Sunday, December 19, 2010

Tax Compact – My Take

Here is my take on a tax compact and the four questions from the November 13 post.

Who should pay an income tax and who should be exempt from it?  My take is that anyone who is not classified as officially poor should be obligated to pay income tax.  This is about 85% of our population.  Compared to the 85% of the non-poor, only 68% of Americans actually paid US income tax in 2006.  My belief is that anytime the Government wants to expand services, then everyone who can pay an income tax should feel some part of the pain whether that pain is 1% or 40%.  In my view, this is necessary to maintain a responsible working social and electoral structure.  All classes will bear their share of the burden.

How much tax is too little?  None.  I don’t know if the minimum tax should be 1% or more, but I would settle for a minimum tax of 1%.  

How much tax is too much?  I believe that no one, no matter how rich, should pay more than 50% of his or her income as a tax.  That is a total income tax and that includes both Federal, state, and local.  In California, the maximum tax is 10.3%.  If the liberals ever succeed in setting the maximum tax at 39.6% or higher, then the highest combined income tax would be 49.9%.  Now that would work with me if that is all there was, but there’s more.

The reason why 50% of income should be the maximum combined income tax is that economic freedom was part of our revolution from the British, and that pursuing economic self-interest in the Adam Smith sense is central to that freedom.  If anyone spends one hour of any day making more money for the Government then for him or herself, then we are in tyranny.  That is why I believe in a maximum tax rate.

If Republicans are going to argue that 39.6% is too much tax and 35% isn’t, then they need a better explanation then “class warfare”.  No one even knows what that means.  They also need to justify it on a basis other than the Laffer Curve, which was discussed in the previous post.  It cannot be used to prove 35% will produce more tax revenue than 39.6%. 

There is a case to be made that small business owners would use the 4.6% difference hiring more workers and generating more overall government revenues.  However, conservatives are not proving the point with data.  The data is there.  Go find the data and make the point.

Okay, so 39.6% fits, except that when Social Security taxes are added, which I consider an income tax.  It is becoming a pure transfer tax from the younger generations to the older ones.   It can no longer be considered an investment.  It is simply, correctly, and honorably, a response to a promise from one generation to another that should not be broken. 

If we add Obama’s 39.6% to Social Security’s 7.65% and California’s 10.3%, then the total rate climbs to 57.55%.  This is 7.65% into the tyrannical range for income taxes.  Some would point out that Social Security taxes max out at $106,800 a year.  Well, as suggested in a previous post, the ceiling should be lifted to convert Social Security from a regressive tax to a flat tax, a move that would go a long way to solving its funding problem.

All of these changes would result in a maximum Federal Income Tax of 32%.  That would be a just tax………..unless the Fed’s challenged California to get its fiscal house in order and lower its maximum tax rate in order for the Fed’s to raise its maximum tax. Let’s see, California would respond that the Federal government should take back some of the responsibilities it has passed down to the states to fund, and it would go on from there.  It would be two behemoths pushing each other around, similar to watching sumo wrestling in Japan.  Now, that would be interesting.

Tail of Two Ideologies - The Laffer Curve

The Republican fiscal ideology is wrapped in something called “supply side economics”.  The concept is based on the concept that individuals work harder when they can keep more of what they earn.  As individuals work harder, the increase in work results in additional jobs.   It is somewhat reminiscent of Adam Smith and his views on self-interest. 

This idea has been taken further.  From a national perspective, there is an optimum tax rate that is low enough to motivate workers while generating the maximum tax revenues to the government.   This curve that theoretically identifies the optimum tax is called the Laffer Curve.

There are some who may confuse the Laffer Curve with supply side economics.  They are related but not the same.  First, let’s discuss supply side economics.

There are several events that supply-siders cite when advocating lower income tax rates.  One is when President Kennedy lowered the highest tax rate from 91% to 70%, and the second is when President Reagan lowered the highest rate from 70% to 30%.  Both actions are credited with causing long economic recoveries for their times.  By lowering tax rates, the economies grew and tax revenues grew.  Unfortunately, government expenditures grew as well, and deficits continued. 

This most recent downturn in the economy occurred just as the census was happening, which was a prelude to Congressional reapportionment among the states.   A recent study compared states that will be adding to their Congressional representation with those that are losing Congressional seats.  The states losing seats are high tax states and have the average of their personal income tax rates is 6.05%, and those gaining seats have average rates of 2.8%. There is the view that when a state lowers taxes, it basically draws economic resources from neighboring states.  In other words, people walk, or even vote, with their feet. 
So, Texas and Virginia are growing state economies and California is not.  These experiences do not necessarily support the idea that lower tax rates create more economic growth.  These states are really drawing businesses from other states, and the situation does not support the argument that businesses within these states are growing by themselves due to lower rates.

These are the main arguments that supply-siders cite when stating their case.  However, one of them, namely Arthur Laffer, in the early 80’s fascinated President Reagan with what has come to be known as the Laffer Curve.  This says that tax revenues will increase as rates increase up to a point, after which as rates increase, tax revenues will fall.  Supply-siders are left with the question of where is this optimum point in the tax rate structure? 

Well, I know of one mainline economic textbook that says that the theory sounds great, but there is no evidence that supports the curve.  Supply-siders cite Kennedy and Reagan, but leave out Clinton, who took Reagan’s highest rate and raised it back up to 39%.  G.W. Bush lowered it to 35%, and we had good economies under both.  Now, Obama wanted to raise it back up to the Clinton rate, and the supply-siders became upset again.  The problem is that they have no data upon which to argue their point. 

And when a group argues a theoretical point without the data, they are being ideological.  Hence, the classification of the Laffer Curve as ideology.

Tail of Two Ideologies – Keynesian Economics

The previous post framed the question of a tax compact around the fact that each party has their respective ideologies.  The Democratic ideology is based in Keynesian economics.  Republican fiscal ideology is wrapped in something called “supply side economics”.  So, let’s take Keynes first.  In the next post, I will review the supply siders.

To start, Keynes says that government can correct a recession by expanding government. This expansion is financed through debt.  Governments are supposed to repay the debt during good economic times.  In the posts on David Stockman, it was noted that the United States has run a deficit in 38 of the past 40 years.  Additionally, the overall amount of national debt will equal the Gross Domestic Product in the next few years.  In 2010 the interest on the national debt will be $209 Billion or 6 percent (up from 1 percent in 2009) of the Federal budget. 

With regard to Keynes, the real question is whether it can and should be used in all economic downturns.  It is in its overuse that it serves as a candidate for ideology status.  In this blog, I raise two questions about it.   First concern, can it be expected to work in a recession resulting from a structural downturn?  In our case, the balance sheet of most American households have been hit hard by the mortgage crisis causing people to increase their saving by abnormally high amount, which, according to Keynes, lowers the multiplicative effect of government expansionary efforts (or in other words, more savings means less expansion).

In the posts on the Stimulus Program it was noted that it failed to stimulate.  One possible explanation is that the program was designed incorrectly and relied too much on some of Keynes’ main ideas.   I speculated that the type of recession was structural in that it was tied to the mortgage crisis (this reduced assets levels), and not tied to consumption, as Keynes would suggest.  One concern that follows from this is the view that the United States may be approaching its maximum debt level that it can carry before the benefits of expansionary borrowing become diluted and less effective.

Another concern is whether government deficit spending has been overused to the point that its beneficial effects have been diluted and is not as effective as it once was.  In other words, is there some inelasticity in the economic tool that was not considered by our policy makers in this most recent crisis?  The answer is ‘maybe’ as David Brooks reported on a recent National Bureau of Economic Research that examined stimulus efforts in 44 countries.  The report argued that fiscal stimulus can be quite effective in low-debt countries with fixed exchange rates and closed economies, and countries like the United States with high debt and floating exchange rates, are generally not as effective with stimulus measures.

The main reason for calling Keynesian ideas an ideology is that they are over used.  Paul Krugman, a Nobel Prize winning economist, advocates that the size of the stimulus was inadequate and should have been significantly larger in order to stimulate the country out of a recession.  Not only would the proposal complicate the country’s problems with debt, but it also would increase the risks of inflation, which is anti-stimulative.

The point is that the evidence does not exist to support Krugman’s proposal.  People who advocate this solution for this particular recession are essentially acting on faith, and that fact alone qualifies it as ideology. 

Keynes’ ideas are tools.  As a tool, people need to understand when Keynes’ ideas should be used and when they should not be used.  The election was not about ideology, but about making the country work, and for that we need tools.