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A Private Sector Fund and Investor Market Solution Alternative to the Congressional Bailout September 26, 2008

Posted by Daniel Downs in Congress, economy, free market, inheritance tax, investment, mortgage, news.
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Times of crisis have often challenged Americans to demonstrate their practical problem solving genius. It is one of those good traits that has made America a leader in the world. I suspect Gary Palmer, President of Alabama Policy Institute, is another possessing such a nationally beneficial genius. But, I will let you make that judgment after reading his September 26 column titled “Bailout Isn’t the Only Option.”

Palmer’s Bailout Alternative should be read by all of our federal representatives before making their final plans.

It is evident that American taxpayers are angry about what it appears Congress is going to do: a $700 billion taxpayer bailout of the ailing financial and mortgage institutions. According to a September 24th USA Today/Gallup poll, 56 percent of the American people want a different plan. Unfortunately, this is very likely an article about what Congress could have done instead of what they will do to recapitalize our nation’s financial markets.

Apparently, the dire warnings from the Bush Administration and others that the economy is on the brink of failure is not enough to persuade American taxpayers that a bailout is the answer to the financial crisis. The perception is that the federal government is forcing the taxpayers to pick up the tab for the problems created by the mismanagement and corruption of greedy corporate executives and their enablers in Congress.

The fact is the bailout is more of a buyout. The package that Congress is considering would commit the federal government, i.e. the taxpayers, to spend hundreds of billions of dollars buying mortgages. This means the federal government will be in the real estate business, at least until it can sell its new real estate holdings, hopefully at a profit.

This action is supposed to result in the recapitalization of the financial industry. Could there be another way to unclog the financial arteries of the nation’s economy without adding $700 billion to $1 trillion to our federal debt?

The answer is yes.

Congress could create an opportunity for private sector funds to be used to recapitalize banks and the housing industry by using assets subject to the inheritance tax. It is estimated that between $1-1.5 trillion in assets will be transferred to heirs over the next ten years. In 2009, under current law, estates with assets worth more than $3.5 million will be subject to a tax of 45 percent on everything above the exemption. And, unless Congress renews the Bush tax cuts, in 2011 the exemption will decline to $1 million and the tax will increase to 55 percent on the amount above the exemption.

In order to get more private equity into the financial and mortgage markets, Congress should create a 12-month window in which anyone with assets subject to the inheritance tax could use those assets to purchase residential real estate or mortgages. The assets used within that time frame would never again be subject to an inheritance tax.

If the real estate purchase produces income, such as rental income or increases in value, the estate owner would pay the usual income and capital gains taxes. However, if the investment resulted in a loss, investors would not be able to deduct the loss on their income tax return.

A 45 or 55 percent tax is a hefty penalty for dying and there is a lot of incentive to try to avoid paying it. Because every dollar of private money infused into the real estate and mortgage markets would replace a dollar that the federal government would have to spend in a bailout, this option could significantly reduce the size of a bailout and save billions of taxpayer dollars.

Given the dire circumstances we face, members of Congress should be willing to consider this option. It will benefit all American taxpayers as well as those faced with paying inheritance taxes. Moreover, even though some portion of the inheritance tax would be eliminated, directing those assets into the financial and real estate markets gives it the effect of a tax in that the resources are being directed to a specific purpose.

There is another idea that also makes sense. Congress should create a six month window in which investors could purchase residential real estate and receive a tax credit of 20 percent of the purchase price as an incentive to buy. The tax credit could be taken in the first year or it could be carried over in successive years until it is used up.

Currently there are more than four million houses on the market nationwide. Given that the median price of a house is around $196,000, it would take about $400 billion to cut that inventory in half. Using the above figure as a baseline, by offering a tax credit of 20 percent of the purchase price, the cost to the federal government of the tax credit would only be $80 billion.

Perhaps the most important thing about a private sector solution is that it would help restore market discipline. A taxpayer bailout increases moral hazard, i.e. the likelihood that this will happen again. Keeping these transactions entirely within the private sector would not only stabilize the market, but would also help restore market discipline and enforce a degree of accountability and responsibility on those who created the crisis. As a result, those who made the really bad deals will still suffer some consequences for their actions.

These ideas will not totally eliminate the possibility of direct federal action. But, if the federal government eventually has to act, it would be at a significantly lower cost to the taxpayers and with significantly less danger of nationalizing the mortgage industry.

Clearly, Congress is going to address this problem. Will Congress pay attention to the American people and consider alternatives such as allowing the private sector to be a part of the solution? Unfortunately, it appears at this point that some Congressional leaders believe the only plan is a taxpayer bailout.

Gary Palmer is president of the Alabama Policy Institute, a non-partisan, non-profit research and education organization dedicated to the preservation of free markets, limited government and strong families, which are indispensable to a prosperous society.

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