Wednesday, April 24, 2013

Why we do Redistribution all Wrong

Redistribution goes back a long time.  The first undocumented case of redistribution was back in caveman times when a particularly disciplined and skilled hunter, let's call him Grok, managed to kill more food than he and his family could immediately consume.  In stepped the tribal leaders who, realizing that others in the tribe were hungry and somewhat envious, confiscated the bulk of Grok’s food and redistributed it to the others.  Of course, in a tradition that would be forever etched in stone, the tribal leaders took a huge chunk for themselves.  Redistribution, in one form or another, has gone on unabated ever since. 

Naturally, in the wake of this redistribution, Grok decided to spend less time hunting and more time on his hobby, which was etching pictures on cave walls.  His family was soon as hungry as the rest of the tribe, and as history has shown, such is the fate of an artist’s family. 

When tribal leaders redistributed Grok’s food, they were doing more than just redistributing his wealth.  They were redistributing his power, responsibility, and rights too. Grok’s power to provide for his family's future was taken from him as was his right to his own work.  Meanwhile, the responsibility to feed others was redistributed to Grok.  Anything can be redistributed, and is in modern societies.  Life, Liberty, and the Pursuit of Happiness included.  Redistribution can be any coerced transfer of wealth, power, or rights from individuals or groups, for the explicit purpose of benefiting other individuals or groups.

Neither Karl Marx, Vlad Lenin, Mao Zedong, or even Barack Obama are innovators in redistribution.  They just took it to relatively new levels in their societies.  Every society, from the most democratic to the most autocratic, does some kind of redistribution.  No politician, particularly in a democracy, can afford to oppose redistribution in its entirety, even though many are philosophically opposed to coercing one person to give to another.  Blame it on the collective will.  Universally, the people allow and desire some redistribution to satisfy needs and envy within the society.

Yet, redistribution is our nemesis too.  It is the opiate of the people.  Free stuff paid for by others.  Rights granted by denying others theirs.  Costs passed to the unborn.  It has led to deficits unprecedented in human history.  It has ruined societies right in our lifetime.  It kills incentive.  It was the primary cause of our recent financial collapse, which was precipitated by a giant redistribution scheme that gave easy money to marginal homebuyers.  And yet, neither party has satisfactorily figured out exactly where to draw the line.   Both parties played roles, albeit to varying degrees, in the recent crisis.  Amidst this confusion, the default position of the voters has been:  redistribute more, and redistribute it to me!

In the US, the two political parties are not far enough apart on redistribution.   It is safe to say that one party advocates progressively more redistribution than we have at any given time, while one party advocates less.  But, that puts them both firmly in the redistribution camp, only with varying degrees.  This results in an arbitrary and nebulous difference between the parties.  Hence, the claim by some that there’s not a “dimes worth of difference.”  As one party just found out, this can result in voter apathy.  History has proven it also leads to runaway deficits regardless of which party resides at 1600 Pennsylvania Avenue.

What I propose is a policy that will create a bold distinction for politicians, win elections for them, and insure that redistribution is done responsibly, all the while acknowledging the undeniable human instinct to redistribute.  This can be done by opposing all redistribution at the federal level, and at the same time recognizing that redistribution is essential at the state level.  This is not a contradiction.  In fact, the Founders showed us how.  The problem is not redistribution per se.  The problem is only federal redistribution.  State and local governments must be free to redistribute as they please. 

But states are not able to print money, and thus market signals will ensure redistribution is done with discipline.  This is essentially what the constitution prescribes.  By articulating this distinction, responsible politicians can both side with voters, who want redistribution, and be 180 degrees opposed to the irresponsible redistributors who want to continue doing it the unsustainable way we have been doing it.

I believe separating redistribution from the federal sphere is the system we were given in 1789.  For one, the constitution limits the power of the federal government to a few things and redistribution is not one of them.  For two, one of the things the constitution does grant to the federal government is the power to create, borrow, and manage money.  Redistribution combined with the power to control money is a formula for disaster.  This sets up a massive conflict of interest for politicians who can use redistribution to endlessly buy votes with borrowed and printed money.

Politicians who run nationally and vow to redistribute less are seen as party-poopers who want to remove the punch bowl.  The austerity approach has been, and will continue to be, a losing one.  Nor has it been an effective one at stopping the problem.  Fiscal conservatives (few though they are) have only been able to slow the acceleration of the fiscal train wreck, but the train has continued to accelerate.  I don’t see voters voluntarily removing the punch bowl either. They like the punch.  It makes them feel good.   They are not going to stop drinking because they have been shielded from the hangover.

I have heard the argument that the constitution twice mentions the term “general welfare” and thus the founders wanted the federal government to be the provider of “welfare”, or redistribution.  This is a canard.  Both mentions of “general welfare” in the constitution refer to the federal government, not to “the people”.  Thus the phrase is not about redistribution, but rather about having roofs over government buildings, paying government workers salaries, arming soldiers, providing adequate courthouses, and the like.  It is about running the government properly and seeing to its general welfare.  General welfare was never intended to mean satisfying the needs of individuals in society.

The constitution however, does enumerate the powers of printing, borrowing, and managing money to the federal government.  As the world’s current lone superpower and issuer of the world’s main reserve currency, we are in a unique position to print and borrow money at little or no present cost.  But that’s just how it appears in the present.  As Milton Friedman was fond of saying, “There is no such thing as a free lunch”.  Someday, the real cost of borrowing $20 trillion and printing trillions more will rear its ugly head. 

What have we done with all those trillions?  We used it to redistribute wealth from future individuals to present ones, with the express purpose of obtaining votes in the present.  This is the “fatal deceit”, to paraphrase a term, of our deadly mixture of federal redistribution and federal borrowing and money printing.  We must separate these functions and eliminate the conflict of interest if we hope to have a sustainable future.

No, we did not spend 20 trillion dollars on “unfunded wars”.  No war in history was ever fought without being financed.  In other words, no wars are “funded” with current receipts.  Our debt and printing issues are the demographic result of the above conflict of interest.   Politicians can only boost revenues temporarily to keep up with our runaway redistribution.  But revenues always fall back to the average of 18% of GDP while the redistribution climbs ever upward.  Even in the 90s, when many people claim the budget was balanced, unfunded liabilities were never included and it was in the 90s when the seeds were sown for the recent financial crisis.  The high revenues in the 90s were short-lived and based on bubbles in technology, housing, and lowering of the capital gains rate.    

Why is it that the party of less redistribution is more successful at the state level (they currently hold 30 out of 50 governorships and 27 legislatures to the other party’s 17), yet they have struggled at the national level?   I would argue the key difference is the seemingly unlimited ability of the federal government to print and borrow money and thus obscure the true costs of its redistribution.  States must function in the real world of finance where choices have consequences and redistribution must be paid for.

One argument would be, “Well, what about California, Illinois, and New York, etc.?  States aren’t so good when it comes to managing their own finances!  Why should we have them run all the redistribution programs too?”  To that I would say, yes some states are a mess, but others are in good shape.  It’s about 33% bad and 67% good for states.  The federal government is a 100% mess!  The states are way better overall, and the ones in trouble are about to have to reckon with their spending because they are bleeding population, businesses, high earners, and cash.  The market is giving them signals, signals that do not exist at the federal level. 

One reason a third of the states are a mess is that they currently have a limited stake in managing their own redistribution.  That’s because, although states manage many of their own redistribution programs, one third of the money comes from the federal government.  The incentive for state politicians is to be as generous as possible, kiss up to the federal government, and tap federal taxpayers somewhere else to pay for their largesse.  But there are limits, which is why a majority of states get it right.  Every state has some form of balanced budget law except tiny Vermont, which is small enough to have a bake sale to make-up any shortfall!

Look at the European example:  The Euro has only been in existence for 12 years, yet thanks to the inability of the PIIGS (Portugal, Italy, Ireland, Greece, Spain) and Cyprus to revert to the printing press, market signals have exposed their bad habits.  Discipline is sweeping the Euro zone, not without some pain, but the result should be a sustainable future.  We in the US currently have no such market signals warning us of our trajectory. 

Again, I’m only talking about eliminating federal redistribution.  Politicians at the national level should not oppose redistribution at the state or local level.  They should be consistent with the constitution and the constitution leaves this up to the states and the people.  Societies want a safety net.  That much is axiomatic.  Voters want a certain amount of welfare, food stamps, subsidized healthcare, free contraception, subsidized mortgages, etc.  Politicians at the national level must defer to the states and support the will of the people.   States and individuals must decide the proper level of welfare and redistribution they desire.  But this can be done much better by the states, with correct feedback signals, than it can at the federal level without them.  State taxpayers will have to make the hard choices and decide the proper level of the safety net they are willing to fund.  No magic money involved.  They also will be in a better position to eliminate fraud and abuse.  (Did you know that the states administer Medicaid, but the money comes from the federal government?  Neither party has an interest in stopping Medicaid fraud: the state because it costs them nothing, and the Feds because it’s not theirs to administer!)

Of course, taking this stand will require transitional details.  How do we turn Social Security, Medicare, ObamaCare, and Medicaid, over to the states?  In fact, any federally coerced transfer from individuals for the explicit purpose of benefiting other individuals would have to be turned over to the states along with the revenue stream which funds it. Federal taxes and spending would go way down, while state taxes and spending would go up by a commensurate amount.

We would also need to address the backdoor redistribution schemes.  This is the type that got us into the financial crisis in 2008.  The federal government mandated that banks lend money to anyone, regardless of ability to make payments.  My Labradoodle could have gotten a mortgage.  Then the feds bought up many of the bad mortgages through government-sponsored creations like Fannie Mae and Freddie Mac (FNMA & FHMLC).  No one's taxes went up.  No wealth was redistributed initially. It was all done through the backdoor in the form of a "redistribution of risk".  All of the explicit redistribution, as well as this backdoor type must go to the states.  

The actual details of the transition are beyond the scope of this proposal.  I’m proposing this as a policy stance for politicians and voters who agree that:  a) Our current debt path is unsustainable. b) Austerity is not a politically viable solution. c) The root cause of our unsustainable path is a conflict of interest. d) The conflict is the result of redistribution combined with our ability to print and borrow money with little or no present cost. e) Voters and most politicians have little incentive to fix this because it benefits them. f) There is, however, a passionate group of politicians and voters who want to fix this. g) The above proposal is a viable strategy to fix it.  Those that agree and know the system best can work out the details.

By standing against all federal redistribution, and simultaneously standing for the rights of states to redistribute as they choose, politicians can draw a clear ideological contrast with their opponents and still be aligned with voters. The only reason politicians will oppose this is because it will interfere with their ability to buy votes.  Smart politicians will smoke them out, and put us on a sustainable fiscal course.  

Tuesday, April 23, 2013

An Economic Lesson from the Boston Marathon Bombing

Looking at the events in Boston, between the bombing and the capture of the second suspect, an interesting economic analogy can be made and a lesson learned:  The free market triumphed where socialism would have failed.

In every case, the key intelligence that ID'd the suspects, led to them, and eventually got them, came not from elite crime experts at the top, but rather from average people functioning in a free market of observations and feedback.  Those that solved this crime were not endowed with special training or powers.  They had no advanced degrees in criminology.  They were simply closest to the action and in the largest possible numbers.  

To review:  A victim named Jeff Bauman woke-up minus two legs and the first thing he did was describe the bomber.  Armed with that information, the investigation proceeded to the video cameras of Lord & Taylor, where the described suspects were clearly visible.  Next the public was recruited to find them, and this paid off when a 7-11 clerk reported a robbery.  Finally, a boat owner stepped outside for a smoke, noticed something amiss with his boat, and climbed up a ladder to take a peek.  There he saw the semi-concious wounded bomber and alerted officials.

To draw an economic lesson from this, free market intelligence signals succeeded where a top-down socialist style intelligence model could not.  The point is, as in socialism where there are impediments to economic market signals, the FBI could not have succeeded if they had shut out the public from this manhunt.  In fact, the government was warned about these two terrorists by a foreign nation, and completely dropped the ball.

This is not to downplay the role of the FBI and local law enforcement in fighting crime.  The armed guys and the intelligence guys who pulled all the threads together were essential to the eventual resolution.  Just as in any functioning market economy, the government is essential to performing functions of law and order.

But under socialism, the government is not limited to roles of law and order.  They either own or control a majority of the economic activity too.  The socialists try to tweak their managed economy according to market signals, but they can never do so as efficiently, quickly, or accurately as a free market economy.  All those non-experts, close to the action, making second-to-second decisions will outperform the elite experts trying to do so every time.  That's what happened in Boston.


Monday, April 15, 2013

The True Tax Rate is 70%!

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” , 1980 (herein referred to as "Friedman's Paradox")
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.
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 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:
· Gross Domestic Product (GDP) was about $15.8 trillion*
· Total govt. spending at all levels was about $6.2 trillion
· Total Income was about $9.6 trillion. ($15.8t - $6.2t = Total Income)
· True Tax rate is about 65%. (6.2t / $9.6t = True Tax Rate)

(Traditionally, tax rates are expressed as a percent of GDP, but GDP can be artificially inflated by money printing and borrowing. Since Friedman referred to “income”, subtracting govt. spending from GDP, makes sense. Government does not generate income, only the private sector does. Moreover, Total Income closely tracks AGI (Adjusted Gross Income) reported on 1040s. AGI is the basis on which income taxes are calculated.)
So the True Tax rate was 65% in 2012, when expressed as a percent of Total Income. 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. We all pay roughly $.70 of every dollar we earn on taxes. You may think your lawyer, oil company, or banker just got a big tax hike, but their increased tax burden is passed right back to you in the form of higher fees. Their hike is your hike, and so it goes, ‘round and ‘round.

(Update: Having recently read some commentary and heard Robert Reich speak glowingly about the economics of the 1950's with its high wages, "high taxes", lots of unions, narrow income gap, etc., I thought I'd calculate the True Tax rate for 1950 and 1960. About those “high taxes”, eh, not so much...the rate in 1950 clocks in at 31.4% and 1960 at 40.3%. True Taxes today are double what they were in the 1950s. The 1950s are so beloved because Europe, Japan, the USSR, etc. were still smoldering from WWII, China was still in loincloths, and we had a brand new industrial infrastructure to unleash. The desire to return to the economics of the 1950s is a fantasy that could only be fulfilled by a third world war fought in Europe and China!)

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, business 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. ***

In 1985, the middle of that decade, we spent $1.5 trillion at all levels of government, reported GDP of $4.2 trillion, and had Total Income of $2.7 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, whether we use 56% or 61% , taxes today at 70% are quite a bit higher than they were in 1985. Certainly not less, as The New York Times piece asserts.

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? They’re probably just human. The main reason voters do not realize they are being taxed $.70 of every dollar of Total Income is that $.40 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 Big Mac 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, onions, 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.

The two big disconnects confronting taxpayers are 1) The level of stealth taxes at all levels of government, and 2) The ability of the federal government to create and borrow money, and then spend it on benefits to buy votes.

1) Stealth taxes are surprisingly the biggest item in the gap between perceptions and reality. Voters should insist on eliminating hidden taxes. Every tax should be leveled at a voter. None at businesses. After all, 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” to voters.
2) The Federal Government, due to its role as issuer of the currency, must not be the entity providing safety net and/or 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/or entitlement items. If states want to increase payments, they must raise revenue. If they want to cut taxes, they must cut spending. States therefore should take-over things like Medicare, Medicaid, Obamacare, Social Security, etc. Voters should insist on this. Moreover, the constitution clearly intended these things be done by the people and the states, not the federal government.
The way to align the needs of voters and politicians in the US is to get the states and local governments to handle all safety net and/or entitlements, and get voters to explicitly pay the True Tax. Of course, federal taxes would drop, federal business taxes would be eliminated, and a commensurate rise in state and local taxes would occur. But going forward, the whole system would be more responsive and visible to voters. If we did just those two things, we would quickly have a smaller, more efficient, less costly, and more responsive government at all levels.

And everyone including Prescott, Ohanian, Applebaum, and Gebeloff would know the True Tax rate.

This piece has been updated from the original which was titled "Taxing Logic" and was published on this site 1/14/13
*Spending figures are from, 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 and numbers were rounded.
***Breakdown figures come from where each revenue line item was subjectively allocated to either direct taxes or indirect taxes. Numbers were rounded.