Other Than the Crash, Captain Smith, How Was the Cruise?

I wrote recently about the importance in investment analysis of distinguishing between the recurring cash flows of a business and those variations in earnings that are more properly attributed to cyclical factors or one-off developments.  In practice, this is often easier said than done, particularly during periods of economic weakness.  To name a few examples, recent investors in newspaper publishers, telephone directory services, and video rental chains may now be wondering if their expectations for performance during a ‘normal’ cyclical downturn obscured signs of fundamental, secular changes to the viability of particular businesses.  This type of thinking is also important for companies themselves.  Critical decisions from managing daily cash balances to budgeting for capital expenditures to financing the enterprise as a whole depend on a sober assessment of the typical timing and quantity of cash flows.  One might think this is common sense (it is) – but human vulnerability to cognitive bias, to say nothing of corporate politics, introduces ample opportunity for error.

My motivation for this discussion was the scary, if not surprising, suggestion that a thoughtful analysis of the sources and sustainability of government revenues has been conspicuously absent from the debate over how to fill and distribute the public purse.  There are fair and important questions of principle involved in how we think about income distribution, income redistribution, and the role of the state as intermediary in that process.  But, to me, these questions are overwhelmingly less important than whether the liabilities the government currently has (and those it may want to incur in pursuit of future social objectives) are likely to be satisfied by the normalized cash flows it can reasonably anticipate receiving.  If not, we are not just rearranging the deck chairs by engaging in principled debates; we’re wrangling over the buffet menu for the Titanic’s second voyage.

(Sidebar: I prefer not to tip my hand too much as to my own thoughts on such principled debates, but since it’s fair to consider my cognitive biases – even though my thoughts are continually evolving – I’d say Matt Yglesias’ bullet points and Wil Wilkinson’s précis are collectively a good first approximation.)

As all levels of government debate their budgets for the next fiscal year, I’d encourage readers with curiosity and time to look through the proposals in some amount of detail.  An enormous amount of human effort goes into the production, analysis, revision, and execution of the proposals contained therein, so it’s a pity that so few voters are actually aware of the scope and complexity of such an undertaking (or so I assume; I would be happy to be proven wrong!)  Honestly, I think that American citizens should be given a national holiday during which they are required to read the Federal budget in its entirety, all supplemental charts and footnotes included.  (As a corollary, if it takes the Average American two weeks to read the budget, and the economy needs to shut down for two weeks as a result – or if the Average American is unable to comprehend the budget given any amount of time – that should tell us something!)   At a minimum, maybe this should be a requirement for claiming any sort of income tax refund or, in the case of high-income earners, claiming an effective Federal tax rate anywhere south of the 25% mark.

Civic duty aside, anyone who enjoys a gripping and timely work of fiction will find governmental budgets hard to beat.  Consider, for example, the government’s forecast of future tax revenue – it speaks volumes, particularly in the context of our earlier discussion of ‘mid-cycle’ cash flows.

I am only going to focus on the column for personal income taxes, which should correlate very strongly to corporate income taxes (insofar as economic growth drives both personal and corporate incomes) and social insurance receipts (which are a function of wages).  And I’m only going to make one point:

The forecast for 2010-2016 is that individual income tax receipts will double over six years, implying an annual growth rate of approximately 12%.  Some of this growth will be a function of the economic pie growing, and some of it will likely be a function of greater marginal tax burdens.  (Since these are nominal quantities, some may also be driven by inflation – although the government forecasts 2% inflation indefinitely.)  Based on some back-of-the-envelope math, I am extremely skeptical that anything near this growth rate has been achieved over a six-year period in recent economic history.  As you may remember, sometimes the economy contracts, which can really screw with a virtuous cycle of continuous compounding. Bear in mind that this is the same forecast that shows us running trillions of dollars of cumulative deficits over the same period.

If you believe that the economic growth of the past decade was to any material degree a function of: (1) unprecedentedly cheap and accessible credit, particularly for American consumers; (2) unprecedented opportunities for American corporations to reap the low-hanging fruit of globalization, which has largely been reaped; and (3) the windfall gains realized by a small number of individuals and institutions that were fortunate enough to sit atop enormous stacks of leverage and not lose — the trillion-dollar question ought to be: are these more properly considered recurring cash flows or extraordinary cash flows?

If the former, you should be betting your entire net worth on Corporate America right now.  If the latter, you should be really worried.

(Legal Disclaimer: That said, please don’t bet your entire net worth on anything!)


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