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Tax Q&A: Who Pays for the Bailout, and How?

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Tax Q&A: Who Pays for the Bailout, and How?

$700 billion. It’s an incredible number. The Troubled Asset Relief program (abbreviated TARP, often just called “The Bailout”) is an unprecedented spending spree. The closest comparison, the Marshall Plan, cost about $110 billion in present dollars, so the scope of the TARP is beyond that of any new government program.

When people hear about $700 billion in new spending, their first reaction after scraping their jaw off the floor is to ask: “Who will pay for this?” with the sneaking suspicion that the answer is, as usual, “The taxpayers.”

But it’s not that simple. The first important thing to realize about paying for the bailout is that it’s not necessarily going to mean a higher tax rate or an end to tax refunds. Although the government will be spending more money, it’s able to print up an effectively unlimited amount, so the usual rules can still apply. That said, doesn’t that huge sum of money need to come from somewhere?

Not quite. Most government spending involves gifts, with strings attached: the government spends money on social security, health care, law enforcement, defense, and many other services without charging directly for them, and pays for some things — public parks, mail delivery — with prices that don’t nearly make up the whole cost.

But the TARP isn’t a gift. It’s a program to buy assets. The government’s goal is to spend $700 billion in order to get about $700 billion worth of mortgages, bonds, and bank equity. What happens next depends on how optimistic you are.

The worst-case scenario is that the government overpays dramatically for these assets — that they are basically handing money over to the banks in order to keep them solvent or make them rich. In this case, the bailout could cost hundreds of billions of dollars. But the government’s cost of borrowing is so low that even if they make bad investments, they may end up with a profit: a stock that only made you 5% per year in dividends and capital gains would be a bad deal, but the government can borrow money for ten years at less than 4% interest. If they borrow $700 billion, and make that paltry 5% return, they still show a profit of $7 billion every year.

This optimistic case is not necessarily likely, but it does demonstrate that even bad investments can end up okay if they’re made at a low enough cost. But no matter how bad things get, the government is at least getting something for its money — so at worst, the bailout must cost something less than $700 billion.

The next scenario is that the government ends up getting a fair deal: they wind up with a collection of bad loans and mortgages, marked down to a price that reflects their risk. Over time, the government would behave like a normal borrower, renegotiating some loans and collecting on others.

Then, there’s a best-case scenario. Some very smart investors have been buying bank stocks and mortgage debt at higher prices than we see today, so there might be a good argument that buying right now gets you a very good deal. If the government is able to make huge investments, at a low price, funded by debt that carries a low interest rate, there’s a chance that there could be some massive profits ahead. If banks recover to their earlier prices, housing values and mortgage prices bounce back a bit, and the economy returns to gradual growth, the TARP might lead to a profit of hundreds of billions of dollars over the next few years.

A profitable bailout? Why didn’t we try it earlier?

Usually, Americans are uncomfortable with the government buying into businesses. The prospect of the US doing what’s good for General Motors instead of what’s good for the voters is too worrisome. In addition, if the government did this too often, it might increase US interest rates — right now, rates reflect how easily the government can raise tax revenue, but if they could only raise tax revenue by taking money from companies they owned, this catch-22 could make them worse off.

But right now, the political situation has changed, interest rates are lower, and the bailout promises to be a temporary solution. So while it’s not ideal, it’s a good idea to consider how well the bailout could turn out. And remember: that $700 billion is the most deceptive price tag you’ll hear about — it’s the absolute limit of the very worst-case loss, and it ignores the real possibility of a profit.


One Response to “Tax Q&A: Who Pays for the Bailout, and How?”

  1. Tax Q&A: Who Pays for the Bailout, and How? · Stocks.ExplainedOnline.Net Says:

    […] Original post by Business Finance & Economy | […]

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