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» Tax discussion » Olstein interview » Rynecki and power

Tax discussion

KAREN GIBBS: It's that time of the year again, when many of us pull out the shoe box full of receipts and prepare to write that check to Uncle Sam, unless of course you happen to be a major corporation. We learned this week that more than 60 percent of U.S. corporations didn't pay any federal taxes from 1996 through 2000, years when the economy and profits were booming.

There are two tax systems in America - separate and unequal, according to David Cay Johnston, Pulitzer Prize winning journalist and author of Perfectly Legal: The Secret Campaign to Rig our Tax System to Benefit the Super Rich -- and Cheat Everybody Else. Bruce Bartlett is the senior fellow at the National Center for Policy Analysis and a former economist in the Reagan White House. Well, David, it looks like your subtitle says it all. Tell me, The Secret Campaign to Rig our Tax System to Benefit the Super Rich -- and Cheat Everybody Else,is that really what's going on?

DAVID CAY JOHNSTON: Well, Congress, you know, every Congressman will tell you, you can't buy my vote; all you can buy is access. But the people who've been buying access aren't you and I, and as a result we have larded up the tax code with all sorts of provisions that benefit various very high income people and corporations. And if you make $400,000 a year, you pay a higher share of your income in federal income taxes, according to new IRS data that came out this week, than if you make over $10 million a year. So instead of a progressive structure where the more you make people above you carry a heavier burden, it goes up like this and then falls back.

GIBBS: But I understand, the way I understand it is that one of the reasons that we received the 2003 tax cut is rich folks said that's my money, we had this huge surplus, and I want it back. Was that not true?

JOHNSTON: Well, the same thing applies to the idea that it's my money to you and I, too. The Bush tax cuts were overwhelmingly concentrated and disproportionately on the very top, highest income group. And the Bush tax cuts also included a half trillion dollar increase on the middle class through something called the alternative minimum tax, or stealth tax. And millions of people, particularly with children, are going to discover that they're going to lose all or part of their Bush tax cuts to the alternative minimum tax over the next few years. And that half trillion dollar increase was explicitly used to help finance reducing the very top rate from 39.6 percent to 35 percent.

Now we can decide the lower rates, but what Americans I think don't know is that the way we've lowered rates on the very highest income people in America, largely those who make $8 million a year or more, is by raising the tax burden on people who make between $30,000 and about $500,000 a year.

GIBBS: Is the perception then that the highest income earners pay the highest taxes the great American myth?

» Tax deconstruction

JOHNSTON: Yes, that is absolutely, it used to be true, but it is not now, and this is in the IRS data from the tax returns so that there's no questioning what's happening. The IRS put out its latest report last week, and it showed that if you were in the $10 million and up class, you paid 25.9 percent of your income on average in federal income taxes. But if you were making a million dollars, you paid 29.9 percent. You paid significantly more.

The top 400 taxpayers in America in 1993, at the beginning of the Clinton administration, paid 30 cents on the dollar in federal income taxes. By 2000, they were down to paying 22 cents on the dollar. Under the Bush tax cuts, they would pay 17 cents on the dollar. They have gotten this huge cut in their burden of how many cents out of each dollar go to taxes. And by the way, the top group's average income is $174 million a year.

Everybody else in America's taxes went up, from an average of 13 cents on the dollar to 15 cents on the dollar. So there's no question the government data show that we are shifting the burden off people at the very top, those who have the biggest access to Washington, onto everybody else. We've taken away from the middle class their ability to save. The reason people aren't putting money in their 401 (k) plans is that they're being overtaxed by the government.

GIBBS: Bruce, isn't the argument though that with the tax breaks for the wealthy they can employ this money into ways that will slowly filter through the economy, creating jobs and therefore enabling the working poor to claw their way a little higher?

BRUCE BARTLETT: Well, I think that's true. I think that all economists agree that saving and investment and entrepreneurship are the things that create jobs and create incomes and wages for everybody, and poor people don't employ poor people, other people. Only rich people do that.

JOHNSTON: Bruce is absolutely right. We want a system that creates opportunity. We want to have more high incomes and more wealth in America. But what the tax system is doing is it's narrowing the base at the very top. Back in 1970, the last 1 percent of income, the very top income group, it took 25,000 people to earn that. By the year 2000, it took less than 1,000 people. In 1970 the super rich -- I define that as the top 1/100th of 1 percent of Americans -- it's about 28,000 people today, they had 1 percent of all the income in America, and the poor, the bottom third, they had more than 10 percent of the income.

Today they're equal. The poor have fallen to 5 percent, and in real terms their incomes are lower now than they were in 1970. And the super rich's incomes have gone through the roof. If you plot the increase in income for 99 percent of Americans from 1970 to 2000, adjusted for inflation, as one inch high, the super rich's income is 625 feet high. These people's taxes are rising, these people's taxes are falling. That's not creating a large and widening degree. Wealth in America is more highly concentrated than in Europe. It's more highly concentrated than it was in 1929. And we want to create a large, diverse class of wealthy people in America. What we're doing is creating a narrowing class of wealthy people in America.

GIBBS: There's also been a very creative move to literally move money offshore. And in fact you said in your book that we have a tax system that says to people with great wealth: move your money out of the United States, invest in offshore. Invest in offshore where labor costs are lower, where taxes are lower, and the rich get even richer.

JOHNSTON: That's exactly right, and we do this also with corporations. The tax law has a bias in it, a number of biases actually, that encourage companies to move offshore. And you know these companies don't actually move offshore, by the way. When you go to Bermuda, all you do is rent a mailbox in Bermuda, and under the Bermuda law plus a treaty we have with the island, the country of Barbados, you can turn your profits in the U.S. into tax deductible expenses.

GIBBS: What about this death tax? Now you've said that you've interviewed people with virtually no assets who literally believe that when they die the government will come in and take half of whatever they own.

JOHNSTON: Correct.

GIBBS: Why do they think that?

JOHNSTON: What they hear is someone on the radio saying, "Well, the government will take half your money when you die." And they don't understand the government exempts at the moment for a married couple $3 million of assets. So that only a small percentage of the population, less than one in 50 people who die every year pay any estate tax whatsoever. But you know there's been this constant focus on the death tax. There is no death tax. There is a tax on your right to transfer your wealth to your heirs. That's what the government taxes.

BARTLETT: I think David's wrong about one thing. I think the vast majority of people who favor abolition of the estate tax know perfectly well that it's paid primarily by the rich. There are a number of polls where they've specifically premised the question by saying, here's a tax that you have to earn whatever, $3 million to pay, do you still think we should get rid of it? And 70 percent or so of people consistently year in and year out say yes, we should get rid of this tax. And I think it's because they just think it's fundamentally unfair to tax again at death assets that were already taxed during people's lives.

GIBBS: How about just close the loopholes that would, and hopefully generate enough money to stabilize Social Security, improve health care, education, police and fire, to say nothing of national security?

JOHNSTON: Well, you can close loopholes. There are always people who will find and create new ones, as I describe in Perfectly Legal. But fundamentally, the tax system has to flow from the economic order, and that's where things are out of whack. And in the long run, it will have a terrible consequence.

What Congress is doing now is putting a moat around those who are already rich and doing work for them and taking care of them. Congress is not thinking about the long-term welfare of America as a society. It is not thinking about, as the Constitution's preamble says, promoting the general welfare. It's thinking about the concerns of a very narrow class of anti-tax, wealthy people who with their contributions and with the thinking that they have promoted through organizations of Washington, what they want in the tax system.

GIBBS: Well, I'm going to ask you the same question that I asked David. Instead of changing the system or reforming the system, just closing those loopholes, would that be enough to stabilize Social Security, improve health care, education, the firefighters, policemen on the local level, as well as pay for national security? The states are really holding the burden now.

BARTLETT: The short answer is "No" I think, because the spending side of our budget with the retirement of the baby boom generation is also broken and out of control, and we can't raise taxes in the existing system, in my opinion, just by raising rates and closing loopholes. We're not going to get enough revenue to fix those problems, whose problems are in the trillions and trillions of dollars. But first you have to have some kind of vision or some consensus about in what direction we want to go in.

And I think in the 1980s we had something like that, and it culminated in the tax reform act of 1986. And since then it's just, we've been just taking that apart piece by piece. And somebody needs to make it a campaign issue, and I would have hoped that somebody like Dick Gephardt, who is a sponsor of the tax reform act of '86, would have brought this issue up, but he didn't, and nobody else seems to want to talk about it either. Certainly the proposals Senator Kerry has put forward are very, very modest and really wouldn't do much of anything. I think he would help himself by coming out with a bold tax reform proposal, and he'll get my support anyway.

GIBBS: I'm sure we're going to hear a lot more as we go toward the election. David Cay Johnston, Bruce Bartlett, thank you very much for joining us.

Olstein interview

GEOFF COLVIN: If you've been hoping to get wealthy knew mutual funds, last summer's revelation had you wonder whether they wanted you to get healthy or just the funds. Congress may impose new rules. Has the fund industry overall been unfairly beaten up? By the way, what stocks does a class "A" heavyweight fund manager like now? Robert Olstein is famous as one of wall street's top detectives of corporate number fudging. His Olstein Financial Alert Fund has been a terrific fund for the six years it's existed.

Bob, the last thing most people remember hearing about the mutual fund industry is that it is, in Senator Peter Fitzgerald's phrase, the world's largest skimming operation. Is he wrong?

BOB OLSTEIN: Look, I understand the Senator's upset. There's been several wrongdoers and it's led to some inflammatory talk here, but inflammatory talk and showmanship doesn't cure anything. There's been 1,000 funds in the last five years that have done 10 percent or more for shareholders. Let's not accentuate the few wrongdoers. Let's punish them, let's set up rules. But to say it's a skimming operation, I really don't know where the Senator's going with that.

COLVIN: Well, part of it was based on the definitely illegal stuff, illegal trading, late trading, that kind of stuff. And I don't think there's any argument about that. You think it should be punished.

OLSTEIN: Absolutely be punished. I wouldn't have even done a deal. I would have punished them even more.

COLVIN: Absolutely. But then the other part of it in his argument had to do with fees, fees that he says are high and fees that he says are not disclosed.

OLSTEIN: Now, fees are disclosed. If you go to page two on prospectuses, they show per $10,000 what is the cost that each shareholder pays in addition to fees, the other costs.

COLVIN: Bob, talking about mutual fund fees, the fees are not always the same as the costs. You were pointing that out with regard to your own fund. What's the difference, and can investors really find out from publicly available documents what the costs of a fund are?

OLSTEIN: Okay. They can, with the exception of certain fees, and that is the trading costs. Okay, by and large every fund has what they call an expense ratio. For example, a fund has a fee that they pay the investment advisor. They may have a 12b-1 fee, which are fees paid to brokers or for marketing. They have obviously administrative fees, which is custody, which is transfer agencies. They're all agglomerated together and expressed as a percentage of assets, and also expressed in a dollar amount per $10,000 in every prospectus.

COLVIN: Well, it's measuring against other funds, though. What the research does show time and again is that the funds on the whole with high fees don't do as well as the funds on the whole with low fees, right?

OLSTEIN: Let's talk about the lowest fee fund out there, the S&P index funds, okay? For the five years ended December 31, 2003, they've charged only .18 percent. Now that's fantastic. So aren't you happy? Wouldn't you like to have owned their fund over those five years?

COLVIN: Well, over those five years it would have been rough.

OLSTEIN: It would have been rough, okay. In fact, over those five years they showed zero return and the fees were $160 million, I'm sorry, $120 million a year or $600 million. Now would you be happy as a shareholder paying $600 million in fees for zero return? In addition, they were the largest buyers of WorldCom, the largest buyers of Enron, the largest buyers of every scandal stock, because it is running a boat in a iceberg, in the Antarctic so why do they deserve any fees?

COLVIN: Well, but Bob, I could point to any number of funds that performed worse than the S&P and charged higher fees.

OLSTEIN: Geoff, we're in an industry where there's 10,000 competitors. Investors have a choice of going from anywhere to .18 percent up to maybe 2.5 percent, okay? So anybody who wants to just buy a fund by their fee, and I don't advise that you do that, okay, can do so and pay the lowest fees available. If I go out there and I overcharge or another advisor overcharges and we're not competitive, and believe me, you guys in the press are pretty good at banging away at fees, although FORTUNE's not a low-priced magazine, you know, I think…

COLVIN: Now the reason for this whole argument is that the advice you read in FORTUNE, and everyplace else frankly, is that the investor should look for funds with low fees because nobody knows ahead of time which funds are going to be the great performers. Nobody knew ahead of time, except maybe you, that the Olstein Financial Alert fund was going to be a great performer.

OLSTEIN: Listen to me. Let's drop the Olstein and let's go to guys like Marty Whitman at Third Avenue Value, Mason Hawkins at Longleaf, Mario Gabelli, they've been doing it for 20, 30 years. I've been doing it for 20, 30 years. I mean, come on. You have to have some predictability. You know Warren Buffett's going to be pretty good over the next five or 10 years. You don't know for sure.

There's no guarantees. So you have to buy, you have to pick somebody in advance to build your house. What if he puts some bad nails in there? What's the probability if you buy a good builder who's been around for a long time? I'm saying you have to look at a lot of other things besides fees. Now John Bogle is one of the biggest advocates of low fees. Now he recently needed very important medical advice. I would doubt that Mr. Bogle went to the lowest-priced doctor.

COLVIN: What is your expertise leading you to today?

OLSTEIN: We have a philosophy in which we believe that the long-term performers are the advisors who make the fewest errors, so I believe like in sports, you have to play defense, defense, defense. Or in essence, you want to buy stocks in which you think about where you can lose, because in this business if you lose, okay, it takes your capital away and then you can't play anymore. So whatever markets we're going into, we want to find stocks that are priced below private market value.

We are stock pickers. We do not get involved in overall markets, okay? And so if you're looking where stocks are selling below private market values, unfortunately there are some problems or negative psychology surrounding the stocks.

COLVIN: Your number one holding would be?

OLSTEIN: Right now Tyco.

COLVIN: Right.

OLSTEIN: We went in and everybody tried to sell my fund Tyco back in the late '90s, and we looked at their financial statements, unlike the index funds, and saw there was some financial chicanery taking place. They were making acquisitions more and more rapidly, and the earnings growth was not 35 percent. We saw 3 percent growth. When in fact Tyco became unglued and everyone said they were going to hell in a hand basket, okay, we saw that Mr. Kozlowski, even though he was a financial magician, he bought some decent companies in some decent divisions.

And when we went through the divisions and Mr. Breen took over the company, we saw that here was a company that if it was run properly had the ability to produce $4 billion of free cash flow, that means after capital expenditures, and we went in and made a major purchase at $14 a share. Mr. Breen has done an outstanding job of weeding out excess overhead. We're finding that this company probably has earnings power of $1.75 to $2.00 a share, and we think it's probably worth somewhere around $35. And that was a lot for me to buy that security when I was one of the main critics throughout the '90s.

COLVIN: You like McDonald's.

» Olstein's stock picks » Burger letter: McDonald's turnaround

OLSTEIN: There's another company. We went in there when everybody says McDonald's was not going to grow anymore. They had stopped growing. And what we liked about it when the new CEO came in, Jim Cantalupo, I wrote him a letter, and I said we just purchased your stock, and in fact if you don't grow anymore and you use your capital expenditures to beef up your own restaurants and stop cannibalizing your stores, you can produce $2 billion of excess cash flow according to our calculations. We went in there. Cantalupo has played this like a cellist.

COLVIN: He has done pretty much what you've described.

OLSTEIN: He's done a wonderful job of beefing up the restaurants, adding to the menu, not wanton expansion. Here's a company that's probably going to do $1.50 to $1.60 this year. We think they have earnings power of $2.00 a share. McDonald's is back full throttle. We think it's worth somewhere around $35 a share.

COLVIN: And another one that had some bad publicity was Interpublic, the big advertising company.

OLSTEIN: Well, there the jury is still out. We just recently took our position. Interpublic, again they went far away from their basic business. They got into motor sports, racing. They had some accounting problems to try to keep the earnings going. New management walked in. We took them apart division by division. We think they've got a great name out there. We think they have earnings power of $1.25 a share. They're going to generate huge free cash flow. We think the stock could go into the low 20s. The jury is still out. We bought it right around here.

COLVIN: Bob Olstein, it's always a pleasure talking to you. Thanks for being with us.

OLSTEIN: My pleasure, Geoff.

Rynecki and power

COLVIN: Not a great buy right now is gasoline at an all-time high price of $178 a gallon, on average, nationwide. Now, it's true that adjusted for inflation, gas prices aren't nearly as high as they were in the early 1980's, but that hasn't stopped John Kerry and president bush from making them a campaign issue and Ford Motor C.E.O. Bill Ford says he doesn't expect gas prices to fall any time soon so his company will start making hybrid gas electric vehicles. That got us wondering how other companies are responding to high oil and gas prices and where investors might find opportunities.

Our FORTUNE colleague, David Rynecki has been looking into that very question and joins us from New York. David, when oil prices go up, the big oil companies do get higher revenues but also have to pay higher expenses. So which companies really benefit in this situation?

DAVID RYNECKI: What's been happening and we've seen a huge rally for actually the last several years in companies such as Exxon Mobil, those guys do benefit, the rising revenues will help them out more than the rising costs are going to hurt them for the moment. What we are seeing a huge swing in demand and what happens with the energy sector is all based on supply and demand. As the global economy has been recovering and China has been on fire, India has been pumping out products like crazy, the United States has also seen an upsurge in demand.

We're seeing that need for more energy and there simply isn't the supply out there. That does benefit the large players, the Exxon Mobils of the world. It also points to some other unique opportunities among the companies that help actually get the stuff out of the ground, such as Schlumberger or Baker Hughes or B.J. Services, is one that focuses on the United States market and these guys have a real knack for providing the tools, the sort of the nuts and bolts that go into getting the energy out of the ground.

COLVIN: They furnish all kinds of tools and equipment, right?
They also punish all kinds of services to the big players.

RYNECKI: That's right. As there's a need and there is a need now for more supply. In order to get that supply, you have to bring in these guys to build the rigs, to do the actual drilling.

COLVIN: What about smaller players? Because the big ones will be affected somewhat, but they're so big it's like turning a battleship it doesn't turn very Far very fast. But there are smaller players I gather could benefit quite a lot. What are they?

RYNECKI: Let's look at two companies, St. Mary Land and Exploration
and Superior Energy Services. These two companies have been featured on FORTUNE's list of fastest growing companies among the 100 best revenue growers of the last three years. Superior, for example, I like to say that what it does is it takes what other companies consider to be inferior and it -- that is, the oil wells and natural gas reserves that seem to be completely depleted. It goes in, takes over these wells and finds every little bit of energy that's left and then brings it to market.

COLVIN: Pretty interesting. We do hear a lot about Ford going into hybrid vehicles, Toyota already is. You have to figure those huge companies will be slightly affected for years to the move to hybrid vehicles. Are there smaller players specializing in this that could be good guys?

RYNECKI: Everybody comes out, one or two years, President Bush was putting the push on hybrid cars, now it is Ford Motor. You take a company like Ballard power who has been on the cutting edge of creating the engines and vehicles that some day a lot of people will drive but so far these are speculative stocks. And what's better for an investor is stick to the drilling companies, the natural gas companies. What I find is that as oil goes up in price, so does the demand for natural gas. They sort of balance off each other and benefit from each other.

COLVIN: Very valuable insight, David. Thanks.

RYNECKI: Sure, thanks a lot.