Topic: Tax and Budget Policy

Real Federalism in Switzerland

An article in the Financial Times notes that the income tax imposed by the national government in Switzerland takes no more than 11.5 percent of a taxpayer’s income, and that most taxation (and spending) takes place at the canton and municipal level. This is genuine federalism, unlike the United States, where the national government is the dominant force in fiscal policy.

A big advantage of real federalism is greater tax competition, which — as the article notes — leads to lower tax rates and less government waste:

The federal constitution gives significant powers both to Switzerland’s 26 regional cantons, and to the individual towns and villages in them. …A handful of cantons have used ultra-low taxation to attract wealthy individuals to stimulate economic growth. Among the best known are Zug and Schwyz, both not far from Zurich. Most recently, Obwalden, a small, mountainous canton near Lucerne, slashed tax rates to match its low-tax rivals.

The cantonal levy is complemented by a local tax, calculated as a percentage of the cantonal level. Again, rates vary dramatically, even between communities in the same canton. For example, in the canton of Zurich, Switzerland’s most populous, local tax ranges from roughly 70 per cent of the cantonal rate in the wealthy and relatively low-tax towns and villages along Lake Zurich’s so-called Gold Coast, to more than 120 per cent in poorer and much more financially stretched communities in the hinterland. The local and communal taxes are capped by a federal tax, payable separately and at a different time of the year, that rises gently to peak at 11.5 per cent for the highest incomes.

Although three levels of taxation might sound expensive, personal taxes in Switzerland are relatively modest compared with much of Europe. Rates in the ultra-low-tax cantons can be as low as 16 per cent. Even “average” cantons tend to charge less than elsewhere in Europe, thanks to the cantonal tax competition that the Swiss say encourages cantons and local administrations to maximise efficiency.

Teachers: “All Your Money Are Belong to Us”

The Georgia legislature is currently considering a scholarship donation tax credit program that would allow individuals and businesses to give money to non-profit scholarship granting organizations that make it easier for parents to afford independent schooling for their kids.

In arguing against the bill, the head of the state’s public school employee organization, Jeff Hubbard, had this to say: “Our opposition is [to] taking state funds, taxpayer income, and giving it over to private schools.”

Umm…. The thing is, state funds and taxpayer income are not interchangeable terms, however much public school employee organizations might wish them to be. You see, you aren’t entitled to all taxpayer income – or even to all state funds – but just to those funds appropriated by the state in taxes and then allocated to the business of running public schools. When taxpayers claim a tax credit for a donation to help low income kids, no money ever enters the state’s coffers. So you see, these are in fact private funds.

For a good discussion of all this, see the Arizona Supreme Court’s ruling in Kotterman v. Killian (.pdf), upholding that state’s scholarship donation tax credit program, in part, on the grounds that the donated funds are not state money.

Paul Krugman’s Fallacious Forecast of a $6-7 Trillion Drop in Housing Wealth

The Case-Shiller index of house prices covers just 20 major metropolitan areas. It shows house prices down by 10.7% between January 2007 and 2008, but that largely reflects the fact that Los Angeles, San Diego and San Francisco account for 27.4% of the index.

In Fortune magazine’s March 17 interview, economist Paul Krugman says “We’re probably heading for $6 trillion or $7 trillion in capital losses in housing.”

Such estimates begin by assuming the S&P Case-Shiller index of house prices (which is now down 12.5% from its peak month) has a lot further to fall, and that it accurately represents the value of all real estate held by U.S. households throughout the 50 states.

The Federal Reserve’s Survey of Consumer Finances (updated with flow-of-funds data by David Malpass of Bear Stearns), shows U.S. real estate worth $22.5 trillion in the fourth quarter—up 2.5% from a year earlier and accounting for 31.2% of household wealth.

If you think the Case-Shiller index will eventually fall by 30% (Krugman said 25%), then 30% of $22.5 trillion would yield an estimate of $6-7 trillion capital losses “in housing.” But the $22.5 trillion is not just single-family homes—it includes commercial property, apartments and farm land. More important, even single-family housing wealth is not located in only 20 major metropolitan areas.

The Office of Federal Housing Oversight (OFHEO) index covers all 50 states, including nonmetropolitan areas, but not the most expensive homes (which is not where Case-Shiller finds the biggest declines). The OFHEO index shows house prices down 3% in January, compared with a year before. But even that average is by no means typical of all housing (much less real estate) in the entire nation.

Between the fourth quarters of 2006 and 2007, house prices rose in all but two of the many states excluded by Case-Shiller, and the increase averaged 3.8 percent.

Economists and journalists who use gloomy predictions about the Case-Shiller index to predict a comparable loss of real estate wealth are making several serious mistakes.

Senator Levin’s War on Taxpayers

In a remarkable display of chutzpah, Senator Carl Levin of Michigan is quoted in the Christian Science Monitor stating that “Tax havens have declared war on honest taxpayers.” This is from a politician who routinely votes for higher taxes and has a rating of “F” from the National Taxpayers Union because he votes against taxpayers 85 percent of the time – a record that puts him below Senators Hillary Clinton and John Kerry. Tax havens, by contrast, have helped taxpayers by forcing governments around the world to lower tax rates. Indeed, a prominent British accountant explains in the story that low tax rates are the appropriate way to deal with global competition. Returning to the theme of chutzpah, an OECD bureaucrat (who receives a tax-free salary!) actually admits that people should have a right to financial privacy – but only if the term is stripped of all meaning by giving governments unlimited snooping rights:

“Tax havens have declared war on honest taxpayers,” says US Sen. Carl Levin (D) of Michigan, who along with Sen. Barack Obama (D) of Illinois is co-sponsoring the “Stop the Tax Haven Act,” introduced last year. … Chas Roy-Chowdhury, head of taxation at Britain’s Association of Chartered Certified Accountants… says… “Governments should open themselves up to the wind of global competition and accept that they need to run efficiently to keep tax rates low.” … Perez-Navarro [of the OECD] adds that individuals should have the right to a certain banking confidentiality, but that when investigators want to see numbers they should be handed over.

Tyler Cowen Thinks Frozen Markets Justify Tougher Regulations?

In a New York Times piece of March 23, “It’s Hard to Thaw Frozen Markets,” Tyler Cowen concludes that “regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions.” That conclusion follows from a surprisingly innocent confidence in regulation in general and capital requirements in particular. But it also follows from a faulty analysis of the situation.

Cowen writes, “What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values… .The results have been a form of financial gridlock.”

To explain this alleged “drying up” process he says, “Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.” Cowen thinks “market prices have been drained of their informational value” in “many asset markets.”

With the possible exception of mortgage-backed securities, that seems fanciful if not absurd. The spread between junk bonds and Treasury widened mainly because Treasury yields fell, but there is massive trading in such bonds. Sales of nonfinancial commercial paper have grown briskly this year, and so have sales of financial paper aside from the “asset-backed” variety. There may be little trading of mortgage-backed securities, but that just suggest many owners (unlike, say, e-Trade) are in no hurry to sell at prices low enough to attract borrowers.

This poses a temporary problem for mark-to-market accounting (and Basle’s bureaucratic capital standards), but this seems a failure of accounting rather than markets. Cowen asks “why seek ‘fire sale’ prices when you might lose your job for doing so?” I would ask, “Why seek ‘fire sale’ prices if (unlike Bear Stearns) you are in a position to wait for a better deal once the market calms down?” Cowen says, “Only so many financial institutions have the size and expertise to buy up low-quality assets in large quantities.” But large holdings can often be sold in smaller batches. And we don’t know who might have bought Bear Stearns, warts and all, were it not for favoritism the Fed and Treasury showed to a single bidder (who was shamed into quintupling the offer).

Liquidity refers to the ease with which various assets can be converted to cash without dropping the value of the asset. Hedge fund managers bought gold on margin at $1000 may find it is less liquid than they expected. But what seems terrible to sellers of marked-down assets (e.g., of Las Vegas condos) can seem wonderful to buyers.

Most people think “liquidity drying up” means banks have cut back on lending, which is demonstrably false – bank loans are growing at a 10-11% annual rate since August, and much faster for C&I loans. Consumers and small businesses were never dependent on mortgage-backed IOUs.

There is no “financial gridlock” for most assets, even real estate (31% of household wealth). Auctions for foreclosed properties are drawing plenty of bids.

Mr. Cowen thinks “investors are instead flocking to the safest of assets, like Treasury bills.” Smart investors shun long-term Treasuries and are flocking to stocks, particularly U.S. stocks. The S&P 500 is down less than 10% this year – much better (in dollars) than most other markets, including Europe and China.

Tyler says, “Every step of the way, the pricing of [Bear Stearns] stock has surprised the market.” Really? It didn’t surprise the shorts, who owned a fourth of the shares. I own the SKF exchange fund (ultra-short financials) which, ironically, fell sharply a couple of days after Bear was sold out by omniscient and kindly government regulators.

Nobody ever said housing was a liquid asset, but even housing is far more liquid than the doomsday crowd imagines. The OFHEO index shows that home prices increased in all but 11 states between the fourth quarters of 2006 and 2007. Home prices fell 4% to 7% in California, Nevada, Florida and Michigan, but home prices rose 4% to 9% in 16 other states—most of which are not even counted in the widely-cited Case-Shiller index (which gives California a 27% weight).

The only problem with financial markets is that information is never free, and it sometimes takes time to discover market-clearing prices. The solution is not more regulations, but more patience.

Capital requirements, on the other hand, can cause very serious problems. The 1988 Basle Accord on capital requirements was a heavy-handed reaction to the 1982 LDC debt crisis. It was also one reason Japan’s monetary base shrunk by 2.8% a year in 1991-92 – the start of a period some U.S. journalists are now foolishly comparing to the restoration of sanity in coastal housing prices.

As I explained ten years ago, Basle “required that by the end of 1992 banks had to maintain capital equal to a minimum of 8 percent of risk-adjusted assets, where risk just happened to be defined in a way that favored government bonds over business loans… . Did relatively higher capital ratios in the United States and Great Britain mean they were less exposed than Japan to LDC default? On the contrary, even in the late eighties outstanding LDC loans still amounted to 93-199 percent of the capital of the largest U.S. banks, and as much as 82 percent for British banks, but only 55 percent for Japan. American banks seemed to have more capital. But unlike Japan, all of the capital of U.S. banks, and sometimes much more, was exposed to LDC default.”

Even if markets for a few risky, exotic U.S. securities appears “frozen” for a short while, that is far less problematic than imposing stern, politicized regulation over a wide array of assets and institutions.

The Fed’s “Central Planning” Woes

Given the financial/regulatory system that we have – which is a very important pre-condition – I grant the Fed and Treasury a TEMPORARY “coordinating” role to help tide over the current crisis.  However, the initiatives and actions implemented so far appear unlikely to succeed.

I agree only with its role in the Bear buyout by JPMorgan.  It is, by nature, a one-time action that does not protect Bear’s shareholders and operators but protects the financial system from unraveling further – similar to it’s actions re: LTCM. Even if it is repeated for another investment bank, it does not raise the issue of moral hazard because no such bank wants to end up like Bear.

However, the Fed’s new and almost direct support of mortgage backed securities through its primary dealers introduces another moral-hazard potential – likely to be a huge problem down the road, and especially because of the interest rate policy it is adopting.

Interest rate cuts are being overdone. Large cuts are continuing the Fed’s past mistakes of introducing greater uncertainty in market participants’ expectations. It is using the wrong (inflation fighting) tool to achieve its goal of systemic stability which has arisen from poorer visibility of asset quality. The added uncertainty will prolong the resolution of current credit/liquidity shortages.

The longer that credit/liquidity problems last, the more likely is the introduction of PERMANENT new financial market regulations – which would hinder efficient operation – in the very function that is key to resolving current credit shortage problems – the generation of price information.

Finally, Prof. Cowen’s recent NYT oped (“It’s Hard to Thaw a Frozen Market”) compares market pricing under capitalist and socialist systems.  In brief, the argument is that socialist systems’ poor market pricing abilities appear to be reflected in the current credit-market woes of the American “capitalist” system. This comparison appears misplaced to me. The general U.S. economy may be relatively free and capitalist – but financial and credit markets are not quite so free.

Current credit market problems are not the result of pure and free market operation/competition.  We have a fiat currency whose supply and purchasing power is controlled by Fed interest rate policies. And it appears to have made serious mistakes in the process. This involves larger issues of whether asset prices should be objects for setting Fed policy and whether and how the Fed should respond to supply/oil shocks. Fundamentally, however, financial market participants naturally don’t look to “the free” market to set their expectations about the dollar’s future purchasing power. Those expectations are set by a “central planner” – the Fed.