Reality Check

We could accomplish entitlement reform by design, but, because of our political dysfunction, we’ll get it by default. Unfortunately, the last election showed that it’s probably still too early for a reality check.

From the WSJ:

None Dare Call It Default

A nicer term for what’s about to sock the middle class is ‘entitlement reform.’

By HOLMAN W. JENKINS, JR.

To call Greece First World may be a stretch, but Greece has defaulted once already, and it is only a matter of time until Greece defaults again. Welcome to default-o-rama, the next chapter in the First World’s struggle for fiscal sustainability.

Japan is piling up debt in the manner of a nation beyond hope. France, Belgium, Spain and Italy are defaults waiting to happen unless Europe can somehow generate the kind of growth that has eluded it for decades.

America’s fiscal cliff is an artificial crisis. We have no trouble borrowing in the short term. But at some point the market will demand evidence that long-term balance is being restored. President Obama said in his first post-election press conference that he doesn’t want any proposals that “sock it to the middle class.” He knows better. A long-term socking is exactly what’s coming to the middle class, which must pay for the benefits it consumes.

A few years ago, when the economy was humming, a common estimate held that federal taxes would have to rise 50% immediately to fully fund entitlement programs. Today, a 50% tax increase would be needed just to meet the government’s current spending, never mind its future obligations.

One way or another, then, entitlements will be cut. Don’t call it default. The correct term is entitlement reform.

You saw this day coming and saved for your own retirement. Don’t call it default when Washington inevitably confiscates some of your savings, say, by raising taxes on dividends and capital gains. Taxpayers accept the risk of future tax hikes that may make the decision to save seem foolish in retrospect.

According to economists Robert Novy-Marx and Josh Rauh, state and local taxes would have to increase by $1,385 per household immediately to make good the pension promises to state and local workers, including firefighters and cops. That’s not going to happen given all the other demands on taxpayers. Default, in this case, is the proper word for cities and states using bankruptcy to repudiate their pension obligations.

Prominent voices ask why the Treasury shouldn’t just cancel the government bonds the Federal Reserve has been buying. It’s money one part of the government owes the other. Dispensed with, of course, would be the idea that the Fed, in buying these bonds in the first place, was engaged in monetary policy. The Fed was printing money so Washington could spend it.

Now let it be said that inflation isn’t fundamentally a solution to the entitlement problem, but the Federal Reserve is being led by increments to accommodate inflationary financing of future deficits. Don’t call it default. Inflation is a risk savers are deemed to have accepted by putting their faith in the U.S. dollar.

Here’s what you weren’t told about Medicare during the presidential debates. Under the Paul Ryan plan, the affluent would pay more. Under the Obama plan, the affluent would flee Medicare to escape the waiting lists, shortages and deteriorating quality as Washington economizes by ratcheting down reimbursements to doctors and hospitals. Don’t call either default. You don’t have a legally enforceable right to the free care you imagined you were promised.

“Don’t worry” was President Obama’s implicit message during the campaign: If cutting subsidies for Big Bird is unthinkable, a joke, how much more so cutting benefits for middle-class voters?

Don’t go running to a judge when this doesn’t pan out. The courts do not overrule changes in government policy just because citizens find their promised free lunch isn’t forthcoming. Nor will it be fruitful to appeal to politicians’ sense of “fairness.” Politicians can be relied on to do what will get them re-elected. And, believe it or not, that is the good news.

If politicians weren’t eager to be re-elected, the trust necessary to be an investor would vanish altogether. While there is no escaping our challenges, there is a path in which the economy grows strongly and we don’t savage each other, and there is the other path. For years the trustees of Social Security and Medicare were accused of exaggerating the programs’ deficits by envisioning that America’s long-run growth would become more like Europe’s. Now who doesn’t fret that America’s growth is becoming permanently slower like Europe’s?

Which brings us to President Obama. He knows cuts are necessary but seeks to position Democrats politically as the defender of all spending. Notice that, with ObamaCare, he is deliberately creating a constituency of the young to set against the old in future fights over the allocation of federal health care dollars.

Meanwhile, saving the dynamism of the U.S. economy, while still affording an entitlement state, naturally falls to the other party in a two-party system.

‘Taxmaggedon’ Is a Real Threat

Never was a big fan of Snow as Treasury Secretary, but this argument regarding the tax treatment of capital should be given close attention. We don’t call it “capitalism” for nothing and the misunderstanding of the role of capital vs. labor and equity vs. credit/debt is what got us into this mess over the past 30 years.

From the WSJ:

Next year’s scheduled increases on dividends and capital gains will retard investment and derail the recovery.

By JOHN SNOW

Nine years ago this month Congress passed President George W. Bush’s Jobs and Growth Tax Relief Reconciliation Act. That bill’s lower rates on capital, as well as the continuity in tax policy it established, have helped make our economy far more resilient.

The legislation’s centerpiece was a reduction in the taxation of dividends and capital gains to 15%. Unfortunately, the 2003 tax rates, including those on capital income, are due to expire at the end of the year.

Capital warrants special tax treatment because of the central role it plays in generating economic growth and jobs. Capital is the very lifeblood of the market economy, the mainstay of innovation, and the foundation for future prosperity. As more of it is put to work today, labor output and wages will rise tomorrow. An appreciation of that critical relationship should guide how the tax system treats earnings from capital.

The double taxation of dividends—with corporate earnings first taxed 35% at the corporate level and then, when paid out to shareholders, taxed again—has been a long-standing and well-recognized distortion in the tax code. It favors debt financing over equity capital formation, because interest is deducted as a cost of doing business and lowers taxable income, while dividends are taxed twice.

The preference for debt financing and leverage shortchanges shareholders and is not healthy for corporate decision-making. Double taxation penalizes dividend payments and discourages managements from making them.

Congress did not eliminate the double taxation of dividends in 2003, but it substantially ameliorated the distortion. Dividends are now taxed at 15%, rather than the typically higher income-tax rates paid by shareholders. Importantly, the 15% tax rate was applied to capital gains as well. Capital gains previously had been taxed at 20% with special rates for assets held five years or longer. This symmetry between dividends and capital gains harmonized and simplified the regime for the taxation of capital and still stands today as a key achievement in modern tax policy.

Corporations responded to the lower rates on dividends by paying out more of their profits, which raises the returns to those holding stock and thus increases equity prices. Both trends strengthen Americans’ retirement savings. As recent actions by Google, Apple and scores of other companies attest, corporations today find it more difficult to sit on cash instead of rewarding shareholders with dividend payouts.

With the expiration of the 2003 tax law at the end of this year, taxes—not only on capital earnings but also on ordinary incomes—will return to the much higher levels that previously existed.

This would be devastating to the fragile economic recovery, and to every American still looking for work. Combined with the expiration of temporary payroll tax relief, the United States faces what has now been labeled “taxmageddon”—a fiscal headwind so strong that it threatens a swift return to recession.

What seems to be lacking is a clear path to the future. Here are some suggestions for policy makers.

First, remember the principle that you always get less of anything you tax. For this reason, society discourages undesirable activities by imposing so-called “sin” taxes. By the same token, high marginal tax rates discourage work, risk-taking and capital formation.

Second, tax rates should be held as low as possible, consistent with maintaining fiscal balance. Low tax rates are not in conflict with fiscal sanity if the rate of government spending as a fraction of gross domestic product is reduced, or if the tax base is broadened with more fundamental tax reforms. It is encouraging to see so much interest gathering in support of changes to the tax code that would scrap many special tax breaks in favor of deeply lower marginal tax rates.

Third, marginal tax rates should be as neutral as possible across different types of economic activities. Otherwise the tax code distorts behavior in ways that sap economic strength, as market participants rely less on market price signals and more on government commands to decide how economic resources are used. Social engineering through the tax code comes at a very high cost.

Finally, policy makers should remember to “do no harm.” A reversion to the kind of drastically higher marginal tax rates that existed in the past would be bad enough. It would only add insult to injury to use the economic crisis as an excuse to raise the tax burden on capital formation and thus reduce the lifeblood of America’s job creators.

Unfortunately, we face that real prospect, as prominent proposals by the administration would triple the top dividend tax rate to nearly 45%, while doubling the top rate on capital gains to 30%. If one intended to cripple job creation, depress stock prices, and lower the value of retirement savings for working Americans, these proposals would be just what we should choose.

As taxmageddon looms, let’s hope we choose wisely.

The Real Causes of Income Inequality

The article below offers some interesting and important insights into inequality and taxes. In the end, Gramm and McMillin appear to be arguing merely for lower income tax rates, but there’s much more to it than that. They have demonstrated where the 1% gets their money and why the 99% is not participating to the same extent from changes to the global economy. It is mostly due to a shift in the capital to labor ratio and the risk-adjusted returns flowing to each. This is due to policy changes in response to a global economy that is liberalizing along free market lines. In other words, societies that wish to succeed in an open, global economy have adopted policies that enhance their relative success, which means focusing on the “capital” in capitalism.  The distribution of capital correlates with inequality. As G&M state:

The vast expansion of labor engaged in world commerce has raised the return on capital and reduced the relative return on labor. The share of income flowing to capital—both traditional and human capital such as education and training—has risen.

But G&M neglect to offer a positive argument on what to do about this. If we desire to reduce inequality in free societies we need to promote widespread participation in the capitalist market economy as something more than a labor cost. But one cannot merely redistribute capital to achieve this and trying to increase labor incomes by government mandate is the quickest route to national impoverishment. Instead, we must use the logic of the market system to promote widespread capital accumulation. This can easily be accomplished through the tax system as we already do through our pensions system. With tax reform, we need to focus on what taxpayers DO, rather than who they ARE, and provide the proper incentives to DO the right thing, which is accumulate private capital. To this end, rich vs. poor matters much less than productive vs. unproductive. Why not more tax-free accumulation of capital accounts dedicated to health, retirement, education and home ownership? Why not zero capital taxes? If we really want the productive (and lucky) to pay their progressive share, we’re going to have to look to wealth taxes rather than income, as income taxes penalize the “getting” rather than the “having” of wealth.

Incumbent to capital accumulation is the need to manage risk through open and transparent financial asset markets together with a combination of complementary private and public insurance institutions. But that’s a much larger subject for another day.

Unfortunately, ideologues and elites prefer to play politics with our fates and offer the same old class warfare defined by subjective “fairness.” It’s a divide and conquer strategy coupled with promises of more “bread and circuses.”

From the WSJ:

Any analysis of taxes paid in high tax-and-spend countries shows that the U.S. has the most progressive income tax system in the world.

By PHIL GRAMM AND STEVE MCMILLIN

In the stagnant days of the Carter administration, when inflation was approaching 13.5% and interest rates were peaking at 21.5%, income was more evenly distributed than in any period in 20th-century America. Since the days of that equality in misery, the measured income of the top 1% of income tax filers has risen over three and a half times as fast as the income of the population as a whole.

This growth in income inequality is largely the result of three dynamics:

1) Changes in the way Americans pay taxes and manage their investments, which were a direct result of reductions in marginal tax rates.

2) A dynamic shift in the labor-capital ratio, resulting from the adoption of market-based economies around the world.

3) The flourishing of economic freedom and technological advances in the Reagan era, which were the product of lower tax rates, a reduced regulatory burden, and an improved business climate. These changes have not only raised the measured income of the top 1%, they benefited the nation and the world.

While income distribution has become a source of protest and political debate, any analysis of taxes paid in high tax-and-spend countries shows that the U.S. has the most progressive income tax system in the world. An inconvenient truth for the advocates of higher taxes on America’s rich is that big governments in developed countries are funded not by taxing the rich more than the U.S. does, but by taxing everybody else more.

In 1986, before the top marginal tax rate was reduced to 28% from 50%, half of all businesses in America were organized as C-Corps and taxed as corporations. By 2007, only 21% of businesses in America were taxed as corporations and 79% were organized as pass-through entities, with four million S-Corps and three million partnerships filing taxes as individuals. By reducing personal tax rates below the level of the corporate rate, the Tax Reform Act of 1986 dramatically influenced how entrepreneurs structure businesses.

This has had a profound effect on what is now measured as the income of the top 1%, since a significant amount of what is now declared as personal income is actually income from businesses that are now taxed as individuals.

In 1986, just 5.6% of the income of top 1% filers came from business organizations filing as Sub-chapter S-Corps and partnerships. By 2007, almost 19% of income declared on tax returns filed by the top 1% came from business income. A significant amount of income that critics claim is going to John Q. Astor actually is being earned by Joe E. Brown & Sons hardware store.

The reported income of the top 1% also significantly increased as tax rates on capital gains were lowered, first under President Bill Clinton and then under President George W. Bush. At a top tax rate of 28%, realized capital gains were 2.5% of GDP and made up 17.7% of the income of top 1% filers. As the top tax rate fell to 20% in 1997 and 15% in 2003, realized capital gains rose to 4.6% and then to 5% of GDP. The percentage of the income of top 1% filers coming from capital gains grew to 26% in the 1997-2002 period and 28.1% during 2003-07.

By reducing the penalty for transferring capital from one investment to another, these lower tax rates increased the mobility of capital. High-income taxpayers sold more assets, declared more income, and paid more taxes.

Similarly, when the tax rate on dividends fell to 15% in 2003, dividend income for the top 1% grew 178% by 2007 to make up 5.6% of the income of these filers. In 2007, immediately prior to the recession, capital gains and dividend income combined was equal to the amount of salary, bonus and exercised stock options earned by the average top 1% filer.

Lower tax rates made dividend-paying stocks more attractive to high-income investors and made dividend payouts more attractive for companies that would have previously retained those earnings or bought back their stock. Capital trapped in companies with below-market rates of return was redeployed and the entire economy benefited.

All of this has had a huge impact on the measured income of the top 1% and the growth in income inequality. This impact can be estimated by examining what would have happened to the income of the top 1% if tax rates had not been lowered and these economic transformations had not occurred.

If the share of income coming from businesses, capital gains and dividends had remained at the levels before the tax rate changes of 1986, 1997 and 2003 respectively, the income of top 1% filers would have been 31% lower in 2007. The growth in income since 1979 for top 1% filers would have been only 2.5 times as large as the income growth of all taxpayers—not 3.6 times as large.

More businesses would have remained C-Corps and been taxed as corporations, fewer assets would have been sold and thus fewer capital gains would have been declared, and fewer dividends would have been paid. All of this would have lowered the income declared by the top 1%. Economic growth would have been lower and aggregate measured income of all taxpayers would have fallen, but the distribution of income would have been flatter.

The growing participation of China, India, Brazil, Russia and Turkey in the world economy has also affected income inequality. The vast expansion of labor engaged in world commerce has raised the return on capital and reduced the relative return on labor. The share of income flowing to capital—both traditional and human capital such as education and training—has risen.

In relative terms, the return to unskilled labor has fallen. Short of a crippling reversal in world trade, which would reduce the value of both labor and capital, this effect will dominate world markets for the foreseeable future. Since high-income Americans own more capital and have higher levels of education and training, their incomes have grown faster than everyone else’s.

The flowering of talent from the expanded freedom and technological progress ushered in by the Reagan era has also played a role. Inequality is a natural result of the expansion of liberty and the development of new technology and new products. Henry Ford, Andrew Carnegie, Sam Walton and Bill Gates caused the income distribution to become more uneven, but they enriched the world.

To vilify success and the rewards it garners is an assault not just on capitalism but on liberty itself. As Will and Ariel Durant observed in “The Lessons of History” (1968), “freedom and equality are sworn and everlasting enemies, and when one prevails the other dies . . . to check the growth of inequality, liberty must be sacrificed.”

Nowhere is the political debate over income inequality more detached from reality than the call for the top 1% of American income earners to pay their “fair share.” The Organization for Economic Cooperation and Development (OECD) data on the ratio of the share of income taxes paid by the richest taxpayers relative to their share of income show that the U.S. has the world’s most progressive tax burden.

The top 10% of earners in the U.S. pay 35% more of the income tax burden than in Sweden and 22% more than in France. These figures—from the 2008 OECD publication “Growing Unequal?”—include all household taxes imposed on income at the federal, state and local level, including social insurance taxes.

In an eternal irony unique to large welfare states, it is the expansion of government in the name of the poor and middle class that always costs poor and middle-class families the most. When the U.S. collects 16.1% of GDP in income taxes, the top 10% of taxpayers pay 7.3% and the other 90% pick up 8.9%.

In France, however, they collect 24.3% of GDP in income taxes with the top 10% paying 6.8% and the rest paying a whopping 17.5% of GDP. Sweden collects its 28.5% of GDP through income taxes by tapping the top 10% for 7.6%, but the other 90% get hit for a back-breaking 20.9% of GDP.

If the U.S. spent and taxed like France and Sweden, it would hardly affect the top 10%, who would pay about what they pay now, but the bottom 90% would see their taxes double.

Since OECD members have significantly higher consumption taxes on average than the U.S., the total tax burden of bigger government is even more heavily borne by lower-income citizens in developed nations than these numbers suggest.

The real and alarming message in these OECD numbers is that there appear to be limits in the real world to how much tax blood can be extracted from rich turnips. With much higher marginal income-tax rates, countries that are clearly willing to soak the rich have proven to be incapable of doing so.

Proposals to raise taxes on high-income Americans in the name of “fairness” not only threaten economic growth. The experience of nations with large governments shows that this argument is simply a red herring for a massive tax increase on middle-income Americans.

In the end, taxing is about feeding government, not redistributing wealth. What nation ever set off on the road to big government promising to tax middle-income workers, and what nation ever got big government without doing it?