You can’t solve a debt problem by accumulating more debt which was the Bush, and now the Obama administration’s approach to solving the financial crisis. I believe taking this approach will not work – and nothing has changed my mind.

Tax revenues are falling while government spending is increasing creating a crisis situation in many states. This crisis could potentially cause traditionally safe investments such as municipal bonds to default, or at the very best, reduce their ratings.

California is a prime example. This from the state controller’s office:

State Controller John Chiang today released his monthly report detailing California’s cash balance, receipts and disbursements in May and through the first 11 months of the fiscal year. In May, revenue was $827 million below the latest projections found in the Governor’s May Budget Revision.

“Without immediate solutions from the Governor and Legislature, we are less than 50 days away from a meltdown of State government. This presents a terrible threat to California’s economy and to the State’s delivery of basic public services,” said Chiang. “A truly balanced budget is the only responsible way out of the worst cash crisis since the Great depression.” (Emphasis mine)

Personal income taxes were $475 million below (-23.0%) estimates in the May Revision. Corporate taxes were down $84.4 million (-25.8%), and sales taxes fell by $109 million (-3.3%).

The Controller has met with Governor Schwarzenegger and Legislators in the past week to brief them on the State’s immediate cash problem. He also sent a letter to State leaders this morning with new cash projections – updated to reflect May actuals and final May Revision numbers from the Department of Finance – that continue to show the State exhausting all available cash by late July. The State is now projected to run $2.78 billion into the red on July 31.

The State started the fiscal year with a $1.45 billion cash deficit, which grew to $19.8 billion on May 31, 2009. That deficit is being covered by a combination of Revenue Anticipation Notes (RANs) and internal borrowing from special funds. Borrowing from special funds is expected to provide enough cash to fund State operations through the end of the fiscal year on June 30.

The controller is right in my opinion. The only responsible way out of this mess is to deal with the problem; live within our means and deal with the consequences NOW, not later. Pumping the economy full of newly, printed money will eventually make the landing harder than if we had just dealt with the problems now.

Yet instead, on a federal level, where the printing presses that make money reside, we’ve elected to take exactly the opposite approach. And, mark my words; the landing may be much harder than it needs to be.

From the rumblings out of California, that may be where the hard landing begins. Think about it, when is the last time that you’ve seen or heard a state controller use the terms ‘meltdown’ and ‘terrible threat’.

Some wise folks are choosing to keep their powder dry, raise their cash holdings on rallies and use absolute returns investment strategies.

The Federal Reserve has expanded its balance sheet by over $1 trillion since last year. In the video I’ve posted below, the inspector general of the Federal Reserve testifies that she hasn’t yet looked into who actually got this money. Unbelievable.

Invest 5 minutes to watch this video – you won’t believe this is actually happening. Listen to her answer when the congressman asks about what she’s done to investigate the reported $9 trillion in off balance sheet transactions at the Federal Reserve. And, then listen to her answer when the congressman asks who’s keeping track of the losses that the Federal Reserve is incurring on its portfolio. The inspector general’s answer? No one that she knows of. Don’t take my word for it, watch it yourself.

Now, President Obama wants to give the Federal Reserve even greater authority. Within the next week, Obama is expected to outline his proposal for overhauling US financial rules. It is expected he’ll propose more regulation with more oversight responsibility for the Federal Reserve (Bloomberg Jun 12, 2009). Watch that video again. How do you feel now?

God help us…

Wall Street Journal Reporter, Tom Herman, just published his final article as a full time employee and writer for the Journal in the area of personal finance. His take on the US tax system is interesting, and likely more accurate than the opinion of many, as he’s been writing about it since his arrival at the Journal in 1968.

Herman recalls how embarrassed he felt as a college graduate in 1968 unable to complete his own tax return. Out of this embarrassment and frustration came one of his first ideas for a story; he hired 5 different tax professionals to do his taxes and got 5 different outcomes. While that made him feel better about his own competency, it did shed light on how bad our system of taxation is.

Since that time, according to Herman, our tax system has moved from being a mess to a nightmare. For example, the number of pages in the CCH Standard Federal Tax Reporter, which records tax law and related material, has increased in size from 26,300 pages in 1984 to 70,320 pages today. Today, more than 60% of tax returns are signed by tax professionals, up from 46% in the mid 1980’s.

In his final article, Herman quotes former IRS Commissioner, Charles Rossotti, “Our federal tax system is so shot through with deductions, credits, exclusions, loopholes and outright noncompliance that it fails in its essential job of raising revenues efficiently. The complexity and instability of the tax system also leads people to believe that the average person always gets stuck, while the big hitters find ways to avoid paying, regardless of the advertised tax rates.” (Source for all the above information, “The Wall Street Journal, April 15, 2009)

Obama is trying to battle that perception. He’s asking congress for more money for the IRS to step up enforcement (Source: Wall Street Journal, April 15, 2009). This will likely mean more audits, increased scrutiny of tax shelters and an estate tax exemption amount that’s constant.

Ultimately though, in spite of Obama’s best efforts and intentions, it’s going to be an uphill battle. The more complex our tax system, the more difficult enforcement becomes. IRS employees have difficulty understanding the nuances of the tax code and what tax planning strategies are proper and legal and which are not.

And, as long as creating and building tax shelters is a high paying activity, the activity will continue and will evolve, with many tax shelter designers staying one step ahead of the ever changing tax code. With each added layer of complexity, with each new revenue ruling and revenue procedure, comes the potential for the creation of a new, allowable tax shelter or tax planning strategy.

Change and complexity create opportunity for tax planning professionals. Increasing tax rates as Obama has proposed, increases the potential reward from using a tax shelter. Combine complexity with increased tax rates and you create an environment where tax shelters and tax cheats multiply – that’ unfortunately, is where we’re headed given current tax policy.

The real answer to the tax problem is a simple tax system, easily understood by the masses. Only then will the problem be solved.