventually) fire, one way or another, any portfolio manager who consistently bought stock that didn’t make us any money. ‘Firing the portfolio manager’ is what you do when you or you pension fund manager move your money from one fund to another. And portfolio managers don’t want to get fired.

All of that (a some more complicated things, too) fall under the heading: the market demands companies control their expenses. Baring government distortion, it is you and I who make companies behave this way.

*** For example, one of the regulations I deal with says in one place that the inscrutable income recognition options as expounded over many pages by authors who evidently never came within a mile of any actual financial transactions to which these rules might apply are not to be applied in such a way as to minimize taxes. Um, what? We go through this massive rigmarole and not ever ask: so, how much do we have to pay, at the end, if we go with this way rather than that way? Instead, we do tons of work in order to, what, get the most aesthetically pleasing result? Pretty numbers? Because that makes total sense.  Nobody pays any attention the that explicit instruction. Instead, they apply the rules in the way that ends up with the best tax situation. Not because they’re evil, but because that’s what reason and the market (us, again!) demand.

**** If you think it is easy to get up in the morning, look in the mirror and think: I studied the Great Book and got an MBA evidently so that I could one day spend my working life getting paid because, among a few other things, I completely understand every useful aspect of the IRS’s tax depreciation rules as applicable to equipment finance, well – OK, it beats mining coal in just about every way.

Author: Joseph Moore

Enough with the smarty-pants Dante quote. Just some opinionated blogger dude.

5 thoughts on “Unintended Consequences: Case Study”

  1. This is an excellent explanation, but one thing I’m not clear on: If you lease out the equipment for $100,000, then aren’t you just making more money that you have to pay taxes on? How come that doesn’t undermine the savings from the deduction?

    1. Good catch. Yes, your income from leasing figures into your total taxable income. However, if you do it right, the depreciation savings will dwarf the additional income from leasing.

      It’s way more complicated than I’m laying out. But, given that it just gets more boring, thought I’d leave all that good stuff out.

  2. OK, it beats mining coal in just about every way.

    Not true! You’d get more exercise, more people would get more use from your labor, and you’d get a lot of material for a rocking country album! 😉 (though an accountant country album might be funny)

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