Tag: deficit

A Value-Added Tax Is Not the Answer…Unless the Question Is How to Finance Bigger Government

While admitting that spending restraint is the ideal approach, Tyler Cowen of Marginal Revolution asks whether a value-added tax (VAT) might be the most desirable of all realistic options for dealing with an unsustainable budget situation.

Read his post for yourself, but I think a fair summary is that he is basically saying that a) there will be a crisis if we don’t do something about future deficits, b) a crisis will result in very bad policy, and c) if we support a VAT now, we will at least be able to extract concessions from the other side.

I have no idea whether there will be a future crisis, but I think the rest of Tyler’s argument is wrong.

But before explaining my position, let’s start by stating what I assume to be our mutual objective, which is to control the size of government. We all agree that there is a problem because government is too big now, and it is projected to get even bigger because of the built-in growth of entitlement programs. One symptom of growing government is deficits, which are very large today and will be even bigger in the near future as more and more baby boomers retire and push up costs for Social Security, Medicare, and Medicaid.

Our side (broadly speaking) wants to solve the budgetary situation by restraining the growth of government. One proposed solution is Congressman Paul Ryan’s Roadmap Plan, which would reform entitlements and curtail other programs so that the long-term burden of federal spending is reduced to less than 20 percent of GDP. Since long-term federal tax revenues under current law - even if the 2001 and 2003 tax cuts are made permanent - are expected to be about 19 percent of GDP, this solves the budet problem  (the tax reform component of the Roadmap includes a VAT, which is a poison pill in an otherwise excellent plan, but let’s set that aside for another day).

The left, by contrast, generally wants to let federal spending consume ever-larger shares of economic output, and they believe that increasing the tax burden is the right way of keeping the deficit from getting too large. No statist has put forth a detailed plan to match Rep. Ryan, but several high-ranking Democrats have made no secret about their desire for a VAT (see here, here, and here). And everyone agrees that a VAT is capable of extracting a lot of money from the productive sector of the economy.

These two visions are fundamentally incompatible, which helps to explain why there is a standoff. The bad guys do not want to control the size of government and the good guys do not want to raise taxes. But now we have to add one more piece to the puzzle. While gridlock normally is a good result, inaction to some degree favors the other side because entitlement programs automatically expand. The helps to explain why Tyler (with reluctance) thinks that it may be best to acquiesce to a VAT now rather than to wait for a fiscal crisis.

Now, let’s explain why Tyler is wrong. First, it is far from clear that surrendering to a VAT now will result in better (less worse) policy than what will happen during a crisis. It certainly is true that some past crises have led to terrible policy, such as the failed policies of Hoover and Roosevelt in the 1930s or the more recent Bush-Paulson-Obama-Geithner TARP debacle. But at other points in time, a crisis atmosphere has paved the way for better policy, with Reagan’s presidency being the most obvious example.

The wait-for-a-crisis strategy clearly is a bit of a gamble, but even if we lose, we get a VAT in the future rather than a VAT today. So what’s the downside? Tyler and others might say that the future legislation in the midst of a crisis could be a vehicle for other bad provisions, but he offers no evidence for this proposition. And it may be the case that the other side would be forced to add good provisions instead. Moreover, the lack of a VAT in the period between today and the future crisis might help lead to some much-needed spending restraint.

What about Tyler’s argument that the good guys could extract some concessions from the other side by putting a VAT on the table. This is horribly naive. Even though George Mason University is less than 20 miles from Washington, and even though Tyler is a renassaince man with many talents, he does not understand how Washington really works.

Imagine there is a budget summit where politicians from both sides get together to work on this supposed deal. Here are the inevitable ground rules - and the consequences they will produce:

1. The deal will be 50 percent spending cuts and 50 percent tax increases, but the supposed spending “cuts” will be nothing more than reductions in already-legislated increases. The tax increases, by contrast, will be on top of all the additional revenue that is already exepected under current law (not a trivial matter since receipts will be $1.5 trillion higher in 2015 than they are today according to OMB). For proponents of limited government, using the “current services baseline” as a benchmark in budget negotiations is like playing a five-minute basketball game after spotting the other team a 20-point lead.

2. All spending and revenue decisions will be examined through the prism of CBO income distribution tables, and the left will successfully insist that nothing is done to make the tax code less progressive. But since a VAT is a proportional tax, the only way of preserving overall progressivity is to raise tax rates on those wicked and evil rich people and/or to massively increase “refundable” tax credits (what normal people call income redistribution). Any proposal to lower income tax rates or eliminate the corporate income tax, as Tyler envisions, would be laughed out of the room (though Democrats will offer a fig leaf or two in order to seduce a sufficient number of gullible Republicans into supporting a terrible agreement, and that might include a cosmetic change to the corporate tax regime).

3. Many of the supposed spending cuts, for all intents and purposes, will be back-door tax increases on saving and investment. More specifically, a big chunk of the supposed spending cut portion of a budget deal will be from means-testing entitlement programs. This sounds good. After all, who wants to send a Social Security check to Bill Gates when he retires? But consider how such a system actually will work. The government will say that people with income (and/or assets) above a certain level are ineligible for some or all of the benefits available to less-fortunate retirees. From an economic persepective, this is very much akin to a higher tax rate on people who save and invest during their working years. And since means testing would only generate substantial budgetary savings if it applied to millions of regular people in addition to Bill Gates, we would wind up with a system that created big penalties on middle-class families who were dumb enough to save and invest.

I’ve already pontificated enough for one blog post, so let me summarize by stating that Tyler’s approach, while not unreasonable, is about how to lose gracefully. Even if his strategy works perfectly, the result is bigger government. I’d much rather fight. If you want some inspiration for the battle, watch this video. If you haven’t had enough of me already, here’s my video explaining why the VAT is a horrible idea.

Update: Tyler has emailed to object to how his position is being characterized. He writes, “I am asking anti-VAT forces to strengthen their argument and am very clearly agnostic and certainly not calling for a VAT today.” Everyone I’ve spoken with has interpreted his post as pro-VAT, and that’s certainly how I read it, but I want to add this addendum to my post so people can see Tyler’s response in case I’m not being fair.

Taxing the Rich Won’t Work

The new budget reportedly hopes to raise $364 billion over ten years by raising the top two tax rates, plus $105 billion by raising the tax on dividends and capital gains to 20% from 15%, and $500 billion through discriminatory caps and limits on personal exemptions and deductions allowed to other taxpayers.

The $364 billion from raising the top two tax rates pales in comparison to the $2.56 trillion from keeping the rest of the Bush tax cuts in place, including $600 per couple (the 10% bracket) for everyone still rich enough to pay taxes (the Obama plan would exempt half of  U.S. workers from paying income tax).  That contrast between $364 billion and $2.56 trillion is definitive proof that Democrats’ endless complaint about the Bush tax cuts going “mainly to the rich” was one of the biggest big lies of the past decade.

The President’s urge to penalize mature, two-earner educated couples earning more than $250,000 is symbolic populism, having essentially nothing to do with reducing the deficit. Table S-2 of the Budget (p. 147) lists “Upper-income tax provisions dedicated to deficit reduction” as just $34 billion in 2011 — less than 1% of estimated spending of $3.8 trillion. Errors in estimating next year’s deficit have often been much larger than $34 billion, particularly during the early stages of economic recoveries.

Still, the false belief that higher tax rates on the rich could eventually raise significant sums over the next decade is a dangerous delusion, because it means long-term deficits are seriously understated.

Here are just a few reasons why punitive marginal tax rates on high-income families cannot possibly raise even the relatively trivial sums the Budget is counting on:

1.    Professionals and companies who currently file under the individual income tax (including most trial lawyers and hedge fund managers) would form C-corporation to shelter income, because the corporate tax rate would then be lower with fewer arbitrary limits on deductions for costs of earning income.

2.    Investors who jumped into dividend-paying stocks in 2003 when the tax rate fell to 15% would dump some of those shares in favor of tax-free municipal bonds if the dividend tax went up, and keep the rest in tax-free IRA or 401k accounts.   Prices of dividend-paying stocks and funds could be depressed, reducing the yield of the capital gains tax.

3.    If faced with a higher capital gains tax next year, investors would rush to realize taxable capital gains (those not in IRAs and 401ks) later this year.  After 2010, investors would make greater efforts to avoid realizing gains in taxable accounts unless they had offsetting losses, and they would also make fewer investments in assets subject to the capital gains tax.

4.    Many two-earner couples would become one-earner couples, early retirement would become more popular, physicians would play more golf, etc.

That is a small sampling of known behavioral responses which economists call “the elasticity of taxable income” or ETI for short.  What that means is this: When the marginal tax rate goes up, the amount of reported incomes goes down.  As a forthcoming study by Joel Slemrod, Seth Giertz and Emmanuel Saez concludes, “There is much evidence to suggest that the ETI is higher for high-income individuals who have more access to avoidance opportunities.”

I presented a 60-page paper in 2008 full of graphs and tables, many derived from the tax data of Thomas Piketty and Emmanuel Saez, offering undeniable evidence that static revenue estimates (which ignore or minimize the ways in which people react to higher tax rates) greatly exaggerate potential revenue from higher tax rates on individual salaries, dividends and capital gains.

I concluded, “There is a serious fiscal risk in the future that overly-optimistic revenue estimates based on the assumption of zero or 0.25 elasticity of taxable income could lead the federal government to make long-term spending plans on the basis of phantom revenues from higher tax rates, embarking on major new entitlement programs (in the guise of refundable tax credits) in the false hope that these static or nearly-static revenue estimates are realistic.”

Obama’s Spending Freeze: Is It Real or Is He Copying Bush?

As reported by the Wall Street Journal, the Obama Administration will propose a three-year freeze for a portion of the budget known as “non-defense discretionary” spending. Many critics will correctly note that this is like going on a drunken binge in Vegas and then temporarily joining Alcoholics Anonymous. Others will point out that more than 80 percent of the budget has been exempted, which also is an accurate criticism. Nonetheless, even a partial freeze would be a semi-meaningful achievement.

But don’t get too excited yet. It is not clear whether the White House is proposing a genuine spending freeze, meaning “budget outlays” for these programs stay at $447 billion for three years, or a make-believe freeze that applies only to “budget authority.” This is an enormously important distinction. Budget outlays matter because they represent the actual burden of government spending. Budget authority, by contrast, is a bookkeeping measure that – at best – signals future intentions. During the profligate Bush years, for instance, apologists for the Administration tried to appease fiscal conservatives by asserting that budget authority was growing at ever-slower rates. In some cases, they were technically correct, but their arguments were deceptive because real-world spending kept climbing to record levels. And needless to say (but I’ll say it anyhow), future intentions never became reality.

Domestic discretionary spending soared from less than $350 billion to more than $600 billion during the Bush years (and rose almost another $100 billion in Obama’s first year!). If the Obama Administration proposes a genuine outlay freeze, he will be taking a genuine (albeit small) step in the right direction. If the “freeze” applies only to budget authority, however, that will be another indication we are in George W. Bush’s third term.

To attack the $1.4 trillion deficit, the White House will propose limits on discretionary spending unrelated to the military, veterans, homeland security and international affairs, according to senior administration officials. Also untouched are big entitlement programs such as Social Security and Medicare. The freeze would affect $447 billion in spending, or 17% of the total federal budget, and would likely be overtaken by growth in the untouched areas of discretionary spending. It’s designed to save $250 billion over the coming decade, compared with what would have been spent had this area been allowed to rise along with inflation. …administration officials acknowledged the freeze is directed at only a small part of overall spending, but that fiscal discipline has to start somewhere. President Obama had requested a 7.3% increase last year in the areas he now seeks to freeze.

The Problem Is Spending, not Deficits

Reckless spending increases under both Bush and Obama have resulted in unprecedented deficits. Congress will soon be forced to increase the nation’s debt limit by an astounding $1.8 trillion. Government borrowing has become such a big issue that some politicians are proposing a deficit reduction commission, which may mean they are like alcoholics trying for a self-imposed intervention.

But all this fretting about deficits and debt is misplaced. Government borrowing is a bad thing, of course, but this video explains that the real problem is excessive government spending.

 

Fixating on the deficit allows politicians to pull a bait and switch, since they can raise taxes, claim they are solving the problem, when all they are doing is replacing debt-financed spending with tax-financed spending. At best, that’s merely taking a different route to the wrong destination. The more likely result is that the tax increases will weaken the economy, further exacerbating America’s fiscal position.

Is Keynesian Stimulus Working?

In his Brookings Institution speech yesterday, President Obama called for more Keynesian-style spending stimulus for the economy, including increased investment on government projects and expanded subsidy payments to the unemployed and state governments. The package might cost $150 billion or more.

The president said that we’ve had to “spend our way out of this recession.” We’ve certainly had massive spending, but it doesn’t seem to have helped the economy, as the 10 percent unemployment rate attests to.

It’s not just that the Obama “stimulus” package from February has apparently failed. The total Keynesian stimulus is not measured by the spending in that bill only, but by the total size of federal government deficits.

The chart shows that while the federal deficit (the total “stimulus” amount) has skyrocketed over the last three years, the unemployment rate has more than doubled. (The unemployment rate is the fiscal year average. Two months are included for FY2010.)

200912_blog_edwards17

The total Keynesian stimulus of recent years has included the Bush stimulus bill in early 2008, TARP, large increases in regular appropriations, soaring entitlement spending, the Obama stimulus package from February, rising unemployment benefits, and falling revenues, which are “automatic stabilizers” according to Keynesian theory.

The deficit-fueled Keynesian approach to recovery is not working. The time is long overdue for the Democrats in Congress and advisers in the White House to reconsider their Keynesian beliefs and to start entertaining some market-oriented policies to get the economy moving again.

Defending Obama…Again

I caught a lot of flack from my Republican friends for my post blaming the FY2009 deficit on Bush instead of Obama. Well, I must be a glutton for punishment because I can’t resist jumping (albeit reluctantly) to Obama’s defense again. I’m venting my spleen for two reason. First, FoxNews.com posted a story headlined “Obama Shatters Spending Record for First-Year Presidents” and noted that:

President Obama has shattered the budget record for first-year presidents – spending nearly double what his predecessor did when he came into office and far exceeding the first-year tabs for any other U.S. president in history. In fiscal 2009 the federal government spent $3.52 trillion …That fiscal year covered the last three-and-a-half months of George W. Bush’s term and the first eight-and-a-half months of Obama’s.

This story was featured on the Drudge Report, so it has received a lot of attention. Second, Bush’s former Senior Adviser wrote a column for the Wall Street Journal eviscerating Obama for big budget deficits. Given Bush’s track record, this took considerable chutzpah, but what really nauseated me was this passage:

When Mr. Obama was sworn into office the federal deficit for this year stood at $422 billion. At the end of October, it stood at $1.42 trillion.

I’m a big fan of criticizing Obama’s profligacy, but it is inaccurate and/or dishonest to blame him for Bush’s mistakes. At the risk of repeating my earlier post, the 2009 fiscal year began on October 1, 2008, and the vast majority of the spending for that year was the result of Bush Administration policies. Yes, Obama did add to the waste with the so-called stimulus, the omnibus appropriation, the CHIP bill, and the cash-for-clunkers nonsense, but as the chart illustrates, these boondoggles only amounted to just a tiny percentage of the FY2009 total – about $140 billion out of a $3.5 trillion budget.

There are some subjective aspects to this estimate, to be sure. Supplemental defense spending could boost Obama’s share by another $25 billion, but Bush surely would have asked for at least that much extra spending, so I didn’t count that money but individual readers can adjust the number if they wish. Also, Obama used some bailout money for the car companies, but I did not count that as a net increase in spending since the bailout funds were approved under Bush and I strongly suspect the previous Administration also would have funneled money to GM and Chrysler. In any event, I did not give Obama credit for the substantial amount of TARP funds that were repaid after January 20, so the net effect of all the judgment calls certainly is not to Bush’s disadvantage.

Let’s use an analogy. Obama’s FY2009 performance is like a relief pitcher who enters a game in the fourth inning trailing 19-0 and allows another run to score. The extra run is nothing to cheer about, of course, but fans should be far more angry with the starting pitcher. That having been said, Obama since that point has been serving up meatballs to the special interests in Washington, so his earned run average may actually wind up being worse than his predecessor’s. He promised change, but it appears that Obama wants to be Bush on steroids.

The Reagan Tax Cuts, Budget Forecasting, and Government Revenue

While perusing the Internet, I saw an article by Iwan Morgan, who is the author of The Age of Deficits: Presidents and unbalanced Budgets from Jimmy Carter to George W. Bush. The author asserted in this article that, “The deficit explosion on his watch was a nasty surprise for Ronald Reagan not a deliberate strategy to reduce government.  In his rosy interpretation of Laffer curve theory, the personal tax cuts he promoted in 1981 would deliver higher not lower revenues through their boost to economic growth.”

The first sentence is an interesting interpretation, since many leftists believe that Reagan deliberately created deficits to make it more difficult for Democrats in Congress to increase spending. I’m agnostic on that issue, but Morgan definitely errs (or is grossly incomplete) in the second sentence. The Reagan Administration did not employ dynamic scoring when predicting the revenue impact of its tax rate reductions. It is true that the White House failed to predict the drop in revenues, particularly in 1982, but that happened because of both the second stage of the 1980-82 double-dip recession and the unexpected drop in inflation (the Congressional Budget Office also failed to predict both of these events, so Reagan’s forecasters were hardly alone in their mistake). Moreover, Morgain’s dismissal of the Laffer Curve is unwarranted. While several GOP politicians exaggerated the relationship between tax rates, taxable income, and tax revenue, this does not mean it does not exist.

The table below, which is based on data from the IRS’s Statistics of Income, shows what happened to tax collections from upper-income taxpayers between 1980 and 1988. Supply siders can be criticized for many things, especially their apparent disregard for the importance of limiting the size of government, but the IRS figures clearly show that lower tax rates were followed by more rich people, more taxable income, and more tax revenue. For those keeping score at home, that’s a perfect batting average for supply-side economics.

1980-88 Laffer