Out with tax shelters, in with investment in productive capacity

Tax shelter for two

-At dinner one spring night in 2004, two bankers had just revealed to a colleague the completion of a transaction between two large companies. The transaction involved setting up a third company for about $800 million. It was perfectly legal, and conformed with all laws. However, the transaction did not add one employee, it did not introduce one new product or service, nor did it any way increase the nation's productive capacity. The sole purpose of the transaction was its income statement affect: it reduced the tax liability of each partner company by about $400 million a piece.

Again, although the transaction was perfectly legal, it always struck me as being somewhat sneaky, unethical, and definitely a waste of the nation's resources: the tax code was being used not to increase the nation's productive capacity but to simply to lower a company's tax liability - - in this case create lower profits 'on paper.'

Discretion: the better part

Another example: Later, in late 2006, two colleagues who own real estate holdings were considering a new venture. A bank wanted to lend them about $2.5 million to buy 10 investment condominiums in a recently-built complex. At that time, the U.S. economy was growing, the housing market was booming - - with home prices increasing by more than 20% per year - - and credit was widely available. The bank was willing to write a commercial mortgage for the investment condos for a modest, variable interest rate, and with only a low down payment. Each colleague approached me about becoming a potential investor in the deal, a third partner, but I turned them down. Only four of the condo units were sold, and the prospect of the carrying costs if the remaining units were not sold / leased was way too much risk for yours truly. The others said the bank was willing to write another loan - - a 'bridge loan' - - to cover those carrying costs to complete the deal, with the bank arguing that those additional costs would be recouped by the higher sales price, when the unoccupied units were sold or 'flipped.'

With that, I put the deal in the category of "mega debt" and said "no deal" very quickly. That turned out to be prudent, as four of the remaining six units did not sell quickly, the condo market tanked in late 2007, and the bank ended up foreclosing on the complex. The two partners, and a third partner they later took on, lost a considerable amount of money on the deal.

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The two incidents above reflect the age's commercial characteristics: investment driven by tax shelters and by the prospect of asset appreciation.

We have to change the tax code so that investment increases the nation's productive capacity - - i.e. that encourages investment that leads to business formation, new technologies, new sectors, and new engines of growth that employ more people.

The United States economic system is resilient, innovative, and regenerative: with the correct reforms, the nation can once again become a strong, balanced, and thriving economy with an increased productive capacity - - one that will increase living standards across society.

Financial Editor Joseph Lazzaro is based in New York.