Tax Policy @ OptimalPortfolio.net

With $150B+ in improved economic efficiency on the table and the potential for improved quality of life and better corporate returns, why haven’t legislators funded a study to replace income/capital taxes with consumption taxes? One justification might be that a $13.8T economy would only see a 1.1% improvement in efficiency by adopting consumption taxes. Legislators may believe that they have bigger fish to fry. On the other hand, giant economic entities, whether government or corporate, rarely get opportunities to improve efficiency by anything like 1% merely at the dash of a pen.

Another justification might be elasticity. If tax revenues were derived from consumer spending, revenues could take a hit if consumers lacked confidence in their future prospects. Governments that aren’t required to balance their budget usually print a bit more money during economic downturns. So how would that be different?

The real explanation is more likely to be soft money. Income tax credits and loopholes allow government to provide a boost to this or that special interest group by diverting revenue away from the treasury before it’s actually captured. The Internal Revenue Service is controlled by the Secretary of the Treasury, who reports directly to the President, which means that the executive branch can in a very real sense ‘fund’ special interests by exempting them from portions of their tax liability.

The point is that the legislative branch does not have a hand on the purse strings of soft money. If the federal government were to abandon income taxes in favor of a consumption tax policy, the executive branch would lose its control over soft money ’spending.’ Article 1, Section 8 of the Constitution grants the power to tax and spend to the legislative branch. We fought a war with King George over taxation without representation.

Tens of thousands of people fought and died to domesticate tax authority, yet soft money ’spending’ does an end-around the legislative branch, effectively crowning a new King, whose vast executive branch has the power to manipulate tax policy and soft money spending without a word or a wink from the legislative branch.

No president who enjoys the trappings of power is going to lobby for an end to soft money spending. Can we conclude that presidents in general are likely to veto a switch to consumption taxes because it would mean the end of their soft money authority?

Soft money is outside the legislative negotiation process, so no representative can be held accountable – blame is clearly within the executive branch. Even better than pointing fingers at the president, some civil servant deep in the bowels of the IRS is the ultimate culpable party for any unpopular ’spending’ program. The legislature gets off Scot-free and the president can rely on plausible deniability.

What were we thinking?

Needed… documentation of the size of each of the loopholes and the soft money ‘budget’.  Following are a couple of significant, yet accessible sources of information on abused income tax loopholes:

America: What Went Wrong? by Donald L. Bartlett and James B. Steele. 1992, Andrews McMeel Publishing. ISBN-10: 0836270010

America: Who Really Pays the Taxes? by Donald L. Bartlett. 1994, Simon & Schuster. ISBN-10: 0671871579

I was reading some of Thom Hartmann’s laments recently, including some of the pages promoting his books.  I applaud his effort to expose the problem, but after reading his democracy will save the middle class rant, his labor perspective becomes more obvious. Hartmann is a rock star every-man author with an armful of book titles to his credit on all sorts of popular subjects, including several on the deconstruction of the middle class, representative democracy, corporate dominance, etc., perhaps the most notable being Screwed: The Undeclared War Against the Middle Class… by Hartmann, Miller, and Palast, but Hartmann is long on productivity and short on substance.

A much better source (probably Hartmann’s too) would be Donald L. Bartlett and James B. Steele’s 1992 America: What Went Wrong? or their 1994 sequel, America: Who Really Pays the Taxes?. Although neither is on the level of Noam Chomsky’s Fateful Triangle dissertation, within the space of the target audience for every-man books on taxes and the economy, Bartlett and Steele deliver the facts in succinct, easily digestible fashion.

Hartmann seems to believe that a conspiracy to dismantle organized labor is the ultimate cause of the deconstruction of the middle class. Conspiracy theories sell books, so it’s likely that Hartmann is tweaking mainstream readers to juice his own royalty stream. Bartlett and Steele don’t draw the conclusions for you, but after digesting the evidence they present, you’d be hard pressed not to conclude that nothing more sinister than unmitigated greed led to the web of policies responsible for expanding the wealth gap and thereby dismantling the middle class.

Ayn Rand defined the capitalist ideal to be a freedom to pursue one’s self-interest, completely unfettered by government regulation, little differentiated from Gordon Gekko’s ‘greed is good’ standard. Unfortunately, the competitive drive coupled with innate human goodness (sic) makes mere independence from government intervention insufficient. Marketplace competition, government regulators, and other potential success inhibitors are most efficiently overcome by lobbying government for grants, contracts, spending programs, and regulatory exemptions. The path represented by conceiving and building innovative products and creatively marketing them is substantially more error prone.

So you might say that it’s natural and inevitable for the tax landscape to become corrupted by special interest lobbying. Perhaps a share of the legislators involved are actually well intentioned (even the most cynical observer must have hope that there’s some good somewhere in government) or maybe they just don’t understanding the downstream consequences of their actions. The unfortunate result, clearly identified by Bartlett and Steele, is an unprecedented transfer of wealth away from the labor class (in which I include most office workers, but not doctors and lawyers), to the capital class. Bartlett and Steele even address Gekko-class corporate raiders. Some of the figures they cite border on astonishing – the very first page in the prologue documents a gigantic transfer of wealth from the middle class to the capital class between 1959 and 1989. In 1959 it took the combined wealth of the bottom 35% of the U.S. population to equal the wealth of the richest 4%. By 1989, the combined wealth of 51% of the population was required to equal the wealth of the richest 4% (using figures published by the Internal Revenue Service). And it’s grown worse… Taylor McKenzie reports that the combined wealth of the top 1% (circa March 2008) equals that of the bottom 95% of the population.

Returning to the prologue of America: What Went Wrong?, there are a slew of uncanny similarities between the Washington Post, New York Times, Los Angeles Times, and Boston Globe articles cited in 1991 and what we’re seeing in the press today. If you didn’t have the dates for reference, you’d think you were reading about the current depression, not the 1991-2 recession. The Fed was slashing the discount rate (to 3.5%, the lowest level since 1964), but one reporter (Richard Ford) in a press conference with the elder Pres. Bush, lamented that a recovery led by consumer spending fueled by low borrowing rates wasn’t going to cut it because people didn’t have jobs with which to pay back the debt they’d be incurring through credit card spending.

I must have taken a ride on H. G. Wells' time machine.  Aren’t these major economic corrections supposed to be further apart? FYI, the federal funds rate is now below where it was in 1952. Stimulative monetarism is maxed out – the economy is so depressed that cheap (virtually free) money cannot cure it. Government drains ever larger vials of blood from the economy and now that the body economic is weak, the vampire offers free seeds with which to sow next year’s crops.

Inequality.org argues that the legal minimum wage is about a third of the cost of living and I’m inclined to agree that business is a major component in the wealth skewing mechanism – too little is being paid out at the bottom, and too much is paid out at the top. Inequality.org has also argued that the wealth imbalance should be addressed via estate taxes, but I’m not so sure.

Private foundations are so much more efficient than government that it gives me pause to consider turning even a fraction of the Gates, Allen, and Buffet fortunes over to the tax man and frugal (sic) federal legislators. Obviously, philanthropic foundations sidestep that capital seizure, thus ensuring that the endowment is preserved. Warren Buffet has never lived a lifestyle with even a fraction of the bling of Jay Leno, much less Elizabeth Taylor, Richard Burton, Paris Hilton, Hugo Boss, or Larry Ellison. He’s dead set against his heirs living like Hollywood stars based on an accident of birth, but I have trouble imagining the Bill and Melinda Gates Foundation (who he’s bequeathed the vast majority of his fortune to) being any less effective than the Smithsonian at spending the money. Do we really want to capture those fortunes and redistribute them through the federal government?

If the very wealthy avoid the tax man by starting private foundations, where’s the government revenue stream represented by condemning that wealth? In all likelihood, based on the way things have been working since the fifties, a continued inheritance tax will simply be re-engineered to expand the wealth gap further. It would be better to ensure fairness at finer points along the way. If pension plans are going to be subject to corporate/pension raiders, why sanction them in the first place? Why not make the original wage earner the trustee of their retirement assets, just as people do now with IRA, 401K, and KEOGH plans?

The U.S. is on the verge of spending a trillion dollars more than the existing budget deficit to counterbalance the depression. The money will be used to stimulate the economy, create jobs, etc., but the first $350 billion Wall Street bailout resulted in bank acquisitions, not loan restructuring. Working class taxpayers bailed out capital class institutions in yet another massive transfer of wealth from the have-nots to the haves. Executive bonuses paid by Goldman-Sachs in 2006 and 2007 totaled $36 billion. Their 2007 bonuses totaled $20B, despite Goldman needing a $3B bailout that same year! How many regular Joes do you know that received massive bonuses despite failing to meet their MBO goals? If Goldman had paid just $3B less in bonuses in 2007, they wouldn’t have needed a $3B cash infusion.

Why bother embezzling millions when you can get your cronies to cut you a check? If you sign mine, I’ll sign yours. Do you harbor doubts about who controls American corporate assets (stock)? Note that America’s wealthiest 1% owns 36.9% of the corporate stock and the next wealthiest 9% owns 41.9%; the poorest 90% owns the 21.3% of stock left over.

Back to the current depression and the Obama administration’s political inheritance… Assume that 15% of the country is unemployed and we want to get unemployment back to 5%. That missing 10% represents about 19.5 million jobs. If the jobs created by infrastructure improvement programs pay an average of $50k per year (a total fabrication on my part), putting most of the unemployed back to work (assuming that finance and computer geeks can sell their resumes to contractors hiring construction workers) will cost $975B per year, which is just about what the economists are saying it will take to stem the slide. What makes me queasy is that infrastructure improvements do not provide ongoing employment, so the question is: Will the economy tank a year later, when the $1 trillion runs out and the roads and bridges are all fixed up?

Printing $1 trillion in fresh greenbacks will also cause a huge spike in inflation, gut foreign exchange rates, and increase the price of American goods overseas, thereby limiting their marketability, in an environment of substantial existing trade deficits with China, Korea, Japan, etc.

Uncle Sam can’t cash in on capital gains on houses and stock portfolios that are declining in value, so it certainly serves the Treasury’s interests to re-inflate the currency by printing a trillion or two more greenbacks. What a racket! The Treaasury prints a mountain of money to bail out an economy strangled by corrupt federal tax policies, thereby inflating the money supply (and devaluing the dollar overseas), and collects taxes on the apparent ‘gain’. Uncle Sam’s revenues also fall when people are out of work. No income, no tax revenue, so you might say that government is primarily interested in ensuring its own survival.

The problem is that taxing incomes is what wrecked the economy’s shock absorbers in the first place. Applied Forecasting cites a Gallup poll showing that Joe Public believed a recession was brewing back in November 2007, yet economists didn’t officially declare one until as much as a year later. What gives?

If Joe Public can call the plays better than professionally trained economists (who can’t officially declare a recession until negative growth has been evident for two consecutive quarters ), wouldn’t it make sense to empower that foresight by putting individual taxpayers back in charge of capital conversions (income taxes being a largely involuntary conversion of individual capital into spending on government)? If individuals had the right to control the conversion of their earnings into government spending (e.g. through consumption taxes), rather than having earnings subject to government condemnation (in analogous fashion to the way that real property is condemned), Joe Public would have more savings with which to weather economic downturns and government wouldn’t need to play such a large role in the recovery.

One can conclude two things: 1) Government conversion of individual capital into current spending has sapped so much of the country’s capital reserve that the economy sits upon a knife edge of instability – a hiccup here propagates and snowballs into a crisis over there, sometimes in seemingly unrelated economic sectors (mortgages to Wall Street to Main Street). 2) No amount of quantitative oversight by Nobel prize winning economists provides the same degree of foresight as an unbiased poll of consumer confidence.

Rand objects to elevating the values and rights of society over those of the individual on principle, and we’ve seen evidence that individuals are better at forecasting the economy, so why have we embraced big government, now running over 30% of GDP ?

In Rand’s insular capitalism (free from government intervention), WaMu, AIG, Lehman Brothers, Merrill Lynch, etc. would be allowed to fail and their stockholders would suffer the loss. Two things make this sort of economic natural selection politically inconvenient on Wall Street: 1) Where was the oversight from the Securities and Exchange Commission in the months leading up to the debacle? Admitting that Wall Street collapsed would be an indictment of the SEC’s oversight. 2) Thousands of non-executive staffers lose their jobs along with the superstar executives and their multimillion dollar annual bonuses. Aside from the after-the-fact government funded intervention, corporate America enjoys a keiretsu-like symbiosis with government actively ameliorating harsh conditions in the business environment.

Curiously, socialists have seized upon the meltdown in mortgage backed securities and the subsequent Wall Street correction as signs that capitalism has failed. The root of the problem stems from the Clinton administration, when Fannie Mae was encouraged to loosen down payment requirements. Fannie Mae’s chairman sounded a warning note at that time, concerned that an economic downturn would likely escalate into a rescue similar to one we saw in the 1980’s. There were other factors, namely a disastrous separation of loan originators from mortgage investors, though speculative interest in default credit swaps (which were exempt from regulation), also played a significant role. So, the current economic crisis isn’t so much the result of capitalism failing as it is the confluence of a social agenda (making mortgages accessible to previously under-qualified buyers), the albatross of federal spending becoming too much for taxpayers to shoulder, and greed driving a gigantic wedge into the wealth gap.

Bartlett and Steele’s first chapter opens with a striking graph depicting aggregate workforce salary increases in three income categories during the 1980’s. In ten years, the income of the entire workforce earning between $20k and $50k increased by 44%. In the $200k to $1M salary range, the aggregate increase in wages over the period was 697%. In the greater than $1M salary range, the aggregate increase in wages during the period was 2,184%. Naturally, all categories can grow via an increase in the number of individuals in the category as well as via an increased average salary within the segment, but as dramatically ambiguous as the opening graphic is, the chapter includes all sorts of insights into where income tax policy is broadening the wealth gap. Notable examples include anecdotes on lavish executive expense accounts; the conglomerate and take public profit cycle; and asset purchase and sweetheart lease back deals that suck the economic vitality out of once sound corporations (not unlike the executive bonuses paid to Goldman Sachs execs in the last few years).

America: What Went Wrong? is 235 pages long including the index. It’s a fast read, even amidst distractions, yet it’s packed with sometimes eye popping facts – it’s a worthwhile read for taxpayers and politicos alike.

Further reading…

Florida Economists Declare State is in Recession

Goldman Sachs 2007 executive bonuses totaled $20B

Goldman Sachs fund gets $3 billion bailout

Goldman Sachs 2006 executive bonuses totaled $16B

Ayn Rand Center for Individual Rights

Economic Inequality in US

Federal outlays as a percentage of GDP, 1940-2003

Concentration of Wealth fact sheet

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…

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

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?

Taxes that require disclosure could lead to criminal prosecution for those that earn income from illegal activities, so they won’t file.   Similarly, illegal aliens risk deportation, so they can’t risk filing.  The net effect is therefore that income taxes effectively subsidize illegal activities, and transfer the burden from cash businesses (who can get away with declaring less) to salaried taxpayers (clerks, secretaries, school teachers, pharmacists, steel workers, …).

People that risk incriminating themselves by indicating their source of income generally don’t declare it, i.e. drug dealers (where the respective drugs are illegal), prostitutes (where prostitution is illegal), thieves, burglars, and bookies (where gambling is illegal). Illegal aliens also avoid paying income taxes because they don’t want to risk being deported. People with cash businesses often report less than they are actually taking in because there’s no hard evidence to the contrary.

Here’s a blog entry on How The Rich Avoid Paying Taxes on the Brookings Institution’s TaxVox blog indicating that 7,300 U.S. taxpayers earning $200,000 or more paid no income taxes whatsoever. Another 85,000 paid worldwide taxes amounting to less than 10% of their income. These figures underscore the argument for abandoning income taxes and all of its associated loopholes in favor of a fairer policy.

The TaxVox story is based on this blog entry: 7,389 Returns With Incomes of $200,000 Paid No U.S. Income Tax In 2005 on Stan Collender’s Capital Gains and Games blog.