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How Immoral Government Creates the Perfect Investment

October 31st, 2012

If insanity is doing the same thing over and over and expecting a different result, you really have to wonder about California Governor Jerry Brown. The two-time Democratic Governor is calling for a 3% tax hike on the state’s richest 1% to help pay for the state’s perpetually cash-strapped education system. He calls it “a moral issue.”

I couldn’t agree more. And it’s one, as you’ll see, that leads directly to a particular investment conclusion.

Let me begin by confessing I have no dog in this fight. I’m not a California resident, so the state’s top marginal income tax – whatever it winds up being – is no skin off my nose. (As for the cost and accountability of our public education system, click here and weep.)

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State Treasurer Bill Lockyer concedes – and Governor Brown well knows – that half of California’s income taxes already come from the top 1% of earners. Yet even with the highest marginal income tax rate in the country, California is in the biggest fiscal mess of all 50 states. (That’s something citizens calling for higher taxes at the national level might bear in mind.)

And the state’s budget calamity is even worse than it looks. First off, California’s finances are dependent on its most unstable income group. It’s a myth that high income-earners are the same individuals year after year. Fortunes and careers routinely ebb and flow for professional actors, musicians, filmmakers, athletes and business owners. These folks can make a million dollars one year and find themselves hard up the next.

Second, while redistributionists routinely boo-hoo about how these spoil-sports won’t sit still and let the state government clean them out, the truth is just 144,000 taxpayers are ponying up nearly half the taxes in a state of 37.7 million people. Needless to say, these individuals have an enormous incentive to get the heck out of California. Many of them do. I can’t tell you how many businessmen and entrepreneurs I know who’ve left the Golden State for Nevada, Washington, Texas or Florida, just four of the seven states with no income tax on individuals.

California is hardly alone in soaking its citizens, however. According to an annual study by the Tax Foundation, state and local taxes total 12.3% in Connecticut, 12.4% in New Jersey and 12.8% in New York.

If Obama is re-elected and raises the top marginal rate to 39.6%, as he has promised, many business owners and self-employed individuals will forfeit most of what they make to the government. The math is pretty depressing. A top marginal rate of 39.6% plus an average state income tax of 6% plus a Social Security tax of 10.4% (on income up to $110,000) plus an unlimited Medicare tax (1.45% for employees and 2.9% for the self-employed) can easily equal most of what an individual makes. And these numbers don’t include sales taxes, property taxes, sin taxes and many others.

The real problem with raising the top marginal rate is that this country badly needs entrepreneurs to create jobs in the private sector. The top 2% of the nation’s income earners – who currently pay half of all federal income taxes according to the Internal Revenue Service – are overwhelmingly small business owners. Over half of Americans work for small companies that pay taxes at the individual not the corporate rate. If the economy is going to pick up steam again, we want to encourage these businessmen (and businesswomen) to take risks.

Sadly, many in power – and others who hope to gain power – won’t risk political exile by clamping down on spending. It’s safer and easier to soak the rich. (Heck, even if they all turn against you, it’s only 1% to 2% of the vote.)

That makes single-state municipal bonds – whose semi-annual payments are exempt from federal and state taxes – the no-brainer of the season, especially for beleaguered high-income earners in states charging punitive rates.

This investment choice will keep the government out of your pocket. However, it’s also capital denied to companies that need it. It won’t create new businesses or expand existing ones or help generate more private sector jobs. That’s the unintended consequence of government spending and selective taxation run amuck.

So Governor Brown has a point. Presiding over massive, inefficient spending, demanding that a tiny minority pay for it, and – in the process – disincentivizing entrepreneurs from creating desperately needed jobs is a serious moral issue.

Too bad he’s on the wrong side of it.

Good Investing,

by Alexander Green, Investment U Chief Investment Strategist


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