The Fed -- Too Little Too Late

What happens when you bring too little too late?  For example, you arrive at the party with only a thimble full of JD. Everyone else has peaked and there you are sober as a judge and all the really cool girls are taken. You might as well retire to the library. You could try to “catch-up” quickly but you know how that will end up. That is the way it is with too little too late. All the good options are gone.

So why do people do this kind of behavior? For one thing, maybe we are clueless. Some of us don’t see a problem or opportunity coming until it runs right into us. Garsh honey, after being married for 28 years I didn’t know you had blue eyes. Anyway, a second reason for coming with too little too late is that you are just basically conservative. You NEVER strike first or fast. You prefer to see how things play out. 

Finally there are those people who assess each problem independently. Sometimes you address the issue quickly – like when your daughter brought home that guy with the really loud motorcycle. Other times you believe a more patient approach is best.

So too little too late can occur for many different reasons. I am thinking about this after Ben Bernanke was quoted last week as saying that while he noticed that his low interest rate policy is creating financial bubbles, he doesn’t see any reason to change his policy. 

His speeches make one pretty sure that important people like Federal Reserve Chairmen are studying problems judiciously and coming to very good decisions. But it is worth wondering out loud whether he is either clueless or inflicted by a habit that ALWAYS waits too long to make the right decision.

A recent report quoted in the press was very critical about Fed Policy in 2007 – faced with a slowdown in the economy, the Fed seemed to be the last one to know that a recession was taking place and needed a boost. Of course just before that the Fed was faced with about-to-explode bubbles in real estate and financial markets and closed it eyes to anything they might do about all this. Inasmuch the Fed went from a policy to stimulate the economy quickly to one that slowed it and then back to a policy to stimulate the economy. Wow – now that is frying pan to the fire kind of stuff. The Fed seemed to be the last one to know that a change in policy was needed.

Of course none of this is new. As inflation built during the 1960s and then early 1970s it seemed to take forever for the Fed to react. By the early 1970s the Fed had to jerk the economy around – so much that they finally had to give up for fear of creating an economic crisis. They admitted failure to control inflation when after being the backbone of the Gold Exchange Standard for almost 30 years, the USA unilaterally backed out of that system. Then Nixon, realizing the Fed could not solve the economic problem talked privately to his own portrait several times and decided to implement Wage and Price Controls. Of course that didn’t work. The main effect of W&P Controls was that a 50 cent candy bar was soon a lot smaller and still cost 50 cents. Apparently the W&P Controls didn’t differentiate between price and price per ounce. Lovers of Baby Ruth bars went into the streets and rioted.

We weren’t finished with inflation – it kept escalating throughout the 1970s – until the Fed finally got serious – after doing too little too late they followed that with too much too late in 1980. Remember the stories of 20% interest rates? Those are not fun stories. It pretty much wrecked us for a while.

This history shows why the Fed ought to be on top of their policies. If Bernanke is seeing bubbles forming then he would do us all a huge favor by taking out a really big and sharp needle and popping those suckers. Do it right now. Why doesn’t he do that? I don’t think he is clueless. I don’t think he needs to study this problem. I think he has a wait and see syndrome. But how much more evidence does he need? Hey mom – I see bear droppings on the front porch. I am scared. Don’t worry honey – there are no bears around here. The Ranger told me so.

Bernanke does not want to upset the applecart. The right policy now is to admit that it is time to end the low interest rate policy. But Bernanke isn't when the bubbles will burst. He doesn't want to do anything to anger investors or bankers right now. We can deal with the aftermath of the bubbles if they ever pop on their own. The Democratic Party is saying the same thing about debt relief. Paul Krugman said we can take care of exploding debt in 2030. The government can be counted on to do too little about bubbles because of politics. 

That is understandable. But the Fed is legally independent of the President and Congress. The Fed does NOT have to support expansionary policy. The Fed is supposedly run by apolitical technocrats. Or did the last financial crisis change that? Has the Fed become a lackey to politicians bent on endless stimulus? I hope not. Too little too late will bring another round of too much too late. And of course another recession. 

Timeout For Lucy

The Debt Ceiling is Scarier Than the Fiscal Cliff was Alan Blinder’s latest contribution to macro policy (WSJ page A17, January 15, 2013). I guess he never read Snoopy and witnessed how Lucy routinely pulled the ball away as Charlie Brown tried to kick it. Now he wants to scare Charlie enough so that he takes one more kick at a vanishing ball. The Republicans have apparently agreed to pass a debt ceiling increase but Lucy is still at work and needs to go to time-out for a while.

Blinder spends the whole article explaining all the horrible things that might happen if the debt limit is not lifted. I admit it is pretty scary stuff although I think he doth exaggerate. We all know the debt limit will be lifted – it is just a question of how long it takes to reach a compromise. Our government is clever enough to juggle the spending for a month or two without really throwing old folks over the cliff. I love the way Blinder and other Democrats keep bringing up how Social Security and Military pay checks might be delayed because recalcitrant, hard-hearted, mean, selfish Republicans won’t lift the ceiling. The President could arrange that kind of evil spending priority but it would be only for political purposes – he and Congress have many other options for spending changes that would be less onerous on a temporary basis.

Blinder mentions how world investors and ratings agencies will downgrade and flee US assets because of a failure to reset the debt ceiling another trillion dollars or more to cover the planned deficit this year. He worries the US would be technically bankrupt. Of course, nothing could be more false. The US has plenty of money and an unshakeable obligation to pay interest to its creditors…more spooky scare tactics by Blinder and his friends. He knows but won’t admit that those creditors could care less about the debt ceiling – what they care about is getting paid back. What matters for creditors is the size of future deficits and growth of the debt. The extra trillion we need now is just a down payment on future increases in the debt that arise because government will not agree on a program to manage the debt. A credible medium- or long-term fiscal program is all that matters. That is what the ratings agencies want to see. That is what the creditors want. Raising the debt ceiling is like me promising to fit into my wedding suit by asking for one more slice of pie.

What is silly is that these scare tactics are so obviously political and so wrong that most people completely write them off as puffery. We all know that the Democrats want one more chance to pull the ball away from Charlie. The Democrats wanted a tax increase on the rich and they got one – as well as a sizeable increase on everyone on a payroll. Now they want more tax increases on the rich. What happened to all that talk in the last year about a comprehensive tax reform and spending restraint? What happened to entitlement reform? “No Charlie – I promise not to pull the football away this time. Take a big whack at the ball.”

The unfortunate message from the Democrats is that they are proving they cannot be trusted to enact anything that comes close to deficit/debt moderation. Higher taxes on the rich won’t do anything beyond nibbling around the edges of the budget pie. Ignoring a broad tax reform and arguing loudly against entitlement reform sends an even stronger signal to ratings agencies and creditors that we are not serious about controlling our debt.

I was once critical of both parties but when I read Blinder’s scare tactics it made me want to point the finger of blame in one direction. Democrats and their mouth pieces must stop holding our country hostage to their unflinching goals of income redistribution and unfettered spending growth. They have to stop these stupid scare tactics and sit down with Charlie Brown and do the hard business of putting our country on a stable financial path. 

Age of Aquarius is over – Put some clothes on

Comments I received after my last blog confirm what I have been sensing since the last US presidential election – people are losing interest in analysis. It is not possible to summarize all the facets of this loss but a common thread is that we are in an age or a cycle that appears to be strengthening – and that stage or cycle is one that seems to be on auto-pilot. 

Thus attempts to argue or reason against it are virtually useless. That some Democrats stress that winning the election gives them the right to move on with their agenda of change just reinforces these feelings of inevitability. 

This posting is meant to address this seeming loss of hope amongst those who do not agree with the policies of the Democrats. I am a little more optimistic than some of these worried folks and I believe my optimism is supported by history. But I have to admit, it is not easy as a macroeconomist to watch the current experiment. It reminds me of looking back at the early 1970s and the Nixon Wage and Price Controls. 

Everyone knew they would fail – the only question was when they would end and how much damage they would cause. Instituted in August 1971 they were finally abandoned in 1974 as prices continued their escalation through 1980. Nixon, a conservative economist was mystified by the newly coined macroeconomic disease – Stagflation – and he lost faith in traditional macro and opted to try something new and different. (By the way I coined the term Infession at the time but apparently my status as a graduate student did not allow my terminology to rival the more popular term stagflation.)

Today our government is tormented again by a new disease – this time it is a housing and financial crisis that led to a deep recession of six quarters followed by a very slow and weak recovery period. Our policy makers responded with a strong dose of traditional Keynesian stimulus – a coordinated fiscal and monetary expansion that injected trillions of dollars into the economy. At the onset of the recession in 2008 it seemed reasonable to support a housing/financial intermediation with a strong Keynesian spending impulse.  But we are now many years beyond the beginning and the end of the last recession and the Keynesians are not ready to throw in the towel. The reluctance to ditch continued stimulus seems shared in many important places including Japan, Switzerland, Great Britain and others.  The European Central Bank joins our Federal Reserve in a pledge to do what is necessary to keep spending growing.  Both have acknowledged risking higher debt and inflation for the sake of short-term economic stimulus.

It may be surprising to many of you that some monetarists support the use of a Keynesian stimulus in the short-run.  Some monetarists accept much of the Keynesian model as it relates to the short-run. But monetarists and other non-Keynesians distinguish themselves when they disagree with Keynes’ statement that we are all “dead in the long-run.” This was Keynes’ way of saying that all that matters is the here and now. Non-Keynesians, however, think we need to worry more about the future. Many non-Keynesians might agree to the stimulus in 2008 and 2009 yet object strongly to continuing such a policy beyond the worst of the recession.

And that is where we find ourselves in 2013. Keynesians believe that austerity or a policy to even gradually remove stimulus today would be tantamount to pulling the proverbial rug out from under the economy.  They don’t even want to talk about it. It is like global warming. If a person challenges conclusions from weather data they are branded immediately as either ignorant or falsely motivated. And those are the nice names. Someone who worries today about future debt or inflation is not considered to be serious. In this environment it is no wonder that people don’t want to analyze or argue.

So let me turn away from the specifics of the debate and explain why history makes me somewhat optimistic. I think we are rapidly nearing the end of an age of government growth. You will scoff at this prediction because you see no end to government growth but it is often just when things look like they will never change that they do. I am not predicting that the government will vanish but I do see signs that the share of government in the economy will stabilize and decrease.

Who could imagine the Soviet Union falling when it did? At one time it seemed impossible that the German advances before World War II could be stopped. Before coal was discovered European wood was rapidly being depleted with the usual consequences on energy and transportation costs. At one time all the South American countries were run by dictators who promised a future with a closed, self-reliant economy. Much of Africa was once run by European colonials and much of the population was in slavery. The Age of Aquarius as depicted in the musical Hair promised a change in values that had its day but petered out...or else we'd all be wearing tie-died clothing.  History suggests that times do change. Sometimes when they seem the blackest is when they are closest to change.

And that makes sense. Because when times seem the worst is when it becomes more and more difficult to tell the same old untruths. The story of the emperor who wore no clothes was written for an important reason. People will go along with things so as to not disturb the leaders. In that story it was child who said the obvious – noting that the emperor was as naked as a blue jay. And then EVERYONE agreed to that reality. Clearly the emperor needed some new duds.

In the case of government growth and current macro policy it won’t take that much longer to see the failures. We have had about 75 years of this age and while I have no desire to go back to the 1930s it is clear that the government process needs a lot of oversight and improvement. The gem of the government process – Social Security – is nothing like what was promised.  Young adults worry that this protection will not exist for them when they retire. The cost of Medicare and Medicaid grew by multiples of original cost estimates. The War on Poverty has done almost nothing to eliminate poverty and some might say that it has institutionalized it. Obamacare is just getting started and one can predict that it will not fulfill some of its most important promises as the economy tries to digest its thousands of pages of new regulations. An article I read this week projects private healthcare policies doubling in price as early as 2014. They will likely be called traitors by our current government. 

Already there is visible proof that neither the government nor the central bank knows how to reverse what were supposed to be temporary stimulus programs. The end of the temporary decrease in payroll taxes in 2013 is causing the US economy to slow even further this year. The politicians promise to reverse engines at just the right moment but we all know that the date is coming closer and closer when we will have violent reactions to rising inflation, interest rates, and national debt.

I probably left out a lot of the writing on the wall – but the more important part of this story is that the average voter is going to soon feel the negative impacts of the end of the Age of Government Growth. We know the rich cannot and will not support the present and future growth. No amount of make-up applied to smiling political faces will be able to mask the impacts on the middle class. Their incomes will be taxed away and inflation will eat at their earnings. The next government financial crisis will make it impossible for young people to save anything for the future as their 401Ks shrink in value. Young workers will feel hemmed in without future prospects. Government programs will be less affordable and the world will no longer lend money to the US government. Government programs will have to be seriously scrutinized. People will be heard saying – why didn’t we see this coming? Why did we let this go so far? We have had major government deficits ever since the 1960s! 

The average person will come to understand through personal experience that while it sounds good for government to help them – it often is not their best alternative. Somehow the government kept this deception going for nearly a century.

So let’s keep arguing. Let’s keep making the case for unintended consequences. Let’s be specific about why stimulus is not always the answer. Let’s keep reminding people why piling up national debt is self-defeating.  Let's keep explaining how and why more conservative policies, though not perfect, are often better than knee-jerk government solutions. The Age of Aquarius is over. So is the age of rapid government growth! Somebody please put some clothes on Nancy Pelosi!

Macro Confusion

I doubt I have ever seen a time when there was so much confusion about macro and policy. I recall being a teaching assistant for Professor Benavie at UNC in 1973 when a student streaked naked through his macro class of 300 freshmen. That was pretty confusing. Benavie was quite a pro. As I recall he made an offhand gesture about the color of the guy’s ski mask and went on talking about GDP.

I wish things were that easy right now. I hardly know where to begin so perhaps a tiny sip of JD will get me headed in the right direction. Okay. The main confusion comes, I think, because macroeconomic policy has several goals. One goal is long-run oriented – to keep the capacity of production and employment growing. A second goal is short-run oriented – to keep current output very close to or at capacity. A third goal is to use policy in such a way that you are able to pay for whatever macro policies you employ.

As you know, the federal government’s macroeconomic policy following the recession in 2008 was to stimulate demand and production. Recessionary conditions meant people were not spending enough. The government created massive fiscal deficits as a means to replace or offset the missing private spending.  Tax cuts and government spending increases were used towards that end. A very expansionary monetary policy was used by the Fed to supplement the government’s attempt to bring weak demand and output back to capacity.

By 2012 the economy was beyond the end of the recession but recovering very slowly. In such times we would normally begin to reduce the amount of short-run policy stimulation. Furthermore after several years of very large government deficits, most politicians agreed that our financial stability and our economic recovery were threatened by rapidly growing federal government debt.  As such politicians set out to find a policy that would address this debt problem. One only has to look at recent history in Europe to know how damaging a debt problem can be to a country. Of course, one can look at Europe and also see how politics can come into play when one has to be specific about the tax increases and spending reductions that would compose such a policy.

Despite wide agreement about the urgency of a deficit reduction plan, no progress was made. So US politicians made a contract with the devil. They agreed on a very extreme austerity program that would automatically raise taxes and reduce spending harshly. It was one way to solve the looming debt problem, albeit an extreme one.

But such austerity clashed with the short-run goal of strengthening the economy. Why? Because such an extreme and fast solution for the debt would knock the wind out of the economy. The plan, of course, gave politicians most of 2012 to come up with a more reasonable way to solve the debt crisis. Please underline something there – the idea was to give them more time to come up with a way to resolve the debt problem.

And here is where the confusion comes in. The government did do something toward the end of 2012 and the first few days of 2013. It was heralded as an historic compromise. It did manage to avert at least partially the phony fiscal cliff they had created. But please note – the purpose of the fiscal cliff and the policies debated all year were aimed at reducing national debt. So what was this great historic agreement? It was an agreement to increase the US national debt by another $1.5 trillion between now and 2017. The debt was already going to increase by $1.7 trillion in those five years – so with the new legislation passed it will instead increase by $3.2 trillion. Already financial experts are predicting a downgrade of US debt. We had more than a year to deal with an explosive debt issue and our government dealt with it by making it larger.

So why would our government behave in this way? I have some possible answers but maybe you do too. So don’t be bashful.

First, these policies to balance the budget appear to be at odds with an economy that has never truly burst out of the last recession. Some people fear that external factors might impact us later this year and push us back into a recession.  I share that concern. But making the debt problem worse right now is no way to strengthen our economy. 

We did not have to accept the drastic tax and spending changes of the fiscal cliff to improve tax revenues and expenditures over the coming five years. We could have gradually implemented a government spending slowdown and an increase in taxes.

Second, they promised to work on the fiscal deficit between January and March of this year. Really! They couldn’t do anything in years about the deficit and we are to believe they are going to do it in two months?  

Third, since the agreed solution was almost totally focused on increasing taxes there was a belief that the coming solution – and one that might address the national debt – would be focused on slowing government spending. But already some politicians say they want more balance with respect to taxes and spending.  The fear is that this is simply code for raising taxes on the wealthy. There are still many politicians who say we cannot remove a penny from Social Security, Medicare or Medicaid. In all, it is hard to see how we will reduce the nation’s debt. 

The most probable path is one where we continue to have macro confusion. It is a path that talks about debt but ignores it in favor of short-term stimulation. It is a path where income redistribution is paramount as we focus on policies to raise taxes on the rich while leaving sacrosanct spending for everyone else.  The sad thing is that this path will do little to prevent a second recession; will do very little to help the middle class; and will do a lot to keep debt high and economic growth low. This is no way to run a country. 

Dumb, Dumber and Space Aliens

Unbeknownst to us, a space ship parked in the outer atmosphere one year ago and promised to destroy Earth on January 1, 2013. It was widely agreed that we could protect ourselves from this menace by launching a two-stage rocket with a nuclear weapon with a large cherry on its nose. Dr. Dumb suggested that the first stage rocket be red. Dr. Dumber wanted the first stage rocket to be blue. In no way would Dumb agree to have the first stage be blue. Dumber explained a red first stage would be unacceptable as well.

Knowing they had the luxury of a year to come up with a solution they did write on a stone tablet that if they were unable to come to an agreement by Dec 31, 2012 then an automatic solution would be implemented in which the red leadership would have to spend a whole evening fox trotting with Nancy Pelosi. The blue leadership would spend the night playing chess with Rush Limbaugh. Enough said. A solution would be coming. No one would want to expose the nation to these possibilities.

Dr Seuss, a well -known compromiser, explained that a purple rocket  might work but that was unacceptable to both sides. So during 2012 the Dumbs and the Dumbers argued. The Dumbs passed a bill in the Dumb House that would shoot a red rocket half way. They reasoned that while it would not kill the aliens, the beauty of the red rocket going halfway would make people more cheerful, especially people in Indiana, Georgia, China, and Nebraska and other places that love red. The Dumber House was not going to fall for that stupidity and spent the year legislating a new requirement that all overweight people would have to spend 90 minutes a day with a hula hoop.

On New Year’s Eve 2012 the Dumbers finally did pass legislation. It advanced a proposal to have the first stage of the rocket be blue but allowed for the possibility that the tip of the propeller could have a small red dot. That was fair and the Dumbs should have no trouble with that. They promised by swearing an oath on Ho Chi Minh’s grave that the next time we have a space invasion they will advocate a first stage rocket totally painted red. And they gave the Dumbs three minutes before the stroke of midnight to decide. The Dumbs were dumbstruck and called in Oprah for help. They decided to call the Dumbers a lot of really bad names. The Dumbers responding by saying nah nah nah nah  and your mother wears combat boots. Both sides did agree at the last minute to send Jello shots into space in such a way that it spelled out a message to the aliens -- “please give us two more months to work on this.”

When the clock was about to strike 12 Cinderella arrived on the scene and kissed the frog and everything was made better. No that’s not right. At midnight the aliens came to earth and announced that they had changed their plans. Planet Earth was obviously too stupid to destroy – and they planned to televise our daily activities on an intergalactic cable network reality TV show called Democracy at Work.

So have a Happy New Year.

Texting, Marginals, and Tax Rates on the Rich

When I was in the fourth grade my teacher said I was marginal. Being confused I immediately took out my ipad and went to Wikipedia. No not really – at that time the wheel had not been invented yet and fire was a new concept. But we did have a huge paper weight in our house that was called a Dickshunary so I asked my mom to help me research marginal. At that time little did I know how much would be riding on something called marginal tax rates. This post explores the importance of marginal tax rates and concludes that little good can come from increasing marginal tax rates on the rich. Raising average tax rates for the rich might be better in economic terms. Unfortunately politics seems to matter more than economics these days.

MY exploration in the dictionary didn’t help much . One definition said that marginal is something found only at the outer limits and therefore is not of central importance. Another definition referred to something on the edge. A third applied the term to apparently less important words written in the margins of a page. Since I had not yet taken on the habit of JD I had little to relieve my marginal headache. I felt even worse when I found the following example of the use of the word marginal – “having reviewed the test, there are two students below the required standard and three more who were marginal.” I wondered who those other students were.  The confusion is that while marginal often refers to things that are not very important – when you have been branded "marginal" like these students – that seems pretty important. It might mean the difference between moving on to the next grade or staying another year with the same mean, ugly, and hateful fourth grade teacher at Coconut Grove Elementary School.

When I took my first economics course at Georgia Tech, Professor Schaffer told me that marginal was critical to understanding decisions. Marginal helps to concentrate the most important factors when making a decision. So let’s suppose we are trying to decide whether or not to walk down the street while texting. On the one hand, there are benefits from this course of action. I can walk down the sidewalk and Tweet to all my friends about how wonderful I feel walking down the street. Let’s call that the marginal benefit of the decision. On the other hand, there are also new costs associated with this decisions. It is quite possible that while I am texting I might walk into a tree or a parked Vespa. Then I would have to go to the hospital. 

Hospitals are costly. Let’s call that the marginal cost of the decision.  I can’t speak for you but let’s say I believe the MB is greater than the MC. Then I make the decision to go ahead and text while walking. Of course if the MC is greater to you than the MB, then you decide not to text while walking. Advanced math explanation:

·         MB > MC then do the action

·         MB< MC then do not do the action

·         MC is an important concept despite the marginal stuff written about it in the dictionary

Last week my post was critical of plans to increase marginal tax rates on the rich. After 396 pages of detailed and insightful analysis, I left out a couple of things. I mentioned that an increase in the marginal tax rate for the upper 2% might not be good for the economy. I suggested it could lead to another recession in the USA as soon as 2013. But I didn’t explain why. So let me carry on that argument.  

Let’s suppose on some planet that resembles Earth that the marginal tax rate for incomes above $200,000 per year was 100%. Let’s call that planet Obiden. The marginal tax rate for incomes equal to or less than $200,000 on Obiden is 35%.  Jim lives on Obiden and runs a manufacturing company that makes Obiden T-shirts. Jim loves to surf on the Han River in his spare time and also enjoys spending time with his family playing checkers and Mass Effect 2.

Jim’s business is doing well and he is thinking of hiring more people and adding a new manufacturing location in a right-to-work state named Michi on Obiden. Michi looks a lot like the outline of my left foot. Anyway, Jim has a crack accountant named Kilt who explains over a couple of Heffe Weitzens that if his income goes above $200,000 he will not get a penny of the increase. With the 100% marginal tax rate on incomes above $200,000 any income he earned above $200,000 would all go to the government for good deeds.  Jim would pay 35% of $200,000 (=$70,000) as his tax. If he made, for example $250,000, he would pay the $70,000 in tax plus another $50,000.Thus his average tax rate would increase to 48%. In this example the government raises revenue, it raises the average tax rate, and it does it by increasing the marginal tax rate.

My liberal friends who are still awake would scream – Larry – no one is proposing a marginal tax rate of 100%. Then they would call me a lot of names and hang up on me. But extremes are often used to make legitimate points. For example, Democrats often depict rich people as selfish and beyond any real empathy for the poor. That extreme view of rich people makes it easier for them to want to punish rich people and confiscate their income and wealth.

But the general point is made. When it comes to the decision to expand Jim’s factory and hire more people on Obiden, it is the marginal tax rate that matters the most.  The definition of marginal is what Prof. Schaffer taught us smelly freshmen – the marginal tax rate is critical for making decisions since it applies to MORE or NEW incomes – not to all our income. When we raise the rate of taxation on wage income, on dividends, or on capital gains on the highest or last income earned – we are directly impacting decisions that involve change.  Changing average tax rates has no such extreme effect.

We don’t know what the critical marginal tax rate is for the USA. Maybe the current rates are already too high for economic expansion. Maybe they are too low. Maybe 39% is too high. No one knows for sure. But you are definitely flirting with danger when you raise these rates at a time when most people are predicting a slowdown in the US economy in the coming months.

When we say rich people we have some idea that these super rich individuals (with incomes over $200,000????) can easily and gleefully absorb the marginal tax increase. And maybe some would or could. But this defies Prof. Schaffer’s lessons. Marginal tax rates impact decisions. Raising MC relative to MB is never a good thing for output and employment. Think of the kinds of decisions that might be made as those with incomes above $200,000 react to the new and higher marginal tax rates:

·         Cut or do not expand output and employment

·         Delay output and employment to a future time when marginal rates might be lowered

·         Work less and take more leisure

·         Move output and employment to another location in Mexico or Canada

·         Consume less as you prefer to not sell stocks or bonds so as to postpone capital gains

·         Consume less as you move from dividend stocks to non-dividend stocks deferring gain to the future

·         Sell your worst stocks at a loss – the benefit of capital losses against taxes is now higher. This reduces your wealth and your desire to spend

These are a few behaviors to note but certainly there are more. The general idea is that raising marginal tax rates reduces the incentives to work, to produce, and to invest. Use the comment section on the blog to tell me what I missed. How else do increases in marginal tax rates cause negative effects?

The main idea should not be lost in the details – raising marginal tax rates create perverse incentives for economic growth. It is possible to raise revenues in such a way that these perverse impacts are minimized. If part of the political solution to current deficit/debt challenges is raising tax revenues on the wealthiest Americans, then more thought should be given as to how to do this. Capping deductions and similar schemes can impact the rich more than others and might have smaller undesirable impacts on economic growth. It goes without saying, however,  the more we restrain unbridled government spending the less has to be done in the way of tax revenues. But that’s another topic and you have shopping to do. So let’s carry this on later.

Uncle Vinny, Uncle Sam, and the proverbial rock/hard place

When people with responsibility and power make stupid public statements on film the press usually goes wild sort of like a swarm of bees after you just bumped into their nest.  Remember when Dan Quayle misspelled potato and when candidate Romney said something about the lower 47%. But when a prominent US Senator, Tammy Baldwin, explained in front of rolling cameras why Social Security could not be part of the coming budget negotiations because it was separate and fully funded until 2037, no one said a peep. The press looked like Marcel Marcaeu as Bip the Clown.

So pardon old Lar if he takes a big swig of JD and takes his chance to spout off a bit. Remember when our leading intellectual Al Gore mentioned the nation’s lock box a few years back? It is the same kind of disinformation. Is it stupidity or a clear attempt to mislead the public? Guys – there is a lock box. But unlike a real lock box that keeps the family treasures and a few naughty photos of grandma when she was 16, the USA lock box is full of a bunch of IOUs from the Federal government. Let’s suppose the Davidson family has a lock box with an IOU for a million dollars from Cousin Vinny. Vinny is in prison serving 90-100 years for financial fraud. Cousin Vinny owes a lot of people a lot of money.  What is that IOU worth to the Davidsons? Right! Zero, Nada, Zilch, Yung.  

It is the same thing with the US lock box. But in this case Uncle Vinny has been replaced with Uncle Sam. For years and years the Social Security system received more in revenues from tax payers than it paid out to prune-eating elderly. Did  Social Security invest those surplus dollar in GE stocks? In a portfolio of stocks? In anything that might come close to looking like an investment? Of course not.  Every year since I can remember SS lent the money to Uncle Vinny – er I mean Uncle Sam. Why? Because the US government has gone more than a half century spending more than it earned in the non-SS part of the government budget. That part of the budget is called "on-budget." That terminology makes no intuitive sense because all government spending, including SS, is included in the budget. 

For example, in 2012 the so-called on-budget part of the US budget had a deficit of approximately $1.4 trillion dollars. In that year the Off-Budget (mostly SS) had a surplus of $67 billion. So in 2012 SS loaned approximately $67 billion to the US government for its on-budget deficit. In return the SS system got another IOU to add to approximately a half a century of similar IOU’s. Those IOUs were stacking up like hotcakes at Denny’s on Sunday morning. Now please tell me what the probability is of the US government paying SS back so it will be solvent through 2037? Can you say zero?

As the surplus in SS soon diminishes – it is expected to be down to $22 billion by 2017, the government will begin paying from the on-budget part of the budget money to cover the deficits in social security.  This is like Uncle Sam getting a loan from Greece.   Since the on-budget will be in deficit too – that just means that we borrow more money from the public.

So when anyone tells you that SS is solvent and does not need to be part of the government fiscal cliff deliberations, please grab your wallet and whatever other valuables you might have with you and run for the hills. These people are either ignorant or the evil man Mini-Me. Either way, get out of town fast.

I feel better now. But I still have another page to ruin so why stop now when we are having so much fun? Let’s talk next about the President’s insistence that marginal tax rates be increased for the millionaires or those in the top 2 percent of the income distribution. First, the overwhelming majority of those in the top 2% are not millionaires – so quit saying that. It is just plain wrong and totally misleading. STOP IT. Aim I yelling?

Second, the top 2% account for approximately (I had to extrapolate from the top 1% and top 5% data) 18% of all income earned in the USA and pay 47% of all income taxes. Okay – so these folks make about a fifth of the income and pay almost HALF of the taxes. So quit saying that don’t pay their fair share. This is bullcrap. Just say they should pay more. If you think they should pay more – just say it that way. Don’t disparage the people who pay for nearly half of all income taxes collected? Don’t bite the hand that feeds you. Just explain why you want them to pay more. Is that so much to ask?

Finally, if some folks are willing to sock it to the upper 2% then why won’t you come off your high horse and work with them? To most of us the difference between a marginal tax rate and an average tax break is the like the difference between nuclear fusion and nuclear fission.  Most of us don’t have a clue about the difference without a quick trip to Wikipedia. To a nuclear physicist about to build a bomb, the difference is pretty critical. To an economist about to promote a policy to strengthen economic growth the difference between marginal and average tax breaks is also very important. So let’s work on this a minute.

One party says they want the rich to pay more. So let’s suppose we agree that the rich paying even more than 50% of all taxes is okay.  Let’s assume the other party says they are ready to sock it to the upper 2% by increasing the average tax rate paid by rich people. The rich will pay more dollars AND the rich will pay more dollars as a percent of their incomes. You would think the first party would be elated. But NOOOOO, that  party sticks up its nose and calls the other party a bunch of stupid poopie-heads.

Why isn’t that party willing to accept an increase in average income tax rates paid by the upper 2%? Why is the ONLY WAY they want to impact the rich through raising the marginal tax rates or brackets of the upper 2%? There is no economic answer. You can sock it to the rich equally with average or marginal approaches yet the President and some in his party insist that it has to be one way and not the other.  I heard Charles Krauthammer the other night explain on television while visibly gritting his teeth the reason for his focus on marginal rates is that President Obama wants to cripple the Republican Party. He thinks by sticking with the very intuitive marginal tax bracket approach that he fulfills his election mandate and sticks up for the average American by raising marginal rates.

I don’t know if Krauthammer is right or wrong. But I do think the President is being disingenuous – and that is a hard word to type if you don’t actually know how to type according to the correct method. On one hand Obama says it is all about math – that you cannot raise enough money from the rich by changing their deductions and thus raising their average tax rates. But that is highly debatable. Furthermore he recently did a complete flip-flop and now says that changing deductions will hurt charities too much. He said exactly the opposite a few years ago. Aside from the flip flop this signals the real reason he doesn’t want to go in the average tax rate direction – he has finally admitted that tax loop holes exist for a purpose. Each loophole was legislated for an important purpose. If you close loopholes then someone gets hurt. He says one day that the tax code and the entitlement system must be restructured. But he is not being honest. Every so-called restructuring will hurt one group or another. Obama does not want to get into all that. It is much easier and politically more fun to go after the rich and rich only via marginal tax rates.

But of course it is a big lie. If he raises his $1.6 trillion mostly from the rich do you really believe that won’t create another economic tailspin? Do you really believe that the 2013 recession will be short and modest? Do you really believe this won’t affect the average person greatly? No way Jose. One way or another – the US has to fix a half-century mess of living like Uncle Vinnie. This is the proverbial rock and a hard place. There are no easy solutions. To me we are better off starting down the path in the right direction with average tax rates. Marginal tax rates on the rich is a path to nowhere. 

Wealth, Income, and Keynesian Boobs

As I write the politicians of both parties are again throwing spears at one another with respect to a cliff.  Rather than complicate that mess further, I thought it might be a nice change of pace to focus on the difference between two economic concepts – income and wealth. Most of us would be happier if the economy grew faster. Faster growth would make solving the financial crisis a little easier. Our Keynesian predilection is to seek policies that aim at income and economic growth. Most of the stimulus policies focus on income. That’s the way we think because many of us were nursed on Keynesian boobs. Apparently we still aren’t weaned. A look at wealth might be more nourishing. 

Income is an intuitive concept. My Dad said that if I would do my chores I would get an allowance. The allowance was my income and while paltry it was worth a lot more than what he got out of me in the way of washing his car and drying the nightly dinner dishes. As an assistant professor at the Kelley School of Business in 1976 I earned a handsome sum of $15,000 in return for a year of confusing students and doing research that led to me to this glorious blog. We all know that we have to pay income taxes on what we earn and what is left to either spend or save is what we call disposable income. Let’s write that in big letters – DISPOSABLE INCOME. I write it in all caps to see if you are still awake. Also because it is the key to Keynesian economics. 

If the economy is weak, then Keynesian fiscal policy aims its bazookas at something that would increase disposable income. The government could give you a tax cut. Or perhaps the government could build a nice new and shiny bridge and pay construction company workers for the work – thereby increasing their take-home pay. A Keynesian monetary policy pours hot money into the financial system with the intent of lowering interest rates – causing homes, autos, and other interest-sensitive goods to be purchased and  produced – enriching with income those who produce all that stuff. So whether it is fiscal or monetary in nature, Keynesians are all about raising spending and disposable income.

That leads us to the four-letter word of the day – Wealth. Okay it is actually 4 letters with a “th” added to the end. Who am I Euclid? 4 letters 6 letters who cares? What matters is that wealth has become an ugly word. It has become an ugly word because most of the wealth – like much of the income -- is owned by a very small group of really rich people who live in castles and eat snails and sit in vaults and count their money over and over. Some even have their own television shows.

But what is wealth and why does it matter? It matters because there is more to economic growth than Keynesian preoccupations with income. Wealth is basically what must of us try to accumulate by earning income. My Dad gave me my allowance each week and said – Son, do not spend all your money and someday you will be a wealthy man. I laughed as I bought enough gum (and the enclosed free baseball cards) to make my dentist a wealthy man. Yes, as a young man I didn’t save a penny and my baseball collection didn’t amount to a hill of beans.

Saving is defined as the part or residual from your disposable income that you don’t spend. That’s easy. While it is true that much of the nation’s savings belongs to the wealthier people – most of us save or at least say we are going to save.  For example, much of our saving is done to provide for times when we no longer work – for bouts of unemployment and for our retirements. The saving that we and/or our employers do for our retirement is called a pension. 

As of 2011 the Federal Reserve estimated that Americans had about $13 trillion in pension reserve funds. We also save through our houses. We often think of the mortgage payments we make each month but the other side of the equation is that our homes are worth something.  The FRB estimates in 2011 U.S. households having homes worth a little more than $18 trillion. Of course we also hold our wealth in many other forms including bank deposits of about $8.6 trillion, equities or stocks worth about $9 trillion and various credit market instruments of almost $4 trillion. In total, the FRB estimates our total assets or wealth to equal about $73.6 trillion. Wealth data comes from the Federal Reserve Board Flow of Funds Accounts published in September 2012:  http://www.federalreserve.gov/releases/z1/Current/annuals/a2005-2011.pdf

Are you feeling rich? Want to buy a used hot tub? Don’t get too crazy. While we own all these assets we also incur a lot of loans or liabilities. If you borrow $1,000 to buy a cool new Fender electric guitar, your wealth has not really increased. You own a guitar but you also owe $1,000. When you pay off your loan in 47 years and your guitar is worth $35 dollars then you have some real wealth. When you subtract the liabilities from the assets, we get something called NET WEALTH. It is in caps because that is the important concept comparable to disposable income and because my Caps Lock key sticks sometimes.

Like disposable income, NET WEALTH gives you spending power. When all of our homes seemed to be worth a ton of money in 2006 because housing prices were making homes more valuable, we felt very wealthy and so we went out and bought groovy  pipes, sweaters with patches on the elbows, and we hired drivers for our all electric cars. NET WEALTH can have powerful impacts on the economy – just like disposable income.

That brings us back to now. US Net Wealth peaked at $66 trillion in 2007 and then subsequently fell to $53.5 trillion in 2008. That’s a decrease of almost $13 trillion or 19%. We felt a lot poorer! Even if a decrease in Net Wealth of $100 decreased spending by only $1, then this impact alone would have decreased GDP by more than $100 billion dollars in 2008. For that you can buy a lot of stinky fish and bindaetteok in Seoul. Much of that decline came from real estate and equities but pension funds and other asset values tumbled. When you see all your wealth vanishing you don’t run out and buy the most expensive Galaxy Note II.

So Net Wealth contributed to the recession we had in the USA in 2009 and 2010. As Einstein said, what goes down must come up. Or something like that. But the point is that Net Worth recovered and by 2011 it was estimated to have increased to about $60 trillion. Net Wealth recovered about half the value it lost after 2007 and was a positive force in the economic recovery. But we all know the recovery has been weaker than usual and we remain concerned that we are stuck at lackluster economic growth rates and high unemployment to boot.

Keynesians want to kick start disposable income. Since 2008 they have been stoking the fires of demand and disposable income and today Keynesians are pushing programs to keep government spending growing strongly and to pay for these increases by impaling rich people, or in modern terminology raising taxes on the rich. Vlad the Impaler would have been proud.  These programs have not been working and yet they keep asking for more taxes to support them.

An alternative approach is to think about New Wealth. If Net Wealth had already increased to its earlier value of $66 trillion it would have had a much bigger impact on the economy. Why didn’t Net Wealth return to its former value? To answer that we need to know a little more about the current market or the replacement value of wealth. Let’s suppose Aunt Lucy gave you some things when she passed in 1990. You received a house worth about $40,000, some stocks valued at about $2,000, and some long-term bonds worth $8,000. Is all that stuff worth a total of $50,000 today? Probably not – inflation has pushed the value of that house to about $120,000. Lower interest rates boosted bond prices so your bonds are now worth about $6000, and the growth in the overall stock market means that your stocks might be worth $24,000. 

Your wealth in this illustration increased to about $150,000 – an increase of $100,000. The point is that many factors can and do affect the prices of the assets we own.

So let’s use this understanding of net wealth in the context of recent policy to see why Net Wealth has not risen more in today’s policy environment.

·        

Explosions of monetary policy contributed to an environment of lower interest rates and that has helped to stimulate housing and autos. But what if the increase in money also contributed to an increase in expectations about future inflation? Bonds and stocks do not do well in an inflationary environment so this contributed to lower expected future Net Worth. 

·         Furthermore, with interest rates so low and the economy recovering that means interest rates will likely rise – and will likely increase a lot. That will not be good for valuations of bond wealth. 

·         Policies that intend to hurt the rich by raising taxes on dividends and capital gains clearly are not good for stock market wealth.

·         A thicket of new regulations on companies specializing in housing, finance, nonrenewable energy, and health are not the best ways to increase the values of the stocks of those companies.

·         Finally, lackadaisical approaches to government deficit and debt moderation a la Europe clearly portend bad things for both bond and stock markets.

Keynesians and other macroeconomic policy liberals ignore the value of national Net Wealth to their peril. It seems fair to them to pay for more government spending for the middle class by taxing the rich. It seems like business as usual to keep middle class taxes low to stimulate disposable income to create growth.  An unrelenting force to redistribute income from the rich to the poor may well accomplish what they want in the short-term but the reality is that this will be bad for National Wealth and for the economy. As in other attempts to do such things, if these folks with their apparent mandates accomplish their policy goals – we as a nation might find fleeting equality but at a much lower level of wealth and income! It is like the guy with one bad foot who prayed that one day both his feet would again be equal. He got his wish and now both of his feet are bad!

The Government Spending Scam

Last week I wrote about the fiscal gap and implications for tax revenues and income tax rates. This week I focus on federal government spending and the fiscal gap. I call the spending discussion a scam because much of the wording describing the course of future spending is all about cuts. And while there are some cuts and the overall message suggests smaller deficits in the future, the truth is that spending will increase at very strong rates and it does not appear that much is being accomplished with respect to the fiscal gap on the spending side. Thus either debt or tax revenues will have to cover the spending.  The data show also that by taking some of the bigger spending programs out of the discussion we purposely and unnecessarily jeopardize the great majority of government services and therefore put even more stress on taxes and debt.

This is not an easy project to do right now. I get my data for federal government spending from the White House web site. It comes from what the President calls the 2013 budget. Fiscal year 2013 started about two months ago on October 1, 2012. The problem is that the budget projection numbers for 2013 and beyond are being estimated based on so-called spending caps legislated in something called the Budget Control Act. I could have used another version of spending produced with a different set of assumptions published by the Congressional Budget Office but that just adds more speculation about what budget changes will be made in the next month or two or longer.

So I am sticking with what is published on the White House site because it is the only official budget right now.  (http://www.whitehouse.gov/omb/budget ) This budget version exaggerates how much spending restraint there will be – assuming that some of the caps will be removed in new legislation. So if spending looks like it is growing in the White House budget – then it will probably grow even more under a new compromise bill. So let’s at least see what is in store for us at the moment.

To create some basis of comparison let’s start by identifying what might be normal changes in federal government spending. From 1992 to 1997 spending increased by $220 billion. In five years the level of spending increased from $1.38 trillion in 1992 to a level of $1.6 trillion in 1997. In the next five years, 1997 to 2002, the level of spending rose by $400 billion. The increase in five years was about double the five years before. From 2002 to 2007 spending increased by $720 billion. So let’s stop there. You can see a progression of government spending increases over five years periods – expanding by $220 billion, then $400 billion, then $720 billion. I am not sure what you would call normal. Focusing on increases you can see a rapidly rising curve of federal spending.

One would expect a significant yet temporary increase in government spending during the recession and slow economic recovery that followed. And we got it. From 2007 to 2012 federal government spending increased by a little more than $1 trillion. Federal spending went from $2.73 trillion in 2007 to $3.8 trillion in 2012. So the change curve was  not dented and simply continued. The President’s budget –- with spending caps in place – has government spending rising from $3.8 trillion in 2012 to $4.53 billion in 2017. That amounts to another five year increase of $730 billion. How do we interpret that increase?

First, does it look like gut crunching austerity? I don’t think so. The government will be spending more and more and more – as we approach 2017.

Second, how do we evaluate the size of the projected future $736 billion increase? Well it is really big. It is bigger than the increase in the 10 years from 1992 to 2002. It is also bigger than the very rapid period from 2002 to 2007 when spending rose by $720 billion.

Point taken – the government is spending at about as high a rate as it ever has – and by "ever has" we mean more and more and more. I could present all this spending information in real terms or as a percent of GDP and it would show slightly different relative outcomes – but the general point would be the same. There is no austerity. Government spending is not decreasing. Government spending did not take a breather after the recession. What was supposed to be temporary government spending to stimulate a recessionary economy is now permanent.

But the issue is more interesting because we haven’t talked about specific components of spending. Luckily the White House website provides lots of details of spending by year and by program. What we see is very interesting especially in light of Harry Reid’s threat that he will never touch one cent of Social Security, Medicare, and Medicaid.

Recall that total federal spending is projected to increase by $730 trillion between 2012 and 2017. Here are the main* spending categories that account for the increases:

Interest on the debt                                        $340 billion

Social Security                                                 254

Healthcare Services                                          251

Medicare                                                         157

Income Security for Veterans                             29

Federal Employment Retirement/Security            24

Other Income Security                                        24

Higher Education                                                19

Ground Transportation                                       16

     Non-Interest Sub-Total                          $774 billion

Total                                                      $1,114 billion

If we count interest on the national debt the government is planning to spend $1.1 trillion over the next five years on these nine categories. That is, in 2017 we will be spending on an annual basis more than $1 trillion than we did in 2012 in these areas.

Notice that if we focus on the Big Three programs – Social Security, Healthcare Services, and Medicare this accounts for $662 of the planned spending increases. When Harry Reid says he is not going to touch these categories of spending he is basically saying there is no way to control federal government spending. Since he can’t eliminate interest on the debt without a national default, any politician who says he can control government spending and not include all spending categories is involved in a scam. What he really means when he says this is that he either wants higher taxes or higher debt.

One final point. The government does plan to cut quite a few programs. The largest cuts will go to Defense ($126 billion), Commerce and Housing Credit ($114 billion), ), Unemployment Compensation ($56 billion), and Elementary, Secondary and Vocational Education ($46 billion). Quite a few others will be cut by smaller amounts.  Some of those cuts are not real policy changes but are the automatic result of an improving economy.  Others are debatable. A lot of programs will see true cuts so that the Big Three programs can enjoy large increases.

I am not advocating that we cut any particular program but I do see a real scam in operation here. By purposely letting the Big Three programs grow we take a blunt ax to the rest of government AND we raise taxes and probably the debt. It seems to me that putting everything on the table is the only way to make progress on our fiscal gap. We can control government spending but we cannot do it by playing politics as usual. 

*There were other categories that had increased spending but I did not include in this table any increases that were less than $10 billion. 

Taxes 2013

Our government is debating what to do about future tax revenues. This is a big issue because there is a gaping hole or gap between what the government plans to spend and the money it will have to make those expenditures. When I was a teenager is was pretty cool to have a small hole in my Levis. But when the hole got big enough I had to buy a new pair of jeans. As you probably know if you live on the planet Earth the US government is spending more than a trillion dollars each year MORE than what they bring in. When governments have such gaps they have to go into debt. This means that each year they have to sell government bonds to the public of a trillion dollars or more. Selling bonds is usually pretty easy but at some point the public begins to wonder if the government will have the resources to pay the interest each year and then the principal balance when the bonds mature. We see this playing our daily with respect to the bonds of Greece, Ireland, Italy and several other places. The result is not pretty. Bloody street demonstrations are just one visible sign of how painful it becomes when people begin to worry that governments are in financial trouble.

In short, the US government is very preoccupied with reducing this fiscal gap. Both parties want to see this gap managed better. The fiscal cliff is just one aspect of this gap. A year ago policymakers said the fiscal gap was so worrisome that they agreed to enact a poison pill of sorts to put pressure on themselves to enact legislation to reduce the gap. This poison pill was an agreement to put in a very tough short-run solution to the gap – one that raised taxes and lowered both military and non-military spending. Most of us thought – wow – these legislators are really serious. Of course they won’t want to take such an awful pill. Of course, they will legislate something before the end of 2012. They had a whole year to get the job done. But alas, they didn’t. They talked and they accused and they argued and they spat and they even had an election. Yet still no agreement.

So as I write it is November 20 – two days before we Americans gorge ourselves with turkey and JD to celebrate Thanksgiving. We read and hear the news that Senator Reid will not even think about some solutions. Boehner has drawn the line or at least obfuscated the line with respect to other solutions. But one thing remains clear – to solve the problem of the fiscal gap means that two lines have to meet somewhere down the road. The gap will close only when the spending line meets the tax revenue line. This means that spending must grow more slowly in the future and it means that tax revenues must grow faster.

At least for the purpose of this blog – as the title indicates – I want to focus on tax revenues. So I am not going to get into spending this time. As I see it the problem with tax revenues has many dimensions but one really important one is definitional. Many people do not know what the term means.  It is a little like sport fans who want to talk about football. If it is a talk between two Hoosiers we probably are referring to American football and probably a game between lackluster teams like Indiana University and Purdue. Two Europeans would instead be talking about a game we Americans refer to as soccer. If an Aussie and a Kiwi are involved in a football discussion it would be a totally different game. So if we are sitting in the 3 Alley Pub in Itaewon – a place where a lot of foreigners congregate in Seoul – and someone says football – it could take a long time before the group can figure out what they are really going to talk about.

The same thing goes with taxes. In the same discussion you might hear all these terms bandied about – taxes, revenues, average tax rates, marginal tax rates, tax base, percent of income, value added, and more. If people are not familiar with the differences and distinctions of these terms, then it is hard to have a good conversation. So perhaps it is worthwhile to work on this language issue.

My above discussion of the gap concluded that tax revenues will have to not only grow but probably grow more quickly. Much of the tax discussion focuses on income tax. Income tax revenue equals the tax rate a person pays times the income they earn. So if Charles makes $100,000 this year and finds himself in the 28% tax bracket, he then pays $28,000 in income taxes, right? WRONG. Wrong for several reasons.

First, Charles may receive $100,000 this year from his wages, interest, and so on – but Charles has deductions. Whether or not he files a Schedule A, Charles will have some deductions so the income that is actually taxed will be lower than $100,000. Charles gave a lot of money last year to the Georgia Tech Foundation for the Advancement of Beer. Some might call this a tax loophole but Charles loves beer and the foundation appreciates the gift. Anyway, let’s say that his deductions come to $30,000. This means that Charles pays tax only on $70,000. A taxable income of $70,000 puts Charles in the 25% bracket so he will pay $17,500 in taxes. Right?  WRONG.

Charles might be in the 25%  bracket – or what we call the marginal tax rate – but the total amount of income taxes he pays depends on all the other marginal tax rates for incomes below $70,000. To break it down he pays:

  $870 = 10% on income up to $8700
            Plus

  $3,390 = 15% on the income above $8700 up to $35,300

Plus

  $8,675 = 25% on the income above $35,300 up to the $70,000

           

= $12,935

If Charles pays $12,935 on a taxable income of $70,000 then his AVERAGE TAX RATE is 18.5%. Charles has a marginal tax rate of 25% and an average tax rate of 18.5%

Arrgghhh. Don’t you just love math! But without knowing the difference between income, taxable income, marginal tax rates, and average tax rates – you do not really understand the current debates.

For example, the goal is to raise tax revenue. Tax revenue is defined as taxable income times the average tax rate. This definition is not debatable. A bourbon whiskey has a definition. It is not debatable. What you do to increase your intake of bourbon is an interesting question. What we do to raise tax revenues is also an interesting question.

So the formula says you can raise tax revenue in only two ways – raise the average tax rate or raise the taxable income. That’s it. Those are the only two ways to increase income tax revenues. But here is where the fun begins.

How can you raise the average tax rate? How can you raise taxable income?

The government can increase the national average tax rate by legislating an increase in the marginal tax rate of any or all of the income tax brackets. Presently in the USA the marginal rates for individuals or couples are 10%, 15%, 25%, 28%, 33%, and 35%. By increasing the marginal rate for any of the income categories the average rate paid by the country will increase. Of course if you only raise the rate for the richest people paying 35% -- only the richest will pay a higher marginal and average tax rate. Everyone below will pay the same marginal and average rates as before. So you can see the political issue. You want to increase the nation’s average tax rate. But the question is whose ox gets gored? You can gore everyone or you can gore those only with higher incomes. Either way you can raise the average national tax rate.

You can raise taxable income in several ways. One way is through policies that increase economic growth that raises earned incomes. A second way is by what some people call widening the tax base. Widening the tax base means either having more people pay tax or by having fewer loopholes or deductions from earned income. We know many very poor people in US do not pay income taxes. Some of them could be added by reducing the earned income tax credit. A more popular remedy is to reduce deductions of people with higher incomes. We have more deductions in the US tax code than Apple has i-phones. Popular deductions are for mortgage interest paid on a primary residence. Charitable giving is another one. 

EVERY TAX LOOP-HOLE is in place for what someone at some time thought was a really good reason. I got a tax break one year because I bought a new furnace. This benefit was given to me because it was more fuel efficient that the old one, I was helping the country’s battle against air pollution. One year I got a tax deduction because I drank more than 100 bottles of JD. I forget why I got that deduction and I am sure that is not why the IRS has been calling me repeatedly lately.

So here is the political issue. Whether it is the average tax rate or the taxable income, there is much to debate with respect to who bears the burden of the new policy to remove the fiscal gap and how the new policy affects the country at large. Any policy that raises marginal tax rates often hits the wealthier people the most, but has ramifications for US economic growth. Any increase in marginal and average tax rates will impact consumer spending, national saving, business profitability, investment, innovation, stock market, and exchange rate. Any policy that increases the tax base will have impacts on charitable organizations, housing construction, and so on.

The fiscal gap has got to go. Tax revenue has to increase. Average tax rates, some marginal tax rates and/or loopholes have to be changed. Some groups will pay more than others. The nation’s economic growth and ability to increase income will be impacted negatively for a time. Democrats were born on Venus. Republicans came from Mars. We need a solution. Hopefully this little primer on tax revenues helps you to better understand the difficulties.