Friedman’s Paradox
Almost every interesting economic proposition shares a
confusing characteristic: what’s true for the individual is the opposite
of what’s true for the country as a whole. To a consumer buying shoes, it
appears as though the price is fixed and the supply is elastic. Consumers
can buy as many shoes as they want as long as they are willing to pay the
asking price. But to the country as a whole, it is the supply of shoes
that is fixed and the price that is elastic depending on demand. This
paradox permeates economics.
-- Milton Friedman - paraphrased from a speech titled “Money and Inflation” Q&A, 1980 (herein referred to
as "Friedman's Paradox")
Two Pieces
On Nov. 29, 2012 the New York Times ran a piece by Binyamin
Applebaum and Robert Gebeloff titled, “Tax Burden for
Most Americans Is Lower Than in the 1980’s”. The authors cite
New York Times research, which makes the case that taxes are historically low
especially on the rich. They calculate rates for various income groups
and come up with a top marginal tax rate, at all levels of government (federal,
state, and local), of 42.1%, compared to the 1980’s when it was 49%.
A couple of weeks later, On Dec. 12, 2012, the Wall Street
Journal ran an op-ed by Edward C. Prescott and Lee E. Ohanian with nearly the
opposite title, "Taxes Are
Much Higher Than You Think". After studying tax rates,
again at all levels of government, Prescott arrived at an average marginal tax
rate of 40%, while the authors contend that the perception is that taxes are
much lower.
So, the New York Times pegs the top marginal rate at 42.1% and
Prescott and Ohanian have the average marginal rate at 40%; not enough of
a difference to get too excited about. Yet, the two pieces seem to
ascribe opposite perceptions to the public, and seem to promote opposite policy
prescriptions. Who’s right?
With all due respect to these esteemed authors, neither is
right. Here’s why taxes are much higher than most people think, and much
higher than even Prescott and Ohanian think. Here’s also why The New York
Times piece is wrong about taxes being higher in the 1980’s.
How
High?
The
True Tax
Keep your eye on one thing and one thing only: how much
government is spending, because that’s the true tax ... If you’re not paying
for it in the form of explicit taxes, you’re paying for it indirectly in the
form of inflation or in the form of borrowing. The thing you should keep your
eye on is what government spends, and the real problem is to hold down government
spending as a fraction of our income, and if you do that, you can stop worrying
about the debt.
--Milton Friedman - from the same "Money & Inflation"
speech, 1980 (herein referred to as "The True Tax")
Both studies cited above employ similar methodologies based on
individual tax rates. But according to Friedman’s Paradox, what is true
for the individual is often the opposite for the country as a whole.
Instead of looking at individual rates in every jurisdiction and arriving at an
average rate as both sets of authors appear to have done, the better way, the
simpler way, the more inclusive way, and the Friedman True Tax way, is to find
total government spending and compare that to Total Income. By doing
that, we learn what is happening with taxes in the country as a whole,
inclusive of all borrowing, printing, business taxes, and indirect taxes.
Here are the results when Friedman’s True Tax methodology is
applied to 2012: Total government spending at all levels was about $6.2
trillion, and Gross Domestic Product was about $15.8 trillion.* To arrive at Total Income, all
government activity was subtracted from GDP as government activity cannot generate
income, only the private sector can do that. $15.8t less $6.2t results in Total Income of $9.6
trillion. $6.2t divided by
$9.6t yields a True Tax rate of 65%.
But that doesn’t include money creation/printing by the Fed,
which may or may not be considered spending. Since 2008, the Federal Reserve
has created two trillion dollars in new money and that money is not included on
any ledger of government spending. The Fed claims it isn’t actually
spending money when it creates money because it is buying US bonds, which it
can later sell. This is the exact same argument Fannie Mae and Freddie
Mac were making about home mortgages - right before they went
under! To settle this, let’s just say inflation has averaged about
5% since we dropped the gold standard in 1971. If we use that
conservative figure, and add 5% to 65%, that yields a total True Tax rate of
70%!**
That is not the top marginal tax rate for high earners like the
New York Times calculated. Nor is it an average marginal rate like
Prescott arrives at. That’s the average tax rate on every single dollar
of our Total Income. When Friedman’s Paradox is applied to tax rates, the
illusion of progressive taxation goes away. Essentially, we are all in
one big tax bracket, whether we know it or not. Our individual income
tax rates vary, but there are enough taxes buried in everything we buy that it
levels-out our average burden, and we all pay roughly $.70. You may think
your doctor just got a big tax hike, but his increased tax burden is passed
right back to you in the form of higher fees. His hike is your hike, and
so it goes, ‘round and ‘round.
The Breakdown
Here’s a rough breakdown of the $.70 tax everyone pays on every
dollar of Total Income: $.30 is paid in direct taxes. These are the
explicit taxes everyone sees: Income taxes, employee’s portion of
payroll taxes, sales taxes, property taxes, etc. $.25 is buried in
the prices of things we buy. These are the stealth taxes: business
income taxes, employer’s portion of payroll taxes, property taxes, use taxes,
fees, etc. $.10 is deferred onto future generations as borrowings,
and $.05 is deferred and/or eaten by inflation due to money creation. ***
Taxes in the 1980's
In 1985, the middle of the decade, we spent $1.5 trillion at all
levels of government and reported GDP of $4.2 trillion, resulting in a True Tax
rate of 56%.* If we add 5%
for inflation, as we did for 2012, that would yield 61%, but the Fed was not
printing $.5 trillion a year in 1985!** In either case, taxes today
are quite a bit higher than they were in 1985. Certainly not less, as The
New York Times piece asserts.
Passing the Buck
Inflation is taxation without legislation.
--Milton
Friedman
The differences between all these numbers and our perceptions
are the result of our political and monetary systems. Politicians at all
levels of government and The Federal Reserve are able to hide huge chunks of
our True Tax burden from us. All we see is the $.30 in explicit taxes,
while the remaining $.40 is buried and/or deferred on others. Are
voters stupid?
No, but they are human. The main reason voters do
not realize they are being taxed $.70 of every dollar of Total Income is that a
huge chunk is in the form of stealth, or indirect taxes, which are buried in
everyday prices. All the taxes and fees paid by businesses, like
payroll taxes, income taxes, property taxes, use taxes, and fees, are built
into everyday prices. Take a simple MacDonald’s hamburger: Before
that hamburger gets to you, the farmer who grows the corn, the rancher who
raises the beef, the farmers who grow the wheat, tomato, lettuce, cucumbers,
and eggs, the trucking company, the oil companies, the restaurant owner, the
advertising company, and many more, all pay taxes for their payrolls, income,
land, fuel, and supplies. Those taxes are passed on to you when you
buy that hamburger, but you have no way of measuring their cost!
Then there are the deferred taxes. The difference between
what governments spend and what they collect in taxes must be acquired either
by creating/printing or borrowing money. Creating new money devalues
the currency (all other things being equal) and will eventually cause
inflation. Excessive inflation is politically dangerous and therefore
avoided, except as a last resort. Borrowing is simply deferred
taxation, or deferred money creation. Of the two, it is much easier
to get away with. Both borrowing and creating money have a deferred
negative impact, but an instantaneous positive one. Voters are
simply acting like imperfect humans and choosing instant gratification while
deferring pain. Unfortunately, they are also taking benefits for
themselves in exchange for passing the costs onto future generations.
Conclusions and Recommendations
The two big confusions we confront as taxpayers are 1) The level
of stealth taxes at all levels of government, and 2) The ability of the federal
government to create money and borrow, and then spend it on benefits to buy our
votes.
1) Stealth taxes are surprisingly the biggest item in the gap
between perceptions and reality when it comes to taxes. Voters should
insist on the elimination of these hidden taxes. Every tax should be
leveled at a voter. Businesses do not vote. We must go back to the
idea of “no taxation without representation”. This is a loophole in our
political system and has led to a huge economic disconnect. A
hidden tax is a license for politicians to do what comes naturally: buy
votes. All taxes, to use Milton Friedman’s word, should be made
“explicit”.
2) The Federal Government, due to its role as issuer of the
currency, must not be the entity providing safety net and entitlement
items. There is an inherent conflict of interest when politicians control
the creation and borrowing of money and can lavish benefits on their
constituents. State and local governments cannot print and borrow as the
feds can. Therefore, they must be the ones handling safety net and
benefit items. If states want to increase benefits, they will have
to raise revenue. If they want to cut taxes, they will have to cut
spending. States must take-over Medicare, Medicaid, Obamacare,
Social Security, etc. Voters must insist on this. Moreover, the
constitution clearly intended these things to be done by the people and the
states, not the federal government.
The revolution we desperately need in the US is to get the
states and local governments to handle all entitlements and benefits, and get
voters to explicitly pay the True Tax. If we did just those two things,
we would quickly have a smaller, more efficient, less costly, and more
responsive government at all levels. That's logical, right?
*Spending figures are from usgovernmentspending.com, and GDP figures are from BEA . Various
pages were used on all sites. 2012 numbers are estimates. All
numbers were rounded.
**Inflation figures are from BLS.gov and numbers were
rounded.
***Breakdown figures come from usgovernmentspending.com where
each revenue line item was subjectively allocated to either direct taxes or
indirect taxes. Numbers were rounded.
(This piece has had two major updates since it originally
appeared. It was updated 1/21 to
correct inaccuracies in the 1985 numbers, and to use Adjusted Gross Income for
Total Income. Second, it was
updated 1/22 to use GDP less Total Government Spending for Total Income. The difficulty is in finding the best
number for Total Income as this is what Friedman intended. The government reports many numbers for
Income but all have issues. GDP
less Total Gov. appears to be the best number for these purposes because it is
free of arbitrary deductions and all government transfers. For comparison purposes, AGI is about
$9 trillion for 2012, and using GDP less Total Gov., total income is $9.6
trillion. The language has
been updated as well for clarity.
Overall, no conclusions have changed with these updates. )
