This past spring break, completely by chance, I spent the night in Fairhope, Alabama. Fairhope was established as a city in 1908, after having been settled in 1894 by a group of, mostly, Iowans seeking their special utopia. They were followers of Henry George, an advocate of no taxes other than a single land tax (property tax). These Single-Tax colonists, according to legend, chose the name for their town after one member said the new colony had a fair hope of success. Besides a unique take on taxes, the early settlers were a band of cooperative individualists, who attracted notice and attention from around the country, drawing an eclectic assemblage of people to Fairhope. I will admit that I found this utopia, located on the shore of Mobile Bay, to be a great place to visit and absolutely charming in its character and beauty. (http://www.cofairhope.com/index.html).
This is not a travel blog, however. This is a personal finance blog and there has been much political talk in recent weeks. Some of this talk has centered around taxes. As such, I believe we all should consider and understand our personal beliefs about taxes and understand the strengths and weaknesses of our arguments, prior to our selection of candidates on Tuesday. I do not intend to advocate for any candidate and, if you think I am advocating for a candidate, let it be known that this is my opinion and not that of the University of Missouri, the Department of Personal Financial Planning, or my dog, Liberty.
There are five philosophical bases for judging the appropriateness of a tax and each has a range of defining variables. There is no right or wrong criteria; at least as long as we live in a free country. Educated citizens, however, have a responsibility to understand the perspectives of taxation, prior to electing representatives, senators, and presidents as they are the creators of our tax system. To say it another way, we create our own tax system by our participation, or lack thereof, in elections.
Criteria 1: Equity
A common concern is to ask the question of who bears the burden of any tax. Companies, for example, are often assumed to shift any tax they pay to the consumers of their good. Obviously, their ability to do this rests on more factors than the existence of a tax, as competition with other firms can prevent the shifting or the demand for their product may be highly responsive to any change in price. It is safe to say that a business can shift the burden of a tax to consumers or to workers, via lower wages. Clearly, this concern is valid but it will not be universal nor will all of the taxes ever be passed on to others, as market factors will not allow such a transfer to exist. It is true, however, that all taxes are ultimately paid by all of us whether we’re a wage earner or owner of a company.
Criteria 2: Ability to pay
The second criterion that has been used to create taxes in the United States asserts that citizens with differing amounts of income (or wealth) should pay different amounts of taxes. Typically, the discussion will center on whether a tax is progressive, proportional, or regressive. A progressive tax has tax rates that increase as taxable income increases. The current federal income tax system and some state tax systems are good examples, where marginal tax rates increase with increasing levels of taxable income. The philosophical basis is that higher income households have a greater ability to pay and that higher income households have greater stakes in some of the functions of government, such as national defense, the transportation system, or regulatory bodies that ensure a competitive marketplace. On the other hand, some of our government expenditures support the social welfare system, so there is a transfer of income from the higher income to the lower. A proportional tax has a constant rate applied to all levels of tax base. An example of this would be the "flat-tax" proposals where everyone pays the same proportion of their taxable income in taxes or, perhaps, the “fair tax” proposals where everyone pays the same percentage sales tax on all their purchases. The difficulty in implementing the first is deciding what to do with those whose income is low, relative to a societal determined minimal level of living, as a portion of income would typically be free of taxes to allow a minimal level of consumption. The fair tax sounds appealing as you only pay taxes if you buy something, it is easy to administer, is transparent, and has few compliance issues. It is philosophically attractive on many grounds. The detractors, however, argue that a fair tax is not fair at all because it is regressive, defined as a greater rate of taxation being experienced by low income households than higher income households. This results from poorer households spending most, if not all, of their income, while those in the highest income brackets save a larger proportion of their income. This saved income would escape taxation – perhaps encouraging more savings – with the amount of tax paid as a percent of total income decreasing, as income increases. Current examples of regressive taxes are sales taxes and payroll taxes (Social Security taxes are not collected after income exceeds the annual limit).
Criteria 3: Benefits received
This criterion states that people should pay taxes in proportion to the benefits that they receive. Those who receive the greatest benefit should pay the greatest tax. As an example, think about quantity taxes, such as fuel taxes, where those who use the roads, primarily funded by fuel taxes, pay the most in fuel taxes. Those who shop downtown pay for the parking garage through the fees they pay to park. All homeowners, in property tax states, pay property taxes which often fund local schools, believing that an educated population benefits all, as well as the one receiving the education.
Criteria 4: Economic Efficiency
Efficiency speaks to the fact that some taxes will have unexpected consequences that are not efficient. For example, if a greater tax on income results in workers working fewer hours or lowering their production, we are potentially less well off than without the tax. On the other hand, taxes that discourage behavior can provide resources to the government, while perhaps reducing the behavior that the tax is levied against. A good example might be a tax on cigarettes designed to reduce the consumption of cigarettes, thus enhancing the health of the taxpayer, while adding to the resources of government.
Criteria 5: Transparency and Simplicity
Simplicity is a measure of how much time and money taxpayers must spend to ensure they comply with the tax law. Anyone that has completed a 1040 form knows that simplicity has been lost. (If you don’t believe me, ask one of the students taking the exam in their tax course next door, as I type this!) Moreover, a simple tax system is less expensive to administer and reduces the cost of enforcement. A related criteria is transparency. Transparency is hindered by greater complexity. When taxes are transparent, we trust that everyone is paying their share of the burden. As taxes become more complicated, there is a genuine distrust borne from a belief that others are able to legally take advantage of tax policy which others might not know exist. If citizens believe that others have an unfair advantage, the distrust and lack of understanding can cause additional societal ills, as trust in each other and our institutions is a necessary ingredient for commerce.
I did not provide much advice this week. It was not my intention. Certainly, paying taxes reduces the income we have for our personal financial success. Yet, at the same time, without the services provided by the government: education, roads, public safety, defense, parks, libraries, social welfare, health care, transportation, and, don’t forget, interest on the public debt, we would be limited in our ability to have financial success. The main point I want to leave you with is to ask you to accept the fact that it is our tax system and our government. We elected those that created it and we can elect those to change it. The electoral process is key to making our local, state, and national governments reflect of our true values. To not vote is an admission of indifference and a lack of caring about the future of our nation and, to some extent, our world. Voting is our right, as citizens of a democracy. Voting is our responsibility, as stewards of the future.
- Robert O. Weagley, Ph.D., CFP(r)
Chair, Personal Financial Planning
University of Missouri
Columbia, MO 65211
Friday, October 31, 2008
Friday, October 24, 2008
It’s about the money, not the death
During these days, it is hard to focus on things other than what is going on in the larger economy. One day, stocks are up. The next, stocks are down. One day, we wonder if the banks are failing. The next, several appear to have been anointed as survivors in our experiment in quasi-socialism. Regardless, let me venture into a more mundane topic: Life Insurance.
When you are considering life insurance you have to answer four questions:
1) Do you need life insurance? This one is simple. If no one will be worse off financially after you die, you do not need life insurance. Let me write that again, If no one will be worse off financially after you die, you do not need life insurance. Life insurance is designed to provide income to your financial dependents, if you experience an untimely demise. OK, so your funeral is an expense and you don’t want that to burden your parents, or others. Well, a funeral is a great time to use your emergency fund and, from a financial point of view, if your parents support you, they might be better off financially – even after paying for your funeral – if you’re dead. Don’t think of this as harsh and NEVER think that they would choose to have you dead, as opposed to having you with them. The point is that your parents will be emotionally, not financially, devastated if you should die. Life insurance is about the money needed by dependents. It is not about the tears they must shed. It is a financial decision, not an emotional one.
2) If you need life insurance, how much? This is conceptually simple, yet complex to calculate. You want to provide enough financial resources to provide for the desired level of living for your surviving dependents. Typically, this is less than what it would cost if you were still eating and going to movies with them. A simple way to think of this is to take a level of income for the time of dependency, perhaps add college costs, loan repayments, or other known expenses and provide life insurance proceeds that are equal to the present value of these needs, less any resources that you already have like savings and Social Security benefits for the survivors. You say, “HUH?” Maybe you should try a calculator like: http://lifehappens.org/life-insurance/life-calculator which is from LIFE, a non-profit organization.
3) What kind do you buy, if you need life insurance? Often the answer to question #2 dictates the answer to question #3. If you have a large life insurance need, often term insurance is the only type a family can afford. Term insurance is pure insurance and the protection is provided for a term of time; one-, two-, five, or twenty-years. At the end of the term, the policy can be renewed if it is guaranteed renewable. (Always buy guaranteed renewable term, in case some dread disease strikes prohibiting you from purchasing insurance.) Other kinds of insurance policies have a savings element that is a part of the policy and can typically be owned throughout one’s life….if one needs life insurance for their whole life. If you have a large estate at death that is subject to estate taxation or if you have a large lumpy asset that you want to preserve, like a farm or business, a permanent, “life-long” life insurance policy might very well be what you need. (We’ll write more about types of policies in a future “Tip”.)
4) How do you want the proceeds paid out, upon death? This is easy. Most people take the money as a lump sum and invest it in other assets, as they spend it as it was intended. On the other hand, it is possible to leave the money with the insurance company and purchase an annuity contract to provide income over time. This choice can be made by the policy owner, if alive, or by the beneficiaries at the death of the insured.
There is much more that can be said about life insurance. It is, however, much easier to make life insurance decisions if you follow a set of questions and do a complete, objective analysis. One thing I often recommend to those that answer the first question in the affirmative is to visit several life insurance sales persons, or web-sites, and see if you receive a similar answer to “How Much?” from several, if not all, sources. If so, I’d recommend you begin to believe the answer and to then chose the vendor that has financial strength, A or A+ rated, and that has a record of customer service. Check with your state Division of Insurance for more information on agents and companies, as well as to read their printed information to increase your chance for Financial Success.
NOTE: If you’ve questions or suggestions for future Financial Tips, do not hesitate to send an email to my gmail account rweagley@gmail.com . I do not plan to answer individual questions, as we’re not a chat room, but I will try to work an answer into a future financial tip. Please put Financial Tip in the subject line, so I know it is not spam. Thanks.
- Robert O. Weagley, Ph.D., CFP(r)
Chair, Personal Financial Planning
University of Missouri
Columbia, MO 65211
When you are considering life insurance you have to answer four questions:
1) Do you need life insurance? This one is simple. If no one will be worse off financially after you die, you do not need life insurance. Let me write that again, If no one will be worse off financially after you die, you do not need life insurance. Life insurance is designed to provide income to your financial dependents, if you experience an untimely demise. OK, so your funeral is an expense and you don’t want that to burden your parents, or others. Well, a funeral is a great time to use your emergency fund and, from a financial point of view, if your parents support you, they might be better off financially – even after paying for your funeral – if you’re dead. Don’t think of this as harsh and NEVER think that they would choose to have you dead, as opposed to having you with them. The point is that your parents will be emotionally, not financially, devastated if you should die. Life insurance is about the money needed by dependents. It is not about the tears they must shed. It is a financial decision, not an emotional one.
2) If you need life insurance, how much? This is conceptually simple, yet complex to calculate. You want to provide enough financial resources to provide for the desired level of living for your surviving dependents. Typically, this is less than what it would cost if you were still eating and going to movies with them. A simple way to think of this is to take a level of income for the time of dependency, perhaps add college costs, loan repayments, or other known expenses and provide life insurance proceeds that are equal to the present value of these needs, less any resources that you already have like savings and Social Security benefits for the survivors. You say, “HUH?” Maybe you should try a calculator like: http://lifehappens.org/life-insurance/life-calculator which is from LIFE, a non-profit organization.
3) What kind do you buy, if you need life insurance? Often the answer to question #2 dictates the answer to question #3. If you have a large life insurance need, often term insurance is the only type a family can afford. Term insurance is pure insurance and the protection is provided for a term of time; one-, two-, five, or twenty-years. At the end of the term, the policy can be renewed if it is guaranteed renewable. (Always buy guaranteed renewable term, in case some dread disease strikes prohibiting you from purchasing insurance.) Other kinds of insurance policies have a savings element that is a part of the policy and can typically be owned throughout one’s life….if one needs life insurance for their whole life. If you have a large estate at death that is subject to estate taxation or if you have a large lumpy asset that you want to preserve, like a farm or business, a permanent, “life-long” life insurance policy might very well be what you need. (We’ll write more about types of policies in a future “Tip”.)
4) How do you want the proceeds paid out, upon death? This is easy. Most people take the money as a lump sum and invest it in other assets, as they spend it as it was intended. On the other hand, it is possible to leave the money with the insurance company and purchase an annuity contract to provide income over time. This choice can be made by the policy owner, if alive, or by the beneficiaries at the death of the insured.
There is much more that can be said about life insurance. It is, however, much easier to make life insurance decisions if you follow a set of questions and do a complete, objective analysis. One thing I often recommend to those that answer the first question in the affirmative is to visit several life insurance sales persons, or web-sites, and see if you receive a similar answer to “How Much?” from several, if not all, sources. If so, I’d recommend you begin to believe the answer and to then chose the vendor that has financial strength, A or A+ rated, and that has a record of customer service. Check with your state Division of Insurance for more information on agents and companies, as well as to read their printed information to increase your chance for Financial Success.
NOTE: If you’ve questions or suggestions for future Financial Tips, do not hesitate to send an email to my gmail account rweagley@gmail.com . I do not plan to answer individual questions, as we’re not a chat room, but I will try to work an answer into a future financial tip. Please put Financial Tip in the subject line, so I know it is not spam. Thanks.
- Robert O. Weagley, Ph.D., CFP(r)
Chair, Personal Financial Planning
University of Missouri
Columbia, MO 65211
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