Tax Policy @ OptimalPortfolio.net

Yesterday the U.S. Supreme Court upheld the Second Amendment right of individuals to keep and bear arms. Gun rights have been slowing eroding since the Bill of Rights was adopted in 1791, of late in San Francisco (2005), Chicago (1981), and Washington D.C. (1976).

Richard M. Daley, mayor of Chicago cries foul, saying they’ll need a bigger budget to fund a larger police force if the populace is armed. I don’t see the connection - the police are rarely on the scene at the moment a crime occurs, they normally show up afterwards to take notes and file a report. If ordinary citizens have guns to shoot robbers, rapists, and other violent criminals at the moment that the crime first takes place, they’ll either be doing themselves a favor by scaring off the perpetrator in the absence of the police (who can’t possibly be omnipresent), or possibly doing the police a favor if they shoot the perpetrator, because the police won’t have to find and arrest the perpetrator after the fact. However the scenario turns out, city mayors will need fewer police, not more. Perhaps the Honorable Mr. Daley is really interested in empire building and pandering to the left wing.

The scarier side of the gun ban in Chicago is that police went door to door in the public housing projects conducting warrantless searches to confiscate guns. San Francisco’s ban also requires that gun owners turn in their guns to comply with the ban. This is the darker side of gun registration. The moment that you tell the government where your assets are, whether they’re guns or a checking account, the possibility of confiscation looms just around the corner. We’re not talking about some rendition of due process where the government serves you papers requiring you cough up the asset or face a judge to explain yourself. They show up at your door, enter forcibly, and take whatever they want. In most cities, it’s a much more serious crime to shoot a police officer than an ordinary citizen. Why should that be? Because it indicates a disregard for authority that deserves more severe punishment? Or, is it possibly that it provides the police with additional leverage against the citizenry they’re ostensibly protecting.

If it weren’t for the musings of Serpico, an obvious madman, we’d have little evidence that police ever acted in anything but the noblest public interest. Any government that passes a law creating special punishments for altercations in which police get killed, maimed, libeled, slandered, or their feelings hurt, clearly has absolutely no understanding of equal protection. Discrimination and abuse of authority are rooted in such class distinctions.

I find myself considering the "Serve and Protect" stenciled on the side of police cars. After they have confiscated all of the weapons in the city except their own, who is going to protect us from the police? It’s the classic path to tyranny - register guns, ban guns, confiscate guns. Then the guys with the remaining guns can do whatever they want. Given that absolute power corrupts absolutely, tyranny is the inevitable outcome at the end of that chain of propaganda and political process.

So… three cheers for the Supreme Court’s recent decision to uphold gun rights. What still disturbs me is that it was only a five-four decision. Nearly half of the United States’ most elite constitutional lawyers don’t see the connection between an armed government of unarmed sheep and the opportunity for tyranny and slaughter. The framers didn’t write the Second Amendment to ensure that citizens would have the right to shoot vermin, defend themselves against bears and wolves, serve fresh venison, or even to defend themselves against pirates, cattle rustlers, and train robbers. The framers feared government. The second amendment was included to ensure that individuals could fight the British wherever they might land (analogous to the Swiss caching machine guns in their basements) and to minimize the potential for U.S. government to become the local embodiment of what they sought independence from in the first place.

Even myopically considering guns as a deterrent to crime, a 50kg woman without a gun is at a disadvantage facing a 100kg man with bad intentions. If she has a gun and he doesn’t, she can deter an impending assault or robbery. Even if they both have guns, the playing field is still closer to level than it was without guns. The only scenario that gun bans serve effectively is the one in which the law abiding victim is unarmed and her criminal assailant has a gun. Gun bans don’t prevent criminals from carrying guns, just law abiding folks. In fact, the mere potential that a victim might be carrying a gun can be a deterrent to an assault. So where is the ban beneficial?

Carrying a gun is heavily regulated, so bearing arms is already effectively lost to history. The danger is that we’re one vote away from a constitutional view that gun ownership is also historically passé. Given that it usually takes about five decades for the court to reconsider a past ruling, I suspect that any future decision striking at the heart of this Second Amendment right will be its death knell.

Further reading:

Bob Levy, the man behind the Supreme Court decision to strike down D.C.’s gun law

The Dirty Dozen: How Twelve Supreme Court Cases Radically Expanded Government and Eroded Freedom by Robert A. Levy and William Mellor

Botched Paramilitary Police Raids

John Dalberg-Acton, originator of the phrase "absolute power corrupts absolutely."

The Fourteenth Amendment was intended to provide broad protection from legislation that denied rights and privileges to segments of society. The particular case that led to its passage was legislation in various southern states denying African Americans the right to vote. It’s unfortunate that the drafters limited the scope of the Amendment to States. As things stand now, any strict constructionist would certainly throw out any attempt to extend the applicability of the Fourteenth Amendment to federal legislation, in effect creating a giant exemption in the equal protection clause for the federal government to slip through unimpeded.

No doubt, this limitation was not lost on anyone at the time - in politics it’s often necessary to draft compromises in order to generate some favorable effect, even if it doesn’t have universal applicability. This is exceedingly unfortunate - had the drafters been a little more visionary or perhaps had the political capital to pass the Amendment without the giant federal loophole, then one could certainly argue that tax treatments that put one class of society at an economic disadvantage to another, violate the equal protection clause in exactly the same way that land ownership as a prerequisite to voting rights denied emancipated slaves the right to vote.

Wouldn’t that be something … the Supreme Court overturning regulations regarding differential tax treatment of earned income and capital as a violation of Equal Protection. Perhaps that’s exactly what’s needed, an Amendment to the Fourteenth Amendment to remove the limitation that it only applies to States. Assuming that such an innocuous Amendment passed, revisiting the Sixteenth Amendment in the light of a broadened Equal Protection clause should have legal traction that even strict constructionists couldn’t ignore.

Now that’s a plan of action…

Taxpayers exert significant effort (about $140B in 2001) to ensure that they’re paying no more than the minimum necessary to comply with myriad federal tax regulations. The Internal Revenue Service also exerts significant effort ($11.1B in 2008) ensuring that taxpayers contribute no less than the minimum proscribed by law.

The efforts of both parties in this minimax exercise could be spent elsewhere. Taxpayers might convert their effort into starting a small business (thus invigorating the economy), putting sweat equity into their house (thus improving their net worth), or just spending a bit more time with friends and relatives in back yard barbeques (thus improving their quality of life). Corporations might gamble on a new product line (thus invigorating the economy) or increase their dividends (thus improving returns for their investors). The federal government might use a reduction in their compliance costs to reduce the federal budget deficit.

The Great Depression inspired people to rethink stock markets, macroeconomics, and the role of government. In particular, John Maynard Keynes was inspired to write The General Theory of Employment, Interest and Money (published in 1936), striking at the heart of neoclassical economics theories based on equilibrium seeking free markets. Keynes was concerned with achieving full employment, something he claimed was impossible within the context of free markets. So far, so good.

The bizarre twist is that Keynes thought that excessive savings would ultimately be the undoing of industrial economies. He presents a thorough analysis, which depends primarily upon inelasticity in savings and spending. One of the more unusual outcomes of his analysis was that fear of capital losses could drive nominal interest rates below zero.

Despite oddities like negative interest rates, Keynes’ ideas were rapidly adopted internationally, giving socialism respectable academic credentials. Governments then and now tinker with fundamental market forces (money supply, discount rates, stimulative spending, …) to regulate market dynamics. Money supply and discount rates are largely attributable to Milton Friedman’s monetarism. Stimulative, often deficit spending comes under the rubric of Keynesian economics. Perhaps the most compelling reason for the widespread adoption of Keynesian economics is that Keynes argued that balanced budgets exacerbated instability during periods like The Great Depression. Whether or not you believe his argument, he had nonetheless green lighted deficit spending and politicians couldn’t be happier.

Over seventy years after Keynes burst onto the international scene, despite substantial evidence that Keynes’ conclusions were flawed, governments continue the deficit spending politicians find so addictive.

The obvious conclusion is that politicians are astoundingly quick to adopt academic justifications that support their policy objectives (overwhelmingly pork barrel politics), but will just as conveniently turn a blind eye toward Himalayan evidence that dashes the academic underpinnings of their spending plans. Keynes’ demand management ideas have been in decline since Milton Friedman’s 1956 Quantity Theory of Money, and just about completely discredited since the Johnson administration when Friedman predicted lower inflation and a recession based on the Federal Reserve crimping money supply growth. The economy almost proved him right, delivering a no-growth period, though no recession. Keynesians largely ignored the Fed’s actions. Later when the U.S. government ran a surplus (1968-9) and the Fed had greatly expanded the money supply, Friedman predicted significant inflation, while Keynesians predicted higher unemployment and lower inflation. This time Friedman had nailed it and the Keynesians were off by a mile.

Forty years after the rise of Milton Friedman and monetarism, politicians still cling to Keynesian justified deficit spending and income tax as an obvious mechanism for defeating the ‘threat’ posed by excessive savings. Both facets of Keynesian thought are still in active use despite the availability of more efficient, liberal economic (free-market) alternatives. “Underlying most arguments against the free market is a lack of belief in freedom itself,” Milton Friedman.

Further reading:

The Fall of Keynes: Milton Friedman and the Monetarist Revolution

The Road from Serfdom: Forseeing the Fall

My general objection to tax loopholes is that they have the effect of reducing the tax burden on one class of citizens at the expense of others. Usually this means that the vocal or well organized minority opts out and the silent, poorly organized remainder carries the burden. The situation applies to subsidies as well as deductions and credits.

Naturally, the eventual result is increased complexity in the tax code and therefore increased compliance costs. However, a subtler effect is also at work - the opt out class is now silenced with respect to objections to that particular element of tax policy. By silencing objections from a minority, government is allowed to grow beyond the pain threshold of the population at large.

If one observes the high cost of government contracts relative to commonly available off the shelf prices (e.g. $160 hammers and $600 toilet seats), it should be obvious that government is not a value oriented consumer. Milton Friedman on government spending: “There are four ways in which you can spend money.

• You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money.
• Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost.
• Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch!
• Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.”

Conversion of capital into goods and services is optimized when income earners and consumers are one and the same. If taxpayers are to get the most bang for their aggregate buck, they should spend it themselves - a clear argument for a minimalist government.

Anyone that has an interest in limiting the growth of government might logically object to policies that allow tax rates to grow beyond the painful revolt threshold of taxpayers. Despite the obvious regressive impact, loopholes that effectively exclude classes of citizens from certain aspects of taxation should be limited because their adoption enables larger government and its associated inefficiencies.

If the number of citizens engaged in the tax policy debate is maximized, government will be forced to operate on a budget defined by the threshold of pain dictated by the poorest voters. Admittedly, this must sound absolutely awful from a socioeconomic perspective, but if one considers government as a living organism, striving to grow and dominate the economic landscape, it’s logical to conclude that such a constraint threshold might motivate it to improve the quality of life of the threshold class, thereby enabling its own growth. That should be the desired effect of government.

Further reading:

Seven Principles for Sound Public Policy

The usual argument in favor of taxing income rather than consumption is that consumption is more elastic than earnings. Although this is the predominant view (supported by studies like: Brookings Paper on Macroeconomics), there is evidence to the contrary.

In the Wikipedia article Wealth elasticity of demand, the author notes that consumption didn’t change substantially after the April 2000 stock market crash (where US$2.1T in investor wealth was wiped out).

On a smaller scale (and admittedly less statistically significant), the Tax Foundation article Delaware Hits the Tax Jackpot shows huge year to year variability in Delaware’s corporate income tax revenue from 1988 to 2007.

If incomes are variable from year to year and consumption is relatively inelastic even in the face of significant declines in wealth, can governments still reasonably justify income based tax policy by rationalizing that incomes are less elastic than consumption? I suspect the explanation is rooted in inertia - if you can find any evidence to support the status quo, why tinker with it?

Perhaps a more disturbing effect is that inflation pushes apparent wages higher while real wages remain static or actually decline. In The Labor Shortage Hoax, Alan Tonelson discusses outsourcing and the labor shortage myth. No less interesting, he drops the little known fact that real wages peaked in 1978 and have declined since then. His prediction is that wages, even high tech wages will continue their inexorable decline.

So incomes are far from inelastic, they’ve been declining for three decades and are expected to continue doing so for the foreseeable future as the Phillippines, Russia, and Vietnam get a taste of future U.S. outsourcing.

Further (slightly off-topic) reading…

Debunking the Myth of a Desperate Software Labor Shortage a 1998 position paper by Normal Matloff at U.C. Davis.

I encourage you to lobby legislators representing your district to consider, if not write/support a bill to replace all wealth taxes (income, capital gains, and inheritance) with a flat consumption tax on new goods and services. Consumption taxes reach the widest possible tax base (including tourists, illegal aliens, and gray/black market elements), thus lowering the average rate. They are also the most ‘voluntary’ form of taxation, allowing the taxpayer to scale their ability to pay according to their projected income and cost of living.

In contrast, income taxes inhibit new capital formation and disregard taxpayers’ vision of future economic conditions. Loopholes intended to offer relief to special interest groups distort the economy and have contributed substantially to the increase in housing costs in urban districts like New York, Chicago, Boston, Washington, Los Angeles, the Bay Area, … Reducing loopholes within an income centric tax system isn’t the answer because it still requires filing (which requires substantial taxpayer effort) and still inhibits individuals from adjusting their spending (and therefore taxation) according to their projected economic circumstances.

This following link provides instant access to phone numbers an email addresses for the U.S. Senators and the congressman (or woman) in your federal district: Contact your U.S. Congressman and Senators. Ask them to restore your financial privacy and give back the time you spend every year complying with myriad income tax regulations. Tell them you need the ability to apply your own vision of economic circumstances to your personal economic circumstances and that means your entire income, not just the portion that the government isn’t presently condemning for tax purposes.

Mention how consumption taxes spread the burden across the entire economy (tourists, illegal aliens, drug dealers, and other gray/black market elements), not just the working class folks pulling a regular (or not so regular) paycheck. Ask legislators to scrap all forms of wealth and income taxes because individuals are best qualified to efficiently exchange capital for goods and services. Tell them that consumption taxes foster increased savings, improved economic robustness (ability to weather economic depressions), and collection/compliance is more efficient.

You might even mention the success story represented by Anguilla’s pure consumption tax structure. The average wealth of citizens has greatly improved over the last thirty years as a result of their pure consumption tax policy (Anguilla has no income, capital gains, or inheritance taxes). [I owe you some hard numbers here. Maybe someone will be kind enough to post a reference.]

We often hear arguments in favor of reduced income tax rates on capital gains. The universally popular argument being that government recognizes the importance of capital as the lifeblood of the economy, if they were to tax capital too heavily (i.e. as heavily as they’re hammering labor), the economy would suffer.

There are several fallacies all bundled within the same argument. First, there is absolutely nothing to differentiate value associated with cash derived by selling labor from capital gains derived from selling goods at a profit. Fifty dollars in your hand from a few hours labor is worth exactly the same in the store as fifty dollars obtained by selling tools out of the trunk of your car, unless you can avoid taxes on one transaction and not the other.

Earned income is capital. Or it would be if the government hadn’t invented an arbitrary distinction to put the working classes at a disadvantage to those that derive their income from ‘passive’ sources like rent, royalties, interest, and dividends.

Visualize a tank of water with a pipe coming out of the bottom (where you draw water for drinking, cooking, etc.) and another pipe filling the tank at the top when the level gets low and you happen to have some water to refill it. Think of the pipe at the bottom as spending and the pipe at the top as income. While the water is in the tank, it’s capital. When you draw water from the tank to spend it, you convert capital into goods and services.

Most (I need to get some hard figures) OECD countries provide preferential treatment for capital, at the expense of current income. The net effect should be obvious - earned income (predominantly derived from working/middle class people) carries the tax burden while established capital stocks (wealthy people) are sheltered.  In reality, the individual’s ability to convert cash into goods and services depends not upon what is going into the tank, but what’s actually in the tank.

In fact, reduced tax rates for capital gains skews the situation further by providing a year to year multiplier (in the form of reduced capital gains taxes) favoring growth of existing capital over the creation of new capital, e.g. by allowing less (as a percentage) current income into the tank.  That’s not just favorable treatment of existing capital, it’s a mechanism deliberately designed to minimize the creation of new pools of capital.  It creates a situation where upward class transitions are more a lottery of extreme circumstances than the policy goal it would be if government served constituents without class prejudice.  Why should government have any preference whatsoever for old vs. new money?

Given that consumer spending is generally considered to be more elastic than income, a consumption tax policy will likely result in greater year-to-year variations in revenue.  An agency like the Office of Management and Budget could accept responsibility for diverting excess revenues from flourishing economic periods into a cash reserve which could subsequently be used to supplement tax revenue when the economy was running lean.

Consumption taxes reach a broader base than income taxes, including participants in black and grey market economies, illegal aliens, and tourists. A broader base means a lower consumption tax rate than the average outstanding income tax rate.

A consumption-based tax policy will reduce or eliminate filing, compliance assessments, and enforcement efforts. Taxpayers will have the option of pursuing the used goods loophole, though low and fixed income taxpayers will likely exercise that option most often. Taxpayers will recoup the time they now spend filing, possibly investing that time in starting a business or sweat equity in their house, or just enjoying their additional free time with friends and family. Taxpayers consequently also regain a large degree of financial privacy, currently sacrificed in the name of full disclosure and enforcement.

Corporations and people wealthy enough to manage their investments full time would no longer have to file income tax or even direct any effort at finding loopholes (because the loopholes would disappear along with the income tax), so they could focus their efforts on making money instead of avoiding taxes.

The secondary effect is perhaps more astounding. A corporate income tax policy, sets the after tax profit optimization goal closer to zero than it would be if consumption were taxed. Corporations use two mechanisms to compete for capital - dividends and growth in share price. If the corporation has all the capital it needs to execute the current tactical business plan, the need to attract capital is reduced, so reducing taxes increases in importance relative the need for capital. Now the corporate finance goal shifts toward tax minimization, away from profitability. Corporate income taxes thereby diffuse the profit objective.

In such an environment, lavish travel expenses for executives start making more economic sense because all of the money spent is above the taxable line at income tax time. People are principally driven by self-interest and corporate executives are undifferentiated from ordinary people in their motivations, though they do exercise control over expense policy. Where the two collide, you find corporation lavishing expense accounts on executives. The logic behind what looks like irrational corporate behavior makes perfect sense if you consider that the corporation’s travel expenses are above the income tax line, while similar expenses for an individual fall below the tax line. The logical optimization strategy is now to transfer as much of the personal travel and entertainment budget to the corporation.

If income tax disappeared and was replaced by consumption taxes, the tax advantage of shifting travel and entertainment expenses from individuals to corporations would be reduced to whose pocket the money was coming out of. Businesses would still have to grapple with what the acceptable expenses were, but it should be obvious that consumption taxes are revenue neutral to who is doing the consuming. Corporations that spend lavishly would pay more tax than those that are frugal, so consumption tax policy rewards economic efficiency, while income tax policy rewards profligate spending by setting the optimization goal at zero profitability (in the limiting case of complete indifference to attracting fresh capital).

So, how about that need to attract capital? What does that imply for growing companies (typically the ones that need fresh capital). Insufficient capital means a need to attract it, which means paying dividends or making a convincing case for share price growth. When you look at both cases, income tax is least avoidable by businesses that need capital and most avoidable by those that have plenty. Income tax therefore favors wealthy companies over ‘working class’ companies that need to grow share price and/or pay dividends in order to attract investors.

Legislators have attempted to eliminate ‘loopholes’, by excluding this and that type of expense in attempt to end around the tendency to optimize for zero taxes. Unfortunately, the end result is that the burden becomes ever more bifurcated, with higher marginal rates paid by companies who cannot escape the tax.

Consequently, the tendency is for income tax policy to place the heaviest economic burden on companies with the greatest need to attract capital. Need for capital stems from a desire for growth - income tax policy is therefore inimical to economic growth.