New tax rules... yikes!

A panel formed by President Bush to refine the Tax Code has come up with some good ideas and some REALLY bad ones. The good ideas are simplification. The economy loses something like $140 billion dollars per year from ineffeciencies related to the tax code. That number is a bit overstated but it shows how damaging the 40,000 pages of tax information can be. Most of the deductions should be eliminated. They aren't worth a whole lot (when you consider that only the amount above the standard deduction really matters). They create a needless burden of document collection and storage. And they provide economic incentives for things based on emotion (medical bills) rather than logic (savings).

The bad is listed right there in the side bar. You have to really look for it to find it but the implication in the second model is that interest expense will no longer be a taxable expense deduction. This is annoying for alot of companies but probably not too damaging. What it is devastating for is the Banking industry. Banks tend to be highly leveraged (relative to other industries) and this change will be a crushing blow to them. The Bank of Americas, Suntrusts and Wachovias will get by fine (although their after tax profits will be cut by 66% or so). What it will eliminate is the community bank. At least as we know it today. I've looked at the financials for several community banks (link goes to FDIC website with public info). Here's the problem. When rates were rock bottom you had a typical deposit rate of damn near 1%. Loan rates were about 4%. Banks generally structure themselves so that rising rates don't hurt them... so as deposit rates have risen to 3.75% loan rates have risen to 6.75%... In our current tax environment this is fine because the net is all that matters. With this tax change the net would no longer matter... That 6.75% interest rate loan would actually have to be 7.60% to compensate appropriately... And here's where it gets tricky. Right now, the Fed raises rates to slow the economy down. This change would magnify that affect exponentially. A fed funds rate much higher than 5% would chill the economy to the core.

Let me illustrate. Suntrust (chosen because they've been tremendously stable) in 1999 made $244,655,000 in after tax profits. If we assume the old tax laws were in affect then that income would have been reduced to approximately $558,280. That's an ROA of 0.0025% and an ROE of 0.02%. That's essentially breaking even.

I hope there's some thought going into this plan... I hope the politicians haven't taken simplicity to its logical (yet absurd) extreme. I'm sure we'll hear more about this in the future. Bankers beware.