tax subsidies

While the country, and indeed the world, struggles to contain the risks of catastrophic climate change it's easy to forget that the US has subsidized fossil fuel production for more than a century, and that we continue to do so. To assess how these subsidies affect domestic industry, Earth Track teamed up with the Stockholm Environment Institute to identify key subsidies to US oil and gas production and model how profits and production would change were these subsidies to be removed. My gratitude goes to both of my co-authors, Ploy Achakulwisut and Pete Erickson at SEI, for their tireless and stellar work modeling the subsidy impacts on thousands of fields expected to enter into production by 2030.

Our final analysis was recently published in the IOP Publishing journal Environmental Research Letters.  You can access the main article here and the detailed supplemental data here.  For subsidy wonks, the supplemental data provides background on the subsidies and how we modeled them that may prove of interest. We greatly hope that our analytical approach will be replicated in other large oil and gas producing countries using their country-specific data on producer subsidies. The carbon reduction benefits from subsidy reform tend to rise if declines in US production don't get displaced by subsidized fuel flowing in from other countries that have not implemented reforms.

This paper updates and expands on work we published in Nature Energy in 2017.  As was done in that analysis, we use field-specific economic cost data developed by Rystad Energy to evaluate how subsidy removal would affect cash flows and investment returns to the field's owners under different price and financial risk outlooks.  We also continued to evaluate discovered but not-yet-producing fields in order to incorporate the full capital cycle in our calculations.  This paper also includes three significant refinements.  First, we incorporated a wider set of subsidies, including industry-specific regulatory exemptions for the first time and a much more detailed look at potentially mammoth unfunded liabilities for well closure and reclamation.  Second, we integrated into our modeling the large changes to the tax code that took effect in early 2018; these changes, primarily through a large reduction in the baseline corporate tax rate, reduced the value of some tax breaks to the industry.  And third, we incorporated reductions in the cost structure achieved by many fracking operators in recent years, changes that reduced economic breakevens on production from these fields. 

Key Findings

At 2019 average market prices of oil and gas, the 16 subsidies could increase the average rates of return of yet-to-be-developed oil and gas fields by 55% and 68% over unsubsidized levels, respectively, with over 96% of subsidy value flowing to excess profits under a 10% hurdle rate (see Figure 1 below). At lower 2020 prices, the subsidies could increase the average rates of return of new oil and gas fields by 63% and 78% over unsubsidized levels, respectively, with more than 60% of oil and gas resources being dependent on subsidies to be profitable under a 20% hurdle rate.  This pattern is common:  without price triggers that automatically reduce or zero our subsidies during strong markets, most of the public support flows to higher profits during periods of high market prices.  In contrast, during periods of low prices the subsidies encourage investments into new production that would not otherwise have happened.  Because new investments in oil and gas will contribute to elevated carbon loadings for many years into the future, the large role government subsidies play in protecting investors from downside market risks is one that we need to eliminate if the country is serious about transitioning away from high-carbon fuels.  We looked at oil and gas extraction sites in this paper.  However, it is important to note that a similar dynamic is at play for very large infrastructure investments such as LNG facilities, pipelines, and petrochemical production -- all of which receive significant subsidies that reduce risks, and therefore financing costs, for these long-lived, fossil-intensive assets.

Under all price scenarios analyzed, the highest-value subsidies in our paper include federal tax incentives that have existed since 1916, as well as less recognized forms of support such as cost exemptions related to well cleanup and hazardous waste management.

Subsidy analysis always requires the authors to define what should be viewed as a subsidy, and a counter-factual case to use to assess the subsidy value.  A global consensus on these definitions among practitioners has been growing over time.  Still, disagreements on both of these factors are common.  Sometimes the driver is differences in opinions on technical issues and baselines.  Often, however, claiming something is not really a subsidy is a political strategy deployed by the beneficiaries.  In any case, because of these definitional issues, our analysis also presents results for selected subsets of subsidies.  This allows readers with some definitional differences to nonetheless make productive use of our analysis and findings.

National estimates of dollars of subsidies flowing to the oil and gas sector are a useful metric of the scale of government intervention.  But the impacts of subsidies on investment and production decisions occur at the field level, and the same subsidy can be more or less significant in propping up producers in different types of geologic formations or parts of the country.  Our analysis helps to guide state and federal decisions on subsidy reform by illustrating which subsidies are most important on a regional level as well. 

Figure 1 below shows the average effect of each subsidy on the internal rate of return (IRR) of new, not-yet-producing oil and gas fields, at average 2019 prices of USD2019 64/barrel of oil and USD2019 2.6/mmbtu of gas. The charts on the left show the oil production-weighted average change across all oil-producing fields, and the charts on the right show the gas production-weighted average change across all gas-producing fields, in the US and in a given state. Fields that never reach a positive IRR (even with subsidies) are not included. 'NA' labels indicate that a given subsidy was not applied to that fuel and/or state.

The underlying data for this figure, as well as for other major oil- and gas-producing states not shown, can be found in the supplemental materials.  Many other detailed exhibits are also available in the published report and supplemental materials as well.

It's been almost two years since Earth Track and Oil Change International released a detailed review of oil and gas subsidies to Master Limited Partnerships (MLPs).  The paper documented the favored exemptions that MLPs receive from standard corporate tax rules and how they primarily benefitted oil and gas companies; the increasing use of IRS private letter rulings to broaden the range of activities able to shelter natural resource-related income from corporate taxation; concerns that efforts to expand eligibility to renewable energy would also dramatically expand exemptions for fossil fuels and conventional electric power generation; and the possibility that the revenue losses from MLPs were being greatly underestimated by the federal government.

Growing push to move energy assets off the corporate tax roles

The key pressures driving "MLP-ification" (an apt term popularized by an equity research team at Goldman Sachs) remain:  an effort to bypass corporate income taxation for large swathes of energy assets, while still allowing access to public equity markets through listed shares.  The tax-bypass challenge isn't just limited to MLPs, and is raising increasingly important policy questions regarding tax collections and cross-sector tax neutrality.  This matters to economic development because political decisions are creating differential tax burdens by industry; and it matters to renewable energy and climate change because the vast majority of the publicly traded energy enterprises escaping federal corporate income taxes are in the fossil fuel sector.

Real estate investment trusts (REITs) also allow publicly-listed partnerships to avoid corporate level taxation.  Like MLPs, tax-favored REITs have been around for decades.  Yet, a similar process of IRS rulings have gradually broadened the definition of eligible property:  most recently, power transmission assets have entered the pool of REIT-eligible assets.   The chart below, developed by Professor Felix Mormann (University of Miami and Stanford), succintly summarizes this expansion (full set of slides here):

Another new entry to tax-favored energy structures is the "YieldCo," an MLP-variant that bypasses limitations in MLP eligibility to open corporate tax avoidance to solar, wind, and hydro assets as well.  While not technically exempt from corporate income taxes, the YieldCo structure forms a "synthetic MLP" to avoid corporate taxes using expenses and high depreciation deductions.

There is no doubt that all of these structures reduce the cost of capital and/or boost margins for eligible players.  But while the energy sector is an important part of our economy, it is not the only part or even necessarily the most important part. 

Tax favoritism for some types of assets or industries over others introduces political bias into which economic sectors succeed.  If one wishes to argue that any taxation of corporate income is inefficient and should be replaced with other mechanisms of raising revenues, that may well be a debate worth having.  But using an arbitrary or politicized process to exempt energy or real estate enterprises from corporate taxation while other worthy sectors face normal tax rates is hardly a logical underpinning for the competitive market that the US purports to be.

Recent trends show continued growth in MLP assets, and increased use of other favored corporate structures for holding energy assets as well

Here's a brief review of some of the major MLP-related themes emerging since our paper was released:

1)  Eligibility continues to expand; IRS proposed rule puts brakes on some sectors, though challenges likely.  The number of private letter ruling requests to the IRS on whether particular income streams qualified for MLP status rose sharply, reaching well more than 30 in 2013.  Despite the growing number of requests for rulings, in the vast majority of the cases the IRS ruled in favor of the petitioners.  As a result, the number of firms and industries successfully able to avoid corporate income taxes through the MLP rules grew steadily.  As the number of petitions continued to rise, however, the IRS decided a more formal evaluation was needed.  The Service released a draft of those guidelines on May 6th.

Although the rules remain open for comment, a  number of early conclusions are being drawn:

• Paper industry-related MLPs, once considered an impending extension of those created for fossil fuel activities, no longer seem likely.  The IRS has argued that because paper requires additive processing of wood and pulp (e.g., the addition of chemicals), it would fail one of its eligibility tests.  Other timber-related activities that don't require chemicals or other substances to manipulate the properties of the wood would be remain eligible -- saw mills or bark mulch production, for example.  Thomas Ford of Andrews Kruth LLP argues the published interpretation is a material change in IRS policy, reversing a private letter ruling from two decades ago. 
• Companies that sell fuels in bulk to airlines or government customers would produce eligible income; general retailers would not be. Fuel terminalling and storage can be organized as an MLP as well. 
• Fuel refining eligible for MLP treatment is not entirely consistent in the IRS proposal.  Olefin production was deemed eligible under prior letter rulings, for example, but appears to be excluded now (existing MLPs would get a 10 year transition period).  Production of natural gas liquids would be eligible if the product was also found naturally in petroleum fractions, but not (as with methanol) if it is always manufactured. 
• Many fracking support operations remain eligible, so long as they are recurring, central to well production, and specialized.  Water delivery is not, so could not be organized as an MLP.  However, water service companies that remove and treat water as well as deliver it would be.

Sidley Austin LLP notes that

The Proposed Regulations appear designed to establish uniform and balanced standards for determining qualification across various types of activities, while remaining true to the directives of the legislative history to the enactment of Section 7704(d)(1)(E). Nonetheless, perhaps constrained by the legislative history, the Proposed Regulations reflect a substantial amount of arbitrariness in the application of the announced standards, and set forth industry-specific applications of these standards.

I'm not fully fluent in lawyerese, but the undertones here seem (and in comments from other law firms) seem clear:  industry challenge of the IRS proposed rule is likely.  And, despite some restrictions on MLP growth, it is also clear from the IRS proposed rules that a growing set of functions in the fossil fuel production and delivery system will remain eligible to operate as tax-exempt MLPs.  Further, by eliminating the need for a private letter ruling, the process of asset conversion to tax-exempt MLPs may actually accelerate after the IRS regulations are finalized.

2)  The market capitalization of tax-exempt MLP fossil fuel assets continues to grow sharply.  The primary driver of this growth appears to be a continued migration of assets from taxable corporate forms to MLPs, as other possible factors seem to be working in the opposite direction.  Lower oil and gas prices and concerns over rising interest rates, for example, have both dampened the rate of increase in MLP share prices.  Further, we have seen some very significant MLP-reversals, where MLP assets were "re-corporatized" due to strategic (i.e., non-tax) factors.  Foremost here was the merger of Kinder Morgan MLPs back into the parent company, a deal estimated to be worth more than $70 billion.  This one transaction alone, absent growth of new MLP assets, would have lopped an equivalent of about 18% of the estimated MLP market cap value when our paper was done (and more than 20% of natural resource-focused MLP portion).

Earth Track and OCI's review of MLPs in mid-2013 found a market cap of all MLPs at about $400 billion, of which about $325 billion was natural resource-related (primarily oil and gas).  The National Association of Publicly Traded Partnerships (NAPTP) periodically prepares an industry overview of MLPs called "MLP 101".  The last public version of this document in October 2013 estimated market cap of MLPS at $490 billion, of which $422 billion was for natural resource MLPs (see Slide 33)  -- again, primarily oil and gas. 

Despite the slowdown and the loss of three MLPs related to Kinder Morgan, the MLP sector has continued to grow.  Total MLP market capitalization as of May 12, 2015 was $679 billion based on an Earth Track review of listed MLPs.  Of this, 77% was associated with fossil fuels -- most heavily oil and gas midstream operations, as has been true in the past as well.  Despite this growth in market cap, official estimates by the Joint Committee on Taxation of revenue losses to the US Treasury from the MLP structure holding this growing pool of assets (JCX-97-14, p. 24) have barely changed -- and are flagged at a maximum of $1.2 billion/year through 2018.

Other items of note:

• A handful of renewable energy firms (about $6 billion in market cap) somehow qualified as MLPs and were listed on NAPTPs census. 
• There has been robust growth in financially-oriented MLPs as more and more large private equity firms seek to tap less expensive capital via public markets using an MLP share listing.  These firms comprised just under 19% of total MLP market cap.  Most of these firms have substantial investments in the fossil fuel sector (often through private partnerships that are part of their investment portfolios), though the fossil fuel share of total investments is not known.  Many of these firms also have highly compensated executives (some of the wealthiest people in the country, in fact) who are also benefitting from subsidies to carried interests in their funds, taxed at lower capital gains rates rather than standard income tax rates.
• A subset of MLPs have chosen to be taxed as corporations rather than as tax-exempt MLPs.  This choice seems rather odd at first, as firms rarely volunteer to be taxed at a higher rate than the minimum required by law.  However, further inspection shows that the vast majority of the MLPs choosing this path are in the oil and gas marine transport business, and are often organized outside of the United States.  While additional research would be needed to conclusively determine why this is happening, the likely explanation is that these firms are able to access special tax rates, often in tax havens, that generate an even lower effective tax rate (combining the tax hit at both the corporate and and unitholder levels) than would be possible as a pass-through MLP.  This is probably a function of the "Alternative Tonnage Tax" that allows tanker firms to choose a (very low) tax on tonnage in lieu of paying corporate income taxes.   The law was passed in 2006 in the US, but similar regimes existed for longer in other countries.  It provides yet another interesting, though not well-quantified, subsidy to the price of oil we see as consumers.

3)  Expansion of tax-exempt corporate structure to renewable assets via REIT and YieldCo structures.  As noted above, energy assets have been shedding corporate tax liability via at least three main venues:  MLPs, energy-related REITs, and YieldCos. 

Two years ago, federal legislation to expand MLP eligibility was being pushed heavily (primarily by Senator Christopher Coons of Delaware).  My concern was that the legislation would (a) make it impossible to ever kill tax-subsidies to oil and gas MLPs (indeed, oil state reps like Lisa Murkowski seemed to recognize this angle, and were co-sponsors of the Coons bill); and (b) open the tax exemption to a larger set of energy assets than perhaps had been intended.  This seemed likely to include power generation and transmission of all types.  Yet, when the revenue loss of the Coons bill was scored by the US Joint Committee on taxation, they estimated an average of only $130 million/year over the ten year period of estimates.  Details behind their calculations were not made public, so it was not possible to evaluate their scoping or assumptions.  But the figure still seems very low to me.

The successful roll-out of YieldCos may render MLP expansion moot.  In but a handful of years, YieldCos have gone from a theoretical construct to a growing number of firms and tax-favored assets.  With a current market cap of more than $25 billion, the sector is on-track to hit $100 billion within a few years according to Jeff McDermott of Greentech Capital Advisors.    A YieldCo-specific ETF has just been launched as well. 

A review of the corporate structure of YieldCos versus MLPs suggests that they have attributes that make them easier to invest in for some institutional investors (emphasis added):

Several factors differentiate a YieldCo from a MLP - including a more traditional tax treatment, which makes it easier to invest in for many institutional investors. First, a YieldCo is a corporation, not a partnership or limited liability corporation like a MLP. Second, assets often targeted for a YieldCo - such as renewable and contracted
conventional plants - are not "MLP-able" under current law. Third, YieldCo's are not eligible for pass through tax treatment, although often maintain significant tax shields and NOLs that mitigate cash tax outflows.[fn]Source: Goldman Sachs Equity Research, "Juncture to Restructure: YieldCo 101," May 14, 2014.[/fn]

It is notable that my concern about tax-favored status to conventional power plants emerging from MLP-expansion may actually materialize via the YieldCo structure instead.

What of the energy-related REITs?  Drop-downs of power transmission assets into tax-exempt REIT structures have begun, facilitated by the 2014 IRS ruling.  InfraReit, for example (ticker HIFR), holds a chunk of TX assets owned by the Hunt family (the nation's 13th wealthiest family according to Forbes) in a new, corporate framework exempt from corporate-level taxation. 

No, the Hunt family is not doing anything illegal:  they are simply leveraging existing law to their benefit.  But the policy trade-offs, and who benefits, are worth thinking about.  And the migration of transmission assets off of corporate tax roles is likely to accelerate -- a trend, by the way, that is most likely to help large scale, centralized conventional power generators while disadvantaging smaller scale distributed generators and energy efficiency. 

Energy-related REIT assets are a fast-growing share of the "non-traditional" REIT universe, according to data from SNL Financial gathered by Ernst & Young (page 15).  The Edison Electric Institute notes (page 6) transmission investments running more than $10 billion per year from 2011 forward by private utilities, so the scale of assets moving off of the tax roles via "WireREITs" could be as significant as we've already seen with MLPs and non-energy REITs.

The effort to push ever more low-cost capital into energy infrastructure of all types is happening in somewhat of a vacuum.  Lawmakers and lobbyists alike are ignoring the distortionary impact that these tax-exempt corporate forms for "special" industries have on the equality of business opportunity within the country.  We should not be.

Master Limited Partnerships (MLPs) are a special corporate form, used primarily by natural resource industries.  They enable firms to both raise capital on public equity markets and to pay zero corporate income taxes.  MLPs deserve far more scrutiny as energy subsidies than they have received to date.   Although the US Energy Information Administration (EIA) excluded them from their most recent study of US energy subsidies on the grounds that other industries also benefit (so the subsidies are not "energy-specific"), EIA's logic is weak.  Based on data compiled by the National Association of Publicly Traded Partnerships in August 2012, roughly 87% of the total market capitalization of the MLP sector was associated with fossil-fuel related activity.  That's pretty focused. 

And the dollars look to be large -- between $5 and $15 billion/year in revenue losses, funds that either increase our deficit or have to be made up through higher taxes on other taxpayers.  More precise review of data on specific MLPs would be needed to tighten this range.  But even at the low end, tax subsidies through MLPs alone generate higher subsidies to fossil fuels than everything else that EIA counted combined.   Let's just say that the government's subsidy figures are highly sensitive to which policies they ignore. 

With enormous pressure on Congress to identify ways to boost revenues and reduce economic distortions from the tax code, stripping the tax exemption of MLPs seems a great place to look.  Of course the industry will lobby heavily to protect their subsidy; it always does.  But elimination is still good public policy.  In fact, were the industry to argue that the world will end if MLP tax treatment changes, we can point out that Canada has already traveled this path.  In 2006, Canada eliminated preferential tax treatment for their energy investment trusts, a corporate structure modeled on, and analogous to, MLPs.  And the oil and gas industry did not disappear.

The remainder of this blog is extracted  from a more detailed review  I did on subsidies that the Romney presidential campaign forgot when it discussed energy subsidies.  

Escaping corporation taxation entirely:  Master Limited Partnerships

With all of the talk this campaign season about reducing income tax burdens on small business, it is easy to forget that an ever higher percentage of small businesses (and many larger ones) are adopting corporate forms that escape corporate income taxes entirely.  This includes sub-S corporations, partnerships, and limited liability corporations.  As a result, the share of national income paid from corporate income taxes has dropped from nearly 30% in the 1950s to less than 11% for the period 2000-2009.^[1]  But one group of enterprises - those raising capital on public equity markets - must generally still use corporate forms that pay corporate taxes.   

One glaring exception is publicly-traded partnerships (PTPs), also known as Master Limited Partnerships (MLPs).  Under special rules, this group of companies can both raise capital on public markets and bypass corporate income taxes entirely.  Tax liabilities (and enterprise-related subsidies) pass directly out to the partners' individual tax returns.  MLPs don't make up a huge chunk of listed firms on the stock market.  But within the tax favored MLP universe, oil and gas companies dominate, including a new one focused on fracking sand. 

One other sector able to use the MLP approach is also relevant to this debate:  private equity firms.  If Bain Capital (the firm that Mr. Romney founded) wanted to go public so partners could cash in their built-up equity, they would likely become an MLP.  Blackstone and KKR, two large private equity firms, have already done so. 

 Table:  Avoided taxes on oil and gas MLPs alone exceed totals subsidies DOE attributed to the sector

[1] Chuck Marr and Brian Highsmith, "Six Tests for Corporate Tax Reform," Center for Budget and Policy Priorities, 24 February 2012.
[2] National Association of Publicly Traded Partnerships, "Master Limited Partnerships 101: Understanding MLPs," August 2012.
[3] Low-end assumes a yield of 6.7%, the average of fossil-fuel-related MLPs based on MLPs listed on the Yield Hunter website with additional data from Google Finance.  High-end estimate is from Telis Demos and Tom Lauricella, "Yield-Starved Investors Snap Up Riskier MLPs," Wall Street Journal, 16 September 2012.
[4] U.S. Energy Information Administration, Direct Federal Financial Interventions and Subsidies in Energy in Fiscal Year 2010, 2011, p. x.

The acrimony on increasing the debt ceiling is hitting a fevered pitch, and the likelihood of a technical default on US debt is unfortunately becoming a larger possibility each day.  I wondered whether there was anything one could learn by looking at the personal financial filings of some of the people opposed to raising the ceiling and/or incorporating increased revenues in stabilizing the country.  Does the way they run their portfolios match or conflict with what they are advocating at the national level?  Are there direct or potential conflicts of interest?

Private spending as a window to public positions?

To do this, I pulled the financial disclosure forms of four individuals:  Rep. Michele Bachmann (R-MN), Rep. Eric Cantor (R-VA), Rep. Ron Paul (R-TX), and his son, Sen. Rand Paul (R-KY).  I looked at their most recent filing (2009 or 2010), as well as the first year they were a member of Congress to see any major changes.  All have been rather vocal opponents of larger government, increasing the debt ceiling, or of including policy changes that boost revenues, even if those changes are merely to eliminate tax breaks rather than increasing the marginal tax rate overall.  All of the Members examined are Republicans, simply because the opposition to avoiding default by increasing the debt ceiling has mostly been a Republican position.  Perhaps others can dig into the portfolios of some on the Democratic side of the aisle to assess whether their investment style highlights concerns as well.

To begin, it is a wonderful thing to be able to actually see the financial condition and positions of the people who govern us.  While the reports (I pulled my copies from opensecrets.org) are not perfect, they do provide an important check to corruption and conflicts of interest.  They tell us the assets our officials own, as these can influence what issues they view as important and how they want them to come out.  The disclosure reports tell us what the Members buy or sell and when, important in evaluating potential misuse of Committee positions or insider information.  Finally, they can tell us if particular Members are facing financial distress or large declines in their wealth, factors that could make them more vulnerable to improper activities.  Imagine being able to see similar information for world leaders such as Vladimir Putin, Robert Mugabe, or Hosni Mubarak.

Now, on to their portfolios.

1)  All four are richer than the median US family.  While many citizens struggle to stay out of debt, all four had a positive net worth.  Even at the low end, this was comparable to or higher than the net worth ($120k in 2007) for the median US household (see Table 720).  The financial disclosure reports present only range values for each holding, resulting in an ever-larger spread between high- and low-end estimates as the number of positions increase.  Thus, Rep. Bachmann has a net worth that could be a low as $112k, or as high as $1.7million, fifteen times higher.  Sen. Rand Paul is in a similar situation, with a net worth spread of $129k to $1.48 million.  Cantor and Ron Paul are in a different category, with net worths of $2.2 - $7.5m and $2.3 - $5.1m respectively.  While certainly not on the order of wealth that Sen. John Kerry (D-MA) has ($183 - 295m), the four still do have more of a financial cushion to fall back upon than many Americans.

2)  Despite positive net worth, all would see large financial losses following a US default.  Although the technical default would initially apply only to US Treasury securities, the default is widely expected to cause severe dislocations in nearly all other asset classes.  This would be similar to the meltdown in 2008, when equities large and small, domestic and foreign, all took a hit.  So did bonds of nearly all types and grades.  Real estate went into free fall, and illiquid partnership interests had a difficult time finding buyers at all.  Even energy plummeted as the recession took a bite out of demand. 

The assets held by three of the four members evaluated fall into one or more of the asset categories battered by the subprime mortgage-triggered recession.  These members would be expected to see large investment declines in a Treasury default as well.  Ron Paul is the most buffered (more on that below), though even precious metals fell during the last recession as gold was lumped in with other commodities and inflation risks that play a role in investing in gold declined. 

It is actually a good thing for Members of Congress to see personal financial losses if they screw up though; it aligns their interests more closely with ours, and increases the chances they will work successfully to avoid defaulting. 

3)  Is anybody betting against the US?

I looked at their current portfolios to see whether there were any positions that would be likely to do well in the case of a default or near-default.  In theory, this could generate a financial interest misaligned with the average voter. 

There were a few candidates for further evaluation: shorting Treasuries, concentrated positions in precious metals, and high international holdings.

Shorting treasuries.  Eric Cantor has been excoriated in a number of places (here's a link to one article on Salon) for shorting Treasury bonds.  He holds between $1-15k in Proshares Trust Ultrashort 20+ year bond fund.  This holding is certainly a problem, since it will do well if Treasuries do poorly.  However, the WSJ points out that Cantor is also long in Treasuries in his retirement account and his spokesperson told that Journal that the short position merely hedges part of that exposure.  If the Ultrashort fund moves 200% opposite the direction of Treasuries (this is its mandate), his short position is at most $30k.  Even incorporating the leverage, however, his long positions in Treasuries were larger ($50-100k in Vanguard TIPS [Treasury Inflation Protected Securities] plus $1-15k in Vanguard Short-Term Treasury Fund).  TIPS are likely to see declines during a default.  Thus, even in the very unlikely event that a default will not spread contagion beyond the Treasury bond asset class, Cantor is a net long and will suffer more from a default than he will gain. 

That said, the Ultrashort products really don't provide much of a useful long-term hedge strategy, and his position isn't large enough to provide any significant cover portfolio-wide.  Further, they sure create the appearance of a conflict of interest.  That appearance would turn into a real one should Cantor sell the position during a period of uncertainty at a gain.  Given these factors, the position seems more trouble than it is worth.

Stocking up on precious metals.  In times of great uncertainty, precious metals surge.  This is happening now, and metals would most likely spike still further following a default in the world's reserve currency.  Of the four Members evaluated, this outcome would mostly benefit Ron Paul.  He holds large concentrated interests in a slew of mining companies and metal funds, heavily focused on gold.  The largest of his positions are Agnico Eagle Mines (international gold mining, at $100-250k), AngloGold Ashanti ($100-250k); Barrick Gold ($250-500k); Eldorado Gold Corp ($50-100k), Gold Corp Inc. ($500-$1,000k), Golden Star Resources ($15-50k), IAM Gold Corp ($100-$250k), Kinross (gold, $15-50k), Mag Silver Corp ($50-100k), Newmont Mining ($250-500k), Pan American Silver ($50-100k); Silver Wheaton Corp ($50-100k), Virginia Mines ($15-50k), and many smaller positions in precious metals firms.  The elder Paul also holds a number of real estate properties, and at least one fund betting on market downturns (Prudent Bear Mutual Fund, $1-15k). 

While his concentrated positions in gold may derive from his ideological goals of getting rid of the Fed and shifting back to the Gold Standard rather than a desire to cash in on a US default and downturn, it is nonetheless quite plausible that he would benefit substantially from such an occurrence.  (As an aside, gold mining is a nasty business; it would be interesting to know whether Paul takes any position on which firms he puts his money in; and whether he supports the "No Dirty Gold" standards). 

While the economic malaise following a US default would certainly affect his real estate and mutual funds, of the four Members, Ron Paul has the greatest likelihood of being a net winner financially from the turmoil.

His son Rand has much less wealth than Ron, and is invested via widely diversified mutual funds and tax-advantaged college savings plans.  He also derives income from real estate holdings.

Eric Cantor has concentrated holdings in range of natural resource firms (more on this below), but more focused on energy than in precious metals.  Michele Bachmann is similar to Rand Paul with primarily diversified funds and little to gain financially from a flight to gold or economic instability.

International stocks and currencies.  One might theorize that declining power of the US following a default would depress US equities, and that foreign holdings would do much better.  This is overly simplistic in my view.  Large US firms have substantial earnings from outside the US; and large foreign firms have substantial earnings within.  Further, there is no magic firewall between US debt markets and global capital markets.  The uncertainty will spread widely across asset classes. Even if foreign positions fell a bit less than US ones, they would still fall sharply, leaving the long investor worse off.

Nonetheless, it is interesting to note that three of the four Congress members evaluated have substantial global diversification (Rand Paul doesn't provide enough specifics on which mutual funds he's in to tell).  There is no "Buy America" in force when it comes to their own investments.  For Ron Paul, this is through a wide array of international mining operations.  Of Rep. Bachmann's 13 mutual fund positions, five of them are all or largely international, including her largest mutual fund position (Capitol World Growth & Income Fund, $50-100k).  Rep. Cantor owns mostly larger firms with a combined domestic and international presence, but also a couple of focused non-US funds:  Morgan Stanley Emerging Markets ($1-15k) and Claymore ETF Trust 2 (investing in Chinese technology firms, $1-15k).  I did not see any significant investments in foreign currencies or bonds, though positions may be embedded in some of the funds owned.

Overall, the international diversification provides Members with some protection against a weakening dollar, but is unlikely to provide shelter following a Treasury default.

4)  Impediments to reforming tax subsidies.  All of the four have looked unfavorably at including revenue increases in any deal to boost the debt ceiling.  This includes eliminating at least some of the many distortionary tax breaks that now populate our tax code for the benefit of constituent groups or particular social objectives.

As documented in Pew's Subsidyscope project, Treasury losses through tax expenditures are now almost as large as discretionary spending (see Figure 1 below, based on GAO data).  These are selective tax breaks, often politically motivated, to support specific industries or individuals.  Their impact is to force higher taxes on the rest of us (or to run higher deficits if the lost revenue is not made up elsewhere), and to generate an uneven competitive playing field as some market partcipants pay lower taxes than do competitors with substitute goods or services. 

Fixing these problems would have enormous fiscal and competitive benefits for the country.  There are, of course, always some losers from reform.  These losing firms are often large political donors, which is a key reason fixing the problems is so hard.  But nearly $1 trillion in tax breaks can no longer be ignored given the fiscal situation the country is in.

Figure 1: Discretionary Outlays vs. Tax

Expenditure Estimates in Constant Dollars
($ billions)

Total Discretionary Outlays
Sum of Tax Expenditure Estimates

Source: GAO analysis of OMB budget reports on tax expenditures, FY1982-FY2009.
Note: The tax expenditure data from FY2000-FY2009 can also be found
in Pew's Tax Expenditure Database (Subsidyscope has not adjusted the estimates for inflation).

Subsidies to energy and metals industries.  Both Ron Paul and Eric Cantor would suffer financially from eliminating tax breaks to energy and mining industries.  Because of his skewed portfolio, I expect the costs would be larger for Paul than for Cantor.  Affected provisions include percentage depletion allowances that allow tax deductiosn in excess of actual investments; antiquated rules for hardrock mining (this includes gold, silver, bauxite and uranium, among others on federal lands) land rights, royalties, and cleanup; and a slew of tax breaks for oil, gas, and ethanol.

These tax breaks are not limited to domestic producers.  Percentage depletion subsidies normally apply to foreign mines if owned by a US taxpaying entity.  International operations also benefit from dual capacity rules that sometimes allow royalties on energy or mineral extraction to be disguised as foreign taxes, earning a credit rather than a mere deduction from US taxes owed.

Ron Paul has few energy companies, but Cantor has quite a few single asset positions in both mining and energy: Archer Daniels Midland (ethanol and corn, $15-50k); Cameco (uranium mining, $1-15k); Consolidated Edison (power, $15-50k); Dominion (electricity and natural gas, $1-15k; one of his larger campaign donors); Georgia Power (debt, $1-15k); Newmont Mining ($15-50k), Rio Tinto (mining, $1-15k), San Juan Basin Realty Trust (oil and gas, $1-15k); Schlumberger (oil field service, $50-100k); SPDR Metals & Mining ETF ($1-15k). 

These positions may be one reason why Cantor has been lukewarm at best on eliminating misguided subsidies to oil and gas.  However, his exposure to real estate, particularly in Virginia, is much larger than his exposure to energy firms.  So too are his family's holdings in firms for which his wife serves as a director (Domino's Pizza, $1-15k in stock, $100-250k in options; Media General, $1-15k in stock; $250-500k in deferred stock compensation).

Subsidies to mortgage interest, college funds, and retirement funds.  All of the Members evaluated have benefited from at least one of these tax breaks over time.  Cantor's wife works in the college fund industry, and their portfolio is peppered with 529 plans.  Rand Paul also has a few.  All have tax-advantaged retirement accounts; two have had residential mortgages.  While these are tax breaks that I also like and benefit from, it is useful to remember that they also tend to disproportionately benefit wealthier people.  When members of Congress push to cut housing support for the poor, but fight tooth and nail to protect mortgage interest deductions -- even for very expensive or second homes -- one can quickly see why ignoring the revenue side makes no sense.

Subsidies to dividends and capital gains. With positive net worth that is held not only through home ownership (a main store of wealth historically for most Americans) but in stocks as well, all four benefit from lower tax rates on stock dividends or long-term gains from selling appreciated stock positions.  These tax rates can be half that paid on ordinary income.

5)  Use of debt in personal finances.  I was interested in how these individuals used debt in their personal lives and whether there were any disparities between personal use of debt and their positions on public debt. 

Ron Paul reported no debt on his last financial disclosure form, though did carry two mortgages in 1994, his first year filing.  One of those mortgages was $50-$200k, issued by Countrywide Funding Corporation.  Countrywide subsequently became the poster child for improper mortgage practices, including offering VIP rates to members of Congress.  (Note: there is no indication that Rep. Paul benefited from one of these sweetheart deals, however.)

Eric Cantor's debt load was 10% or less of his family assets.  Michele Bachmann had two loans, a mortgage in the amount of $250-500k; and a business loan for $100-250k.  This generated a debt level commensurate with 36-41% of her assets.  For Rand Paul with roughly $200-500k in commercial mortgages, his debt level is 29-32% of his assets.

Comparisons with national debt are a bit tricky.  Debt is approaching 100% of our GDP, but GDP is a flow-measure, not a stock of assets similar to the values included in the personal financial disclosure forms.  While the share of net assets would be lower, the scale remains worrying.

Still, it is useful to note that all of the Congressional members here relied on debt at one point in their life.  Further, this reliance on debt might be even more striking were we to look at their campaign finances, particularly after their first runs for Congress, rather than just their personal accounts.  Clearly, they all have seen that debt can be useful; it is merely ensuring that the levels stay in control.

6)  Other general thoughts on the financial disclosure forms.

• Aside from making a general point about the gold standard, from a financial diversification perspective Ron Paul's portfolio structure seems insane.  He's had a grand run recently with the global run-up in gold and silver prices.  But if I were his family member, I'd be working hard to get him to do some serious asset diversification.
• Michelle Bachmann has so many mutual funds that some of them are likely overlapping with each other in holdings or conflicting in mandates.  This overlap often results in index-like returns but with active management fees.  More to that point, most or all of the funds she holds seem to be actively managed rather than passive ETFs or broad index funds.  The active funds have higher fees, higher tax costs from churn, and over the long-term often under-perform the very inexpensive ETFs.  
• Bachmann's first filing (for 2005-06) had a detailed listing of honoraria paid to both her and her spouse.  These are nowhere to be seen in the most recent filing, though it would be a surprise if such engagements had stopped.  All that shows up now is a single line item titled "spouse salary," with "N/A" listed for amount.  This seems a large gap in the reporting framework for all Members, as only in an imaginary world would large compensation sources to a spouse have no impact on the decisions or views of the Member.
• Eric Cantor's portfolio structure seems to me to be quite haphazard, with a mix of fairly large individual stock positions, mixed in with assorted funds.  Most of the funds held in his first filing in 2000 were from Goldman Sachs.  Quite a few Goldman funds remain today.  Goldman is not normally viewed as a mutual fund leader, so the concentration there is financially puzzling.  Politically, there seem to be employment and campaign ties however (Goldman was the fourth largest donor to his campaign and some of the listed investments came from a Goldman Sachs retirement plan).  Also puzzling is Cantor's decision to proceed with holding fairly large individual stock positions in a domestic equity portfolio that doesn't seem fully diversified across sectors.  Perhaps the positions are legacy, or part of an actively managed account where the manager believes he or she can outperform the benchmarks even on large and thoroughly researched domestic equities.  Good luck with that.  Under-performance is far more likely, especially after manager fees, trading costs, and taxes.  The large, single positions also give a much greater perception of conflicts of interest than simply owning funds or ETFs. 
• Despite fairly substantial wealth, there is not much in the way of hedge funds or private equity holdings in the Holder or Ron Paul portfolios.  This may make them more open to eliminating tax breaks to hedge fund manager's "carried interest", though political contributions from financial firms would obviously pressure them in the opposite direction.
• There is not much clarity on the non-traded partnership and real estate holdings that many of the Members have.  The dollars are sometimes quite large, but it is difficult to assess how these positions might bias Members without having further information on the deals and who else they involve.

Overall, three of the four Members evaluated are likely to suffer enough in a downturn that their interests in avoiding default are aligned with the rest of us; the fourth will probably see large losses as well in a global contagion.  All benefit significantly from specific tax breaks to portfolio holdings, and this may be an impediment to their moving forward with logical and beneficial corrections to our tax expenditure budget.  That would be unfortunate.

UPDATE - December 27, 2011

In addition to betting against the country with their portfolios, Congress has often been attacked for using inside information they have on firms and pending legislation to profit in their market trading.  A recent review (summarized in this Boston Globe op-ed) by Andrew Eggers at the London School of Economics and Jens Hainmuller at the Massachusetts Institute of Technology suggests that if Congressmen are investing based on insider information, they are doing a poor job of it.  Analyzing the entire portfolios of members, the two found that:

members of Congress generally perform no better than ordinary investors.  Over the 2004-2008 period, the stock portfoio of the average member of Congress underperformed the market by 2 to 3 percent per year.  Put another way, in a five year period during which the market lost around 20 percent of its value, the average Congressional portfolio lost 30 percent.  Even individuals whom Schweizer[fn]Author Peter Schweizer, who argued that insider trading within Congress was widespread in his book "Throw Them All Out".[/fn] singles our for suspicious trades would probably have been financially better off if they had replaced their stock portfolios with a passive index fund.

Last week, the National Academy of Sciences (NAS) launched an important project to assess the impact of the federal tax code on greenhouse gas emissions (ghg).  Tax expenditures now total more than $1 trillion per year, and trigger a wide variety of changes in the level and distribution of economic activity relative to a more neutral tax baseline.  Understanding whether these subsidies also exacerbate (or in some cases lessen) ghg emissions is increasingly important. 

The NAS has engaged a highly skilled panel for this initiative, and launched a website on which project information will be posted. 

Earth Track submitted written comments to the panel last week.  These comments summarize many of the issues that have come up in my work on environmentally-harmful subsidies over the two decades, and provides recommendations on how to address them.

I am anxious to see NAS' work successful.  Back in 2000, I was paired with a tax specialist to work on a similar research task for a large foundation.  The objective of that effort was to examine the tax code well beyond the energy tax breaks that had been examined to date, including policies in the areas of forestry and agriculture, transport, and housing. 

Unfortunately, there were early conflicts among contributors on how to view tax expenditures within the research scope.  This conflict slowed, and ultimately derailed, the project.  The specific disagreement:  should tax provisions that diverge from our existing tax system be treated as subsidies (my position) or ignored on the grounds that under other tax bases (e.g., a consumption rather than an income tax) those provisions would not be subsidies (my co-author's position). 

One of my current recommendations to NAS is that they address this issue quickly upfront -- such that a review of alternative tax systems and how they could help or hinder the challenges of climate change is considered, but as a standalone research task.  The core review and modeling of tax expenditure reforms should be based on the tax system we have now, and are likely to retain in most of its forms for many years to come.