Archive for January, 2006

The Incredible Flow-Through Leak

January 29, 2006

Former Canadian finance minister Ralph Goodale’s department is currently under investigation by the RCMP regarding an alleged leak of information concerning the decision in his (most recent) income trust fiasco. The formal allegations were brought forward by the NDP during the election campaign. They allege that Bay Street insiders privy to the leak benefitted by purchasing income trusts and dividend paying stocks, which stood to rise after the decision became public, which it did on Nov 23, 2005. Further background to this can be found here.

Notable nay-sayers to the likelihood of a leak include the Bay Street community, according to various media reports. Of course they are hardly unbiased, not being eager to point the finger at themselves. However, in this case they are one group with enough (indeed, more than enough) knowledge of and familiarity with the situation to actually draw the right conclusion, as opposed to those who saw the trading frenzy of Nov 23, and in a knee-jerk or partisan reaction cried “Leak!”

Here I want to outline and explain the argument against a leak, which is based on correct market anticipation as grounds for the pre-announcement trading activity. Of course I don’t know if there was a leak or not, but based on the reasoning below I find it highly improbable.

In September 2005, the finance department initiated a public consultation regarding perceived tax problems related to income trusts. The consultation was scheduled to take public input for consideration until Dec 31, with a decision expected to be reached early in the new year. Among the options being explicitly considered was the possibility of introducing a new tax on trusts. It wasn’t long before the uncertainty created by this situation resulted in a significant drop in income trust market values. (To be sure, a coincident drop in oil prices also depressed the values of energy trusts, but this factor was far from alone.)

This trust value scalping made minister Goodale the target of criticism from many sides: trust investors large and small, trust managements, investment bankers, would-be trust convertees. This only aggravated the problems of the tottering Liberal minority government. Moreover, the media was eager to unearth any tidbits they could regarding this on-going situation. Any time the minister gave them even a vague comment relating to hypothetical outcomes, the markets stirred in reaction. It soon got to the point where, for fear of misdirecting trigger-happy traders, the minister publicly refused to provide any further comment on the situation until 2006 when the consultation would be completed. This is a very important thing to realize, which many leak-seekers probably don’t take into account.

Now move ahead to Nov 22. After a long period of silence, and with the Liberals on the brink of non-confidence, Goodale finally has something to say: the trust situation will be resolved imminently, before the fall of the government. This, in essence, was the leak; and it was public! If you actually think about this, the implications are immense and fairly clear. First, an imminent announcement signals a decision either having been made (or about to be finalized). And second, an early end to the consultation.

Concerning the decision to be made, it could be either bad or good. A “bad” decision would have been along the lines trust stakeholders were dreading, something like “we’re putting a new tax on trusts” and perhaps other restrictive or draconian measures. For the minister to close off public input prematurely, before everyone could have their say, and impose a decision like that, particularly in the face of other concurrent anti-Liberal sentiment (Gomery et al), was just not a real possibility.

So, if the decision couldn’t be bad, it had to be “good”. Namely, at the very least: no new measures or taxes affecting income trusts directly. This is what almost everyone wanted, and is really the only possible acceptable reason for ending the consultation early.

And what about dividend stocks? It was widely realized by those somewhat familiar with the tax system that the “problem with income trusts” was largely a problem of duplicate taxation, in particular concerning dividends. This had been widely reported in the media, and had been pointed out in early publicly released submissions to the trust consultation, along with the suggestion to eliminate duplicate taxation of dividends. In his mini-budget, the minister even thanked early contributors for such thoughtful and useful suggestions.

Therefore, it was not a big leap to conjecture that the minister’s decision would involve a tax reduction on dividends. This was a sensible idea, would be well received, and moreover would inject some substance into the decision, rather than just saying “we’re backing out early and doing nothing for now”, implicitly because “we can’t take the heat”. (Incidentally, the actual proposal by which dividend taxes were to be reduced, also adopted by the Tories, appears to be rather pedestrian.)

All of the above reasoning is of a highly probable nature. Bay Streeters doubtlessly thought along these lines during the day from Nov 22 to Nov 23, and those of them eager to place bets before an announcement began buying income trusts and high dividend paying stocks on Nov 23 (if not already nibbling at them on Nov 22). This would not require knowledge that an announcement was to come on the evening of Nov 23. One was coming soon, so best get in early or simply jump on the bandwagon. This could easily have cascaded into the broad frenzy that did take place in those securities that day.

Seeing this strong anticipatory reaction, finance would have had little choice: best to finalize and out the decision at once, before the speculation could run wild any longer. Thus the near haste with which the announcement was revealed after market close on Nov 23 may have been partly in reaction to the building frenzy. Some concluding remarks:

  • A leak can never be ruled out for certain, even if the RCMP dismisses the case for lack of evidence. However, all of the publicly available evidence can be readily and reasonably explained as outlined above, with no need to assume a leak. An unbiased person doesn’t even have to be an financial insider to see this. The markets are very good at reading these kinds of tea leaves, and they usually get it right.
  • Conservative leader Stephen Harper played this incident very well politically. While always hedging his statements, he slanted them strongly in favor of a leak. But his true beliefs were probably revealed by the fact that he left it up to Jack Layton’s NDP to launch a formal complaint on the matter. In that way, when the final RCMP report in all likelihood comes out negative or inconclusive, the egg will be planted squarely on Layton’s face.
  • As for Ralph Goodale, I find it quite implausible that he was involved in this alleged leak, but I don’t feel too sorry for him. Given his repeated, incompetent meddling with the income trust sector, one might call it retributive justice if a baseless scandal broke loose and bit him on the butt.

Making a Minority Government Work

January 24, 2006

Here’s a novel (I hope) idea for how to proceed in cases of minority government. But first, why might we need this?

After 18 months of Liberal-led minority government in Canada, flaws in the current setup have become quite evident. Let’s list some of the worst:

  • A marginal “tail” in parliament (in this case, the NDP) has the power to “wag the dog”, imposing their policies rather undemocratically.
  • The governing party (in the case, the Liberals) was able to delay an official vote of confidence for months, in the process ignoring several votes tantamount to confidence, on technicalities at best. As a consequence, a disfunctional parliament can drag on with wrangling replacing accomplishment, all just to extend a term in power, and perhaps try to time an election advantageously.
  • The governing party can get away with bribery-type schemes to induce opposition members to “cross the aisle” (e.g., Belinda Stronach’s 15 minutes of “non-political” fame and ministry).

So how could such problems be avoided, or significantly minimized?

The basic idea is to take the leading parties and force them to cooperate, if at all possible. Easily said, but how? In detail:

  1. Start with the leading two parties, in terms of seats, and group them together. If they still don’t total a majority of seats, then group in the next leading party, and so on, stopping once a majority of seats is represented by the group. Call this group, say, the “Enforced Governing Coalition”, or “EGC”. This group would be expected to try to cooperate and form the government. In practice the EGC would usually consist of just two parties, and perhaps very rarely three.
  2. Now the key: Give every party in that group a loaded gun. Specifically, each party in the EGC should have the right, at any time of their own discretion, to declare non-confidence (or perhaps better, call it “non-cooperation”), dissolve parliament and force an election. (Call this a “parliamentary veto” if you will.)

For example, in the both the current and last parliaments, the Liberals and Conservatives would have formed the EGC, and either one could have ended parliament to force an election at any time they chose. When the NDP tried to call the Liberal’s shots, the Tories could have put a stop to it in that way.

Logically, this scheme can be viewed as an extension of the usual majority government, in which a single party forms the “EGC” and has the right to call an election. Conversely, a majority government is a special case of this more general scheme. Also note that, due to the arithmetic involved in selecting members of the EGC, such parties would have roughly comparable numbers of seats and thus be roughly equally deserving of their special “veto” power.

Next, consider the main benefits of such a system.

  • It would represent a democratic assignment of power. The most widely elected parties would run the government together as majority.
  • It could prevent a marginal party from wagging the dog. However, it doesn’t totally exclude the useful possibility of two parties, one in the EGC and one not, cooperating together on a issue, provided this is not seen as completely unacceptable by another member of the EGC.
  • The leading party could not hang onto power desperately or maliciously if things were not working, because the other member(s) of the EGC could pull the trigger.
  • The leading party would have a difficult time recruiting aisle-crossers. For, recruiting one would indicate the enforced coalition was not working, and would likely be seen as an act unscrupulous enough to warrant dissolving parliament.

A key question of course is: Would the EGC parties cooperate? I believe the answer is, Yes, they would be forced to cooperate to the greatest extent possible; because if they didn’t cooperate while the public perceived they could, the stalemate would lead to an unnecessary election. It might be amazing how well they’d each behave with the “veto gun pointed at their heads”. There would be some political poker alright, but you couldn’t bluff too often.

Note that it would be very dangerous for any EGC party to call an election frivolously, or even be perceived to have caused one unnecessarily. This would most likely be political suicide and damage their future position badly. Just look at all the hand-wringing that went on recently regarding a dreaded winter election. The public doesn’t want an unnecessary election, and if they felt one had been created, the party that caused it would be punished accordingly.

Another potential objection: Wouldn’t an EGC party just go ahead and call an election opportunisticaly if things developed such that they were pretty sure they would win a majority? Yes they would, but there’s nothing wrong with that. For if they win, it means they have the people’s support, and it is time to get on with a real majority government.

Alternatively, if the EGC really was at loggerheads and found they simply could not cooperate on anything constructive anymore, the onus would be on them to make this clear politically to the people, and then perhaps agree jointly to call an election and let voters have their say again. That would open the door to a potentially different balance of power.

The Conservatives’ Last Mile

January 21, 2006

Two days until the Canadian federal election on January 23. Polls now suggest a Conservative minority government, with their number of seats predicted to range from about 125 to 145, somewhat short of the 155 needed for a majority. Close, but not quite tantalizingly close.

But polls are only polls — what if the unexpected happens? The most likely unexpected outcome would surely be a Conservative majority. But, what could put the Tories over the top? The Liberals’ various forms of self-destruction combined with the Tories’ more calm centrist stance have brought things here, but I think those forces have run about as far as they can. Surely, even the flailing Liberals can’t accelerate themselves “on the march” (to oblivion) within the next two days, and the Conservatives have now more or less expressed their platform (aside from some devilish details, but who’s paying attention anyway?).

So, I think any final Tory push, if it happens, has to come from outside of the various parties; it has to come via decisions within voters themselves. And one thing they might be thinking is: “We’re sick of minority government, and all the unproductive wrangling, posturing and underhanded tricks that come with it. After 18 months of this, wouldn’t it be better to have a majority government?” With the conservatives perched near this, being the only viable possibility to achieve it, it’s realistic to conceive that a useful slice of votes could swing their way for the above reason, to “give them a chance and see what they can do?

A Tory majority may not happen (perhaps most likely not). And if it does, though we’ll never know for sure the final reasons that swayed voters, the above seems quite plausible from here.

Muddled Tory Re-investment Proviso Harbinger of Hell

January 17, 2006

Late last week, Canada’s Conservative party vaguely revealed, in a speech by leader Stephen Harper, a new tax proposal in their election platform. While details are as yet scant, it reportedly would allow deferral of tax on capital gains provided that proceeds of sale are re-invested within six months. Apart from the predictable opposition Liberal party gainsaying, most media reports I’ve seen (e.g., at GlobeInvestor.com) take a rather benign and uncritial view of this proposal. In the January 14 National Post, J. Chevreau’s article at least mentions the possibility of “the devil being in the details”.

It is a bit risky to criticize something before all the details come out. Nevertheless, it is not hard to extrapolate at least roughly how a policy like this must work, given the stated goal and current rules on related matters of capital gain taxation. Doing this it appears all but certain that a very nasty devil must be hiding in the details.

First, I am entirely in favour of eliminating tax on capital gains. It’s my firm belief that taxing capital gains on equity securities is (in the long run) unjustifiable double taxation, and is entirely inconsistent with the elimination of double taxation of dividends. (More about this well below.)

What bothers me deeply about the proposal is its proviso “subject to re-investment within six months”. Apparently no details have yet been given on how this would work, but a reasonable guess might be something like this:

1 When capital property (stock, bond, fund unit, real estate, etc.) is sold at a gain, the proceeds go into a “notional cash account” and bring with them a cost base equal to that of the property sold. This cost base is averaged in with any pre-existing cost base for money already in the notional account (much like current identical property rules).

2 When new property is purchased (“re-investment”), one has the option of allocating all, or part, of its purchase price with money from the notional account, and pro-rating the cost base of that money into the purchase’s cost base.

3 Six months after any money enters the notional account, that amount of money is reduced by any amounts allocated to re-investment as above, and the remainder is then deleted from the notional account, whose cost base is then re-calculated to reflect the deletion. The capital gain originating from the original sale which created the deleted funds would be taxed as currently.

This is clearly an utter bureaucratic and accounting nightmare. A number of problems are immediately seen, the most significant one of which I list first:

* The cost base of any single property could depend upon ALL of the other properties one had ever sold previously (anytime after the proviso came into effect). I.e., the effects depend globally on one’s investments, and can propagate forward indefinitely!

* Tracking the evolution of the notional cash account and its attendant cost base, as described above, is an onerous task. Most Canadians today have enough trouble calculating capital gains under present rules. Keeping track of the above would daunt almost anyone. Also, no brokerage or fund company could do it, because they don’t know about all your property transactions. So people would either not do it and gain no benefit, do it themselves and make a mess of it and constantly revise their tax returns, or go to accountants, who would be very happy indeed, and whose fees would eliminate any benefits of tax deferral.

* Similarly, can you imagine a CRA tax audit in the far future, where you would have to document and explain your entire capital property activity’s history over prior decades just to justify the capital gain on a single security that was sold without re-investment?!

* If property is sold in November or December, the six month period expires after the corresponding tax return is due on April 30. Thus one might not even know by tax time whether the proceeds have been re-invested, yet one has to decide whether to declare a taxable gain or not.

* If bonds are eligible re-investment options, this leaves open the possibility of short term bonds, money market instruments or money market funds too. But if you can “re-invest” in such short term products then, effectively, the six month period could be extended forward indefinitely.

* If a capital gain is transferred from a stock to a bond via re-investment, and the bond is held to maturity, is the capital gain thus converted into interest? One might expect this would be the default behaviour — a punitive result since interest is taxed at the highest rate.

Given such problems (and there must be many more), it is clear the six month re-investment proviso, or any similar thing, is an absolutely untenable disaster with onerous accounting and legislative special casing consequences. What should be done instead is very simple: phase out capital gains taxes by reducing the inclusion rate from 50% to 0% in a timely and orderly manner.

All of this makes me wonder if, in fact, the Tories really want to just eliminate the capital gains tax entirely (as should properly be done), and that they are using the proviso as a temporary political smokescreen to deflect opposition criticism before the election.

Returning briefly to why taxing capital gains on securities is undesirable: For stocks, capital gains are driven by two factors: corporate net earnings and investor sentiment; but the sentiment factor is bounded and averages out over time, while corporate earnings are already taxed, so taxing the stock gains they produce is duplicate taxation. As for bonds, their prices are determined by interest rates, and do not “grow to the sky” since interest rates tend to remain bounded from below. Hence taxing bond capital gains is, in the long run, also a horribly inefficient and counter-productive exercise for the CRA to engage in.

Unfortunately, some of those most knowledgeable might not be motivated to speak out against the Tories’ misguided re-investment proviso. Not accountants, who stand to benefit. Not pension funds, who are unaffected. Mutual fund companies may not like the tax cut in any form, as it would help investors flee poorly performing managed funds. Investors need to raise a firestorm of criticism before the oncoming train runs over them.

Political Promises and the Value of a Vote

January 16, 2006

In the context of the Canadian federal election on January 23, 2006:

The problem of politicians not keeping their election promises is, arguably, at most half the problem. Usually, it is even worse when politicians do keep these promises. This is because politicians find themselves desperately escalating their ill-conceived pledges in an attempt to buy more votes than their competitors.

Consider the array of spending and costly programs being promised now by all parties, to be paid for by other peoples’ money that was never intended for such purposes (e.g., GST revenues or budget surpluses). These kinds of expenditures are particularly insidious, because they are on-going and become entrenched; no politician will ever repeal them (unless perhaps to replace them with even costlier programs).

So the situation concerning politicians keeping election promises is that we damn them if they don’t and we’re damned if they do. My (not entirely tongue-in-cheek) solution to this problem has two parts:

1 During an election campaign, place a gag order on all politicians. In this way they can’t make any promises, either to be broken or more disastrously to be kept. (The penalty for breaking this rule is found below Part 2.) With the politico’s traps mercifully shut, voters would have to make their decisions based on past record — surely a better guide than empty promises made under duress. Do the incumbents warrant another term or not? Did the opposition present reasonable arguments and proposals in parliament? How did they all conduct themselves in question period?

2 As for the vote-buying, that could no longer be accomplished by promise-making; it should instead be done by more direct means. (Yes, you read that right.) There is really nothing wrong with this, as long as the process is open, transparent and subject to full disclosure.

Specifically, any person or organization should be able to donate as much money as they wish to the party (or parties) of their choice — money that is ear-marked specifically for vote-buying. These donations must be disclosed fully and immediately, e.g., using the Internet. Parties could then use this money to strike deals with voters who wish to have their vote bought, again with full disclosure. (Voters choosing not to be “bribed” would retain the right to a secret ballot.) This process would come to an end, say 2 days before the election. Bribed voters would at least be sure to get something, rather than the current situation of broken promises. And the bribe money would at least be intended for this purpose, and would not result in perpetual public expenditures.

Finally, in the event of transgressions of the gag rule, parties would have their vote-buying abilities severely curtailed (i.e., be allowed to spend less on bribes, excess money being returned to donors). Pre-arranged bribes may need to be cancelled because of this; in that event the voter would be notified and would recover the right to vote for any party they wish.