Ev Ehrlich's Everyday Economics

What the —-?

Although the title of today’s entry wasn’t meant to refer to it, the call at first base on what would have been the final out of Armando Galarraga’s pitching baseball’s 21^st perfect game was not the worst call in baseball history.  Don Denkinger’s call on Jorge Orta in 1985 was not only far more obviously wrong – it wasn’t even a bang-bang play –but changed the outcome of the World Series, which is far more severe than marring one player’s individual accomplishment.    Ken Burkhart’s call in the 1970 World Series was particularly egregious as he ended up in the middle of the play, as well as blowing the call.   And Larry Barnett’s failure to call Ed Armbister out for interference in 1975 was not only wrong, but marred perhaps the greatest World Series ever (although I’ll take 1991, thanks, with props to 1960, 1924, and 2001)   

So Galarraga now enters baseball history as one of the three guys to have “asterisked” perfect games.  He’s really the third of the three.  The second is Harvey Haddix’s famed 1959 outing, in which he threw a 12 inning perfecto – 36 up, 36 down – only to lose, 1-0 to Lew Burdette and the Braves in the 13^th on an error, a sacrifice, an intentional walk, and a homer by Joe Adcock that ended up being only a double because he passed Henry Aaron on the basepaths.  The first great “not perfect” game was in 1917 when Babe Ruth, pitching for the Red Sox, walks the first batter, argues the call, gets thrown out by the umpire, and Ernie Shore, who replaces Ruth, picks the runner off and gets the next 26 in a row.   Can you imagine?  It’s a different list  but Galarraga’s on it, and the beauty of baseball is that its devotees keep and respect both lists. 

So much for the sublime.  Now, on to the ridiculous.

For the first time in my career as an economist, I’m getting “the question” – friends, colleagues are coming up to me and with the hushed tones usually reserved for intimate conversations in public places and dope deals, ask me; “What the --- is going on out there?”  The blanks, of course, vary as do the askers.

I don’t take this as a sign that economists are now climbing up the ranks of respectability, leaving lawyers and other reprobates behind, but rather that the daily stream of news is so confusing, so off-the-map, and creates so much volatility – markets and their underlying sentiment taking giant steps in opposite directions with each passing day – that “what the ---“ becomes the only appropriate response.  “What if everybody felt that way, Yossarian?”/”Then I’d be crazy to feel any different.”

So here’s the hyper-condensed version of events that I’ve developed in response to the dominant questions of the moment.

When we last left the Western economies, they were imploding after the collapse of the housing market.  The balance sheet hit created by crashing home values led banks to cut back lending and led consumers to retrench.  This spread the pain and failure to the general economy, which ignited a second stage of financial collapse. 

The second stage was caused by “credit default swaps.”  Over the previous years, banks and other institutions had made bets that many large firms would never go bankrupt.  They did this by buying credit default swaps, a device in which they were paid a nominal amount in exchange for the promise to take a bath if a firm went broke and its securities went unserviced.  As long as big companies never went broke, there was nothing to lose.

Oh well.  It was this second stage that put the ship on the rocks.  Many – almost most – major financial institutions had that kind of exposure.  And the ones who bet the right way – by recognizing that one day these credit default swaps might take a bath – couldn’t collect what they were owed because it never occurred to them that their counterparty (or as we called them back in North Queens, losers) would be unable to pay.  That’s a major oversight -- I don’t lend my neighbor Fitzgerald ten million bucks because I know he’ll never be able to pay it back.  So when Goldman tells you it didn’t need the bailout – horsefeathers.  They received billions of the money that went into saving Bear Stearns, and they got it because they didn’t think about this point.

Faced with the reality of their major banks shutting down, the major governments had two options – do something, or do nothing.  Monday morning quarterbacks on both the left and right are making careers out of critiques of option A, but only a few folks well-removed from reality dispute that Options A was the right move.  (For example, Casey Mulligan argued in the New York Times that it was senseless to spend so much money bailing out banks as pension funds and university endowments could match savers and investors just as well.  And this guy teaches people?  Give me a break.)    Other critics thought that the banks ought to be given the kind of rousing reception that greeted Mussolini at Giolino di Mazzegra, others that bailing out Bear but not Lehman was inconsistent.

But the actions taken by the new Obama Administration and the other Western governments brought the world back from the frightening paralysis that would have taken place if the banks were shuttered -- lending would not occur, assets would not be exchanged, liquidity not provided for businesses, and further trillions of dollars would be lost.  Time out for an aside – you all owe your asses to the Administration and, yes, Tim Geithner, for keeping themselves focused on the one thing that truly mattered – recreating financial stability.  Like comedy, it wasn’t pretty.  But it avoided reproducing the very same mistakes that made the Great Depression a catalyst for a decade of great film and theater. 

Bailing out the financial system took a lot of money – ultimately, less money than was thought at the time, but that merely means “a lot” of money, as opposed to “psychotropically unfathomable”  amounts of money.  But, in the world of financial bailouts, if they cost a great deal, it means you haven’t spent enough yet.  The real budget hit came from the downturn in the real economy, not the cost of mopping up after the hogs ran through town.  The stimulus was big but sorely needed, and again, some credit is due to the Administration – here I see Summers at work – for understanding that the response had to be commensurate with the problem – enormous.

Which takes us to the present, where the economy is stable and beginning to grow anew.  As I’ve said elsewhere on these pages, I’m optimistic about that growth, and I’ll double-up on my optimism before this entry is out.  But behind the prospects for a meaningful recovery lies the specter of an ocean of government (sovereign) debt.  There was a frightening amount of government debt before this mess, and adding on more makes it all the more unnerving.  I don’t think it’s beyond the pale to expect some U.S. municipalities or even states to default in whole or part of what they owe – heck, California already issues IOU scrip and when that trades below par, that’s already a form of default.

So the issue now is whether all of these sovereign debts will be repaid.  When governments were busy shoveling dollars into the boiler, people put that fear aside, using a variant of what economists call “Tinbergen’s Rule” – that is, one crisis at a time.    But once the crisis appeared to abate – as it does now – there was the morning after question – how is all this debt going to be taken down?

And against that backdrop came the startling revelation this Spring that Greece, with enthusiastic support from Goldman Sachs, had set up currency and perhaps other trades in order to hide the true level of their government’s deficit.  That Goldman would suggest such a thing to a government is outlandish – that the government would take them up on the offer speaks to Goldman’s uncanny craft.   But the news that Greece’s deficit was much larger than previously thought sent a new shock wave through the system.  Would Greece be willing to repay all it owed?  And what about other European countries with debt levels that, in some fashion, rivaled those of Greece – Spain, Portugal, Ireland, maybe even Italy?  Could they, would they, somehow reneg or default?

And so Europe went from a crisis not of their own making – the U.S.-born mortgage/credit default crash – to one entirely of their own doing – the need to stitch together the Eurozone.  The framers of the Euro, 20 years ago, understood that once the individual nations of Europe didn’t have their own currency – pesetas, lire, escudos, drachmas  -- to degrade (by borrowing like madmen), they had to be prevented from degrading the one they now all shared.  They passed rules about limits on deficits, but those rules were impossible to enforce.   When confronted with the choice of temporarily bailing out the high-debt nations or watching the European economy founder and the Euro be abandoned by several of its participants, the Germans, Europe’s official embodiment of rectitude, got pragmatic quickly and started dishing out money.

So now the issue has changed.  The major industrialized nations all owe staggering amounts of money.  Some of it came from the financial bailout, some of it from the Euro-bailout, but most of it is related to the economic conditions that ensued.  Some amount of the ongoing deficits we see will fade if the economy, but most of it won’t.  And cutting deficits is tough – Greece imagines cutting about 2 percent of GDP each year from its deficit for four years  -- that’s going to hurt, hurt badly, and hurt for a long while.  Will their per capita income be higher or lower than today’s in 2020?  I don’t know.  That’s a long time to go nowhere and it requires a population willing to lose that decade because they understand that the alternative is worse.  Imagine Glenn Beck – or Jamie Galbraith – chewing on that one.

But even as sovereign debts have become riskier, investors have raced to buy them, because in the midst of a financial crisis, there’s little else to buy.  But when you add the precariousness of government debt to the staggering quantities of it that’s been snapped, you get the ultimate bubble – not a “housing bubble” or a “dot.com bubble” or a “leverage bubble” but a sovereign debt bubble­ – the possibility that government debt instruments are wildly overvalued because they haven’t been priced to reflect the true probability of default.  And like any bubble, when it pops, it’s going to be a bitch; can you imagine the carnage when and if a government announces it’s only going to pay back X percent of the face value of its securities?  Or declare an interest-free holiday for itself?  People generally walk around thinking “well, that couldn’t happen” until the moment it does.  Think of the nanosecond in which Fannie and Freddie turned from makers of orderly markets to oceans of suck.  Now apply it to Treasuries.  Man.

With that said, and while fully cognizant of all the risks involved, I think that the world economy will most likely escape this trap, when all is said and done.  And I base that on a short list of factors.  For one, the political processes outside the United States are probably capable of dealing with the unrewarding task of fiscal retrenchment, particularly in Parliamentary systems that have greater continuity and discipline.  Second, my earlier remarks to the contrary, markets aren’t being caught by surprise as they were with mortgages and credit default swaps – investors are paying attention to sovereign debts, and the credit rating agencies, which screwed up royally last time, are both chastened and attentive.  The spreads among government instruments are responsive to new developments, and we’re probably beyond the point at which such a debt is regarded as “risk free.”

But even more importantly, to me, we live in a world bereft of inflation or inflationary pressure.  Pervasive technological change is reorganizing the world economy, and hundreds of millions of people, particularly in Asia and the former Soviet Bloc, are being integrated into it.  It is very hard to tell a convincing story about how costs – particularly wages – are going to rise to create overall price pressures, and resources such as oil are now far less important than they used to be in triggering economy-wide price changes – a dollar of GDP now takes about half the oil it did back when OPEC could bring the world to its knees.

This is important because the most rudimentary way to manage too large a stock of government debt is to print money to pay it back.  This is frowned on for two, interrelated reasons.  First, it causes inflation – you know the old saw, “inflation happens when too much money chases too few goods.”  Well, regardless of the universality of the proposition, too much money can lead to higher prices, so it bears watching.  Second, when debtors print money, their currency falls in value, which makes its foreign debts harder to pay (since your currency fell in value relative to the currency in which you have to repay), which perpetuates the loop.  But inflation is going to be hard to sustain in today’s world – I’m far more bothered by the prospects of deflation than inflation. 

And you can’t have a “run” on the dollar, or the Euro, or whatever else unless there’s something to run to, and there isn’t.  All of the “advanced” economic areas and their currencies have the same basic problem – too much debt, slow growth, aging populations, and so on.  You can’t abandon all of these currencies at once – where do you put the money?  Some might argue that it will end up in gold, but gold’s historic role as a way to store value when inflation east away the value of paper money.  Are investors really going to flock to gold when there’s no inflation on the horizon?  I doubt it.

So we have a historically old problem – governments taking on too much debt – in a radically new historical setting – a deflationary world environment.  That means we will have more latitude to manage economic growth and expand the supply of credit while trying to work out the overhang of government bonds around the world.  And it means that we can use monetary policy to keep the economy moving while we tighten on the fiscal reins.

But these circumstances also suggest one final economic policy item to me.  By next year, with the recovery underway and jobs back in the plus column, it would be very, very wise to raise taxes.  A well thought-out tax increase would show global investors that the U.S. was capable of overcoming its own bipolar lunatic fringe and acting responsibly, and that the dollar was still the safest place to be in a scary global economy.  Interest rates here would drop and stay low, investment would increase, and we would be better off.

The tax increases that were part of the Clinton budget package in 1993 were greeted with derision by those who claimed they would lead to a recession – and those critics included some in our own Administration.  I recall heated conversations in which the other side of the debate mocked the idea of “crowding in” – freeing up resources for better uses by cutting deficits.  But they lay the basis for a decade of growth.  The 2011 tax increase – and hopefully reform – would do the same.   It will be some very heavy lifting.  But it’s a better answer to our circumstances than more “what the ---.”

One For You, Nineteen For Me (II)

Don’t you just hate it when you’ve invested an hour in a television program that you know is waste of time in the first place, only to find out at the end of the hour that the program is TO BE CONTINUED?  I pulled this stunt last week, setting up some ideas about reforming the tax system, only to stop at the apogee of my orbit.

This week, I outline a proposal – using a broad brush to be sure, but it’s a beginning. 

Let’s start with this question; what is the right basis for the tax system?  There are any number of possibilities.  Income is a good one, as it represents material well-being.  But it poses two problems.  One is that when you tax it, you reduce the incentive to earn it, even if that idea has been carried to extremes in some corners.  Second, we have a system based on income, and it’s failed, due to the holes we’ve poked in, and the contorted definitions we’ve attached to it. 

Which takes us to consumption.  For one, consumption’s like income in that it’s a good measure of well-being.  Moreover, there are times when our incomes are lower than our consumption –as a student or in retirement – or vice versa – like when we’re saving in the peak earning years before retirement – which means that what we choose to spend might be a better measure of our long-term well-being than our actual income.

These aren’t the only two options.  Property is another.  But real estate is too volatile and limited a basis to run a tax system, and a broader tax on “wealth” may be attractive as a measure of who’s really got what, but we’re not there politically by a long shot.  And, to be technical, income and consumption are flows, while wealth is a stock – it requires us to tax someone’s wealth and then tax essentially the same wealth all over again next year?

There is also the idea that we should tax things that are “bad” -- carbon taxes, or taxes on cigarettes or transfats, for example?  We’d be better off if we had a tax on pernicious greenhouse gasses and used the proceeds to fund Social Security instead of the asinine, regressive, anti-employment payroll taxes we now deploy.  But, the problem is that these taxes are designed, if successful, to do away with themselves, which makes them a poor choice as a basis for financing the country. 

So, with all that said, there’s a strong argument for shifting the foundation of the system away from income towards consumption.  Of course, consumption taxes, such as the Value Added Tax used in many industrialized nations, are often criticized as being regressive, for the obvious reason that people with low incomes consume a higher share of their income than people with higher ones.  But this is not a reason not to consider them; it is a reason to implement them as part of a larger program.

That’s because of the advantages a consumption tax offers.  Taxing consumption reduces the incentive to spend and conversely induces saving.  And the broad incentives to save provided by a consumption-type (VAT) tax are far fairer and probably more effective than the archipelago of IRAs, special accounts, and other pinball gimmicks and features that give folks who generally already save a break for doing what they would have done anyway.  While the roots of saving are cultural as well as economic, these broad-based incentives stand a good chance of moving the needle on our saving rate.

Taxing consumption rather than income has other advantages.  Since consumption is usually more steady from year-to-year than is income, government receipts are steadier as well, and less prone to the stage of the business cycle we’re in.  And while fraud and circumvention are always going to be a part of the mix, they’re harder to carry out in the world of buying things than in the world of getting paid –  you can avoid income taxes by working for cash, but sooner or later, that cash must be spent.  No less an economic seer than Frank Zappa embraced them for that reason. 

But a consumption tax alone cannot be the entirety of the system, in large part due to fairness considerations.  For one, as stated, consumption is a declining share of income as one’s income rises – that much is inescapable.  A massive switch to a consumption tax would also be unfair to today’s retirees, who saved income when it was taxed, only to consume it when that became the tax basis. 

Moreover, it’s one thing to save, but it’s another to save without effort – some people may never consume all the income their assets generate.  There is a meaningful difference between someone who defers consumption through savings to finance their children’s education and their own health and retirement, and the well-to-do whose clipped coupons exceed their needs, or even desires.  A consumption tax, for such an individual, is a social license to steal.   

Given these realities, a consumption-based tax must be accompanied by two other components.  The first must be a relatively flat and very broad income tax with a very high personal exemption, which offsets some of the consumption tax burden.  Moreover, preserving the income tax in this fashion would provide a vehicle for maintaining some important and readily-justified features for the working poor.  For example, the Earned Income Tax Credit, child care credits, and other tax-based income support features for this group should be joined into a single, rebatable treatment and administered through the tax system.

And this system should be completed by maintaining an anti-dynastic inheritance tax.  Much has been made of the inequities of the “death tax,” but the inheritance tax has already been loosened aggressively in response to these concerns.  Moreover, the sorrowful stories of, for example, families forced to give up their farms in the face of an inheritance tax bill stemming from the passing of a parent turn out to be just that – stories.  It is very possible to imagine such a situation, but it is nigh on to impossible to find one. 

Adopting this three-legged stool of the income tax, a consumption tax, and an inheritance tax means abandoning many of the special and popular tax provisions referred to above.  The home mortgage interest deduction would be capped and phased out – simply going to the new system would reduce its importance.  (But the phase out must be long enough to allow the already weak housing market to stabilize.)  Special savings accounts would be unnecessary since all savings would go untaxed.  Employer health-care contributions would presumably be part of taxable income.  Income and all forms would be treated equally (partly because the rationale for their different treatments would be eliminated). 

And this system would also allow us to abandon the corporate income tax.  There is, however, a genuine double taxation problem in the code – the taxation of corporate income.  Think of it this way.  The newly-activated Supreme Court recently decided that corporations’ status as legal “people” entitled them to freedom of speech.  The counter-argument is that corporations are distinct entities only insofar as the corporate form defines the limited liability of shareholders, and that granting them “freedom of speech” extends their status as distinct entities beyond reasonableness.  But if progressives believe that argument, then they should question whether corporations should be taxed separately as well. 

Some (again, usually my fellow travelers) see the taxes paid by corporations as the price of the privilege of limited liability.  But there are ample opportunities, through a variety of judicial and regulatory means, to balance that privilege.  In fact, the corporate income tax simply taxes revenue as it makes a pit stop on its way to its ultimate destination, the stockholder.  There are any number of way abolish the double taxation of corporate income – the one favored here (for administrative simplicity) would tax corporate income before dividends were paid and then exempt those dividends from personal income.

Good ideas – such as these purport to be – are the bottom of the policy food chain.  Before the tax debate – or at least this round of it -- is over, people with far greater probity and credential than I have will issue important and well-reasoned reports in the hope that their ideas provide a benchmark in the policy process.  But those people know, as does everyone else, that calling on the system to enact good ideas because they are good is both naïve and futile. 

The question, then, is who will, should, or even could be the champion of such a newly designed system?  An informed and involved citizenry is always best, but let’s get serious.  The best answer may well be – the forward looking elements of the business community.  That’s because they are in a unique position to appreciate and understand how a better tax system leads to a better business environment.

Policies such as these determine to a great extent our nation’s competitiveness.  Our lattice-worked world economy has eliminated virtually every traditional source of “national” economic advantage – capital, technology, education, skill, and everything else can be accessed anywhere in the world if they are unavailable at home.  If any resource can travel anywhere, what makes a nation’s economic environment unique?

What remains “national” in this context is the environment in which these factors are integrated, and that environment includes among other factors, our system of corporate governance and finance, the culture of our business enterprises, the rationality of our regulatory system (including the questions of whether to regulate and how), and the economic policies we pursue.  Taxing and spending decisions are obviously a part of that: encouraging residential construction means discouraging other investments; requiring businesses to be responsible for providing health care will burden them when competing with those freed of that burden; and, most relevant to this case, if we run endless fiscal deficits and ask the people of the world to lend us their dollars, they will have fewer left over to buy our goods.

The business community is in a unique position to fathom this reality and the failings of the current tax system.  Moreover, a balanced approach to taxes can bring their interests and those of the “average American” far closer than before.  And business is in a similarly unique position to demand that the two political parties abandon their scorched earth tactics and come to Jesus on this issue.  One such group has already done so. 

There is a “center” in the tax debate.  The question is whether anyone will occupy that center when the debate takes place.

One For You, Nineteen For Me (I)

The health care debate was a walk in the park.

Don’t believe it?  The Bush tax cuts of 2001 expire at the end of this year, and if the accusations of death panels and socialism seemed excessive, as Al Jolson would have said, “You ain’t heard nothin’ yet.” 

Because taxes go even deeper into the woods of ideology and doctrine than health care did. 

The Bush tax cuts were passed in 2001 with a “sunset” provision that makes them expire at the end of this year; this was done to avoid accounting for them in long-term deficit calculations, while sardonically betting that no one would have the nerve to take them back.  Given the calamitous path of deficits since, this gaming was conspicuously wrong-headed. 

So now the issue of whether and in what form to extend these cuts must be joined amid the nation’s worst fiscal crisis in our lifetimes.

Even if we weren’t presented with the expiration of the Bush tax cuts, the time would still be ripe for a rewrite of the tax code.  By next year, the expansion will be well underway and employment will be in an extended climb back to something like normalcy.  The economic debate will have shifted from stimulating the economy and making credit effortless to secure to finding an “exit strategy” that avoids the widely-feared outcomes of goods and services inflation (overrated), hyperliquidity-driven asset bubbles (not so overrated), currency stampedes (oversold, at least for some while), and undue risk taking and profound moral hazard (a genuine concern so long as financial regulation goes unaddressed), and a return to greater systemic risk (ditto). 

Moreover, we should remember what Peter Peterson and other budget scolds have repeatedly warned – that we had a long-term fiscal crisis before the 2008-09 economic collapse.  The government’s contingent liabilities, when estimated before the current deficit projections, were already as large as all of American private wealth – they were already the equivalent of financial anti-matter capable of destroying any and all matter with which they came into contact – in this case, all the wealth our society has produced to this moment in history.  From that perspective, all the 2008-09 crisis and the response to it did was move this moment of financial conflagration up in time.

But as the tax debate gains traction, we will inevitably confront the reality that the tax system is broken beyond repair.  By “broken,” many mean “unpopular,” or “impenetrable,” but the situation is actually worse than that.  That is, our tax system is increasingly incapable of generating revenue, either effectively, or at all.

That is because the tax system is so shot through with holes as to be porous.  Irate critics from all political perspectives speak of “loopholes” for “special interests” and, however egregious these may sometimes be, the great bulk of the holes in the system were put there, and are kept there, with broad, bipartisan, and usually enthusiastic support.  Among them are:

• The home mortgage interest deduction, an unindicted co-conspirator in the 2000s boom and bust of the mortgage market, but which has nonetheless left the rate of American home ownership not appreciably different from other advanced nations that lack such a feature;
• The tax-deductibility of employer-provided health benefits (admirably put on the table in 2008 by candidate John McCain), which helps blind users to the cost of their care and surely pushes up insurance prices while counter-productively tying workers to particular employers and employments;
• The myriad of tax-privileged savings accounts – IRAs, Roth IRAs, 529 and 527 college plans, health savings accounts, education and training accounts, and others.  None deliver benefits as efficiently or as fairly as would be hoped; consider the audacity of telling a worker making $30,000 or $40,000 a year that a college or health savings account is the answer to the problem of limited access and affordability;
• The differential capital gains tax rate, which leads to a multi-billion dollar struggle by lawyers and accountants to redefine more highly-taxed “conventional” income as more lightly-taxed capital gains, much as early missionaries discovered that their native converts had  baptized their meat as “fish” and ate it on Friday.  Special capital gains treatment makes the tax code complicated if not bewildering, reduces its progressivity, and does much to change the form economic activity takes but little to change (positively) its absolute level.

The base of the current system, therefore, is so limited that it is incapable of delivering adequate quantities of revenue.  In fact, under the current arrangement, increasing tax rates to bring in more revenue would increase the desirability and importance of these features, as well as bolstering the political will to preserve and expand these features, making the system even worse. 

In short, the tax system is an old grey mare that ain’t what she used to be.  Its weakness begins at the ends and is spreading to the center.   Capital income is disappearing through capital gains treatment or is sheltered in special accounts.  Meanwhile, the zero-bracket, the Earned Income Tax Credit, and remaining progressivity all provide some (justifiable) relief to the working poor and the lowest strata of the middle class.  Thus, our tax code is rapidly devolving into a tax on the wages and salaries of the upper reaches on the middle class. 

And if the middle-class had any thoughts of escaping this burden, it finds its avenues of egress blocked by the Alternative Minimum Tax.  As many taxpayers learn each April, the AMT claws back a rising share of the total value of itemized deductions – principally the aforementioned mortgage interest deduction and the value of state and local income taxes paid.  It, therefore, falls primarily on families with big mortgages in high-tax states and localities – Good Morning, New York! – and thereby ensures that the burden of taxes falls not necessarily on those with the greatest income or wealth, but on this group.  What is even more galling is that, decades ago, when this feature first entered the code, the deductions it reined in were capital gains and the like, the beneficiaries of which were those who had a greater normative obligation to pay something.  But like the rest of the tax code, the AMT has been turned to train its guns on the middle class. 

Thus, even if we were to accept these the system as fair, it would be impossible to raise rates on this ever-shrinking base to levels remotely commensurate with the problems we confront.  As I recall Rudy Penner once casually but accurately saying in a CBO staff meeting coming on 25 years ago, “the more we ask the tax system to do, the less it will accomplish.”

And then, we would encounter the traditional sloganeering and shibboleths of both the left and right.  These merit review.

From the left, we start with the championship of tax-free accounts or special tax treatments regarding education, renewable energy, or what-have-you.  The goals are admirable, but the results are often not.  Expanded Pell Grants, for example, would give more money more transparently to needier students.  Direct spending on to support research, development, and demonstration in the use of renewable resources and carbon capture and sequestration -- and an effective cap-and-trade regime -- would provide a better and, ultimately, cheaper way for the renewable industry to gain scale, reduce costs, and make investments than substantial tax credits for homeowners for digging geothermal wells.  Forgiving taxes on employer health insurance drains away resources that could be used to create true universal coverage and health care security.  We have, in short, tried to morph unpopular spending increases into popular tax cuts, and it’s not working.

On the right, discourse about a “simpler” tax system is directly at odds with their advocacy of different treatment for different types of income, meaning capital income.  These differentials are the driving reason why the system is unduly complex and why its compliance costs are so large – because of the hordes of lawyers and accountants who area hired to explore, expand, and exploit these crevasses in the system.

The conservative analysis behind the different treatment of capital income deserves mention.  It holds that capital income, if taxed, would be subject to “double taxation.”  For example, consider a fellow who makes a dollar, saves a dime, and who earns a penny on that investment – taxing that penny, it is argued, would be “double taxation” because the source of that income – the dime saved – has already been taxed.

I don’t get it.  If the penny in this example results from saving rather than work, why should it escape the system?  Saving represents the foregoing of consumption, but work is the foregoing of leisure.  And if the goal is to let the fruit of saving go untaxed, how can we distinguish between saving and inheritance?  And what of the person who uses the dime to pay for a skill-building education and realizes more income as a result?  Why favor those who invest in one factor (capital) but not another (skill)? 

And despite claims that taxing the returns to saving deters saving itself, there is little convincing evidence that tax features affect the propensity to save the last dime of the income dollar; witness, for example, the strikingly low U.S. savings rate during the various (and significant) tax changes during the Clinton and George W. Bush years.

The greater concern is, and should be, the rate at which the dollar, not the penny, is taxed – the incentive we give people to work and earn, and to do what they want with what they get when they do.  And, again, not taxing the penny forces us to raise taxes on, and reduce the incentive to earn, the underlying dollar.

 Both the left and right, however, make some good points on tax system goals.  Let us all exhale deeply and attempt to acknowledge and concede these merits, whether promoted by our adversaries or not.

First, you cannot raise tax rates forever without interfering with the incentive to earn. The “Laffer Curve,” so fittingly first drawn on a cocktail napkin, has led to undue belittling of this reality.  But, there is truth in the premise that, as I once heard the late Jack Kemp say, “there is only so much blood you can squeeze from the turnip.”  But I don’t think this principle means that we should bribe the indolent rich to go back to work; it’s probably more important for second-earners in families, retired or semi-retired workers, people under the Social Security ceiling, and others for whom the rewards of additional work would be substantially taxed away.  Meaning it’s probably true to lower rates than higher ones.

Second, on the other side of the debate, we need a progressive income tax system.  The idea of one rate for all payers has a Steve Forbes-ian and Ayn Rand-ish sophistic virtue to it – it’s great if you think of it wholly out of context.  But it fails on all counts in the real world.  In fact, as basic as these institutions may be, the rich benefit disproportionately from the existence of a state that promotes security, the rule of law, and, most importantly, the protection of property using its monopoly franchise for sanctioned punishment.  And while interpersonal comparisons are odious, Engel’s Law and the principle of diminishing marginal utility tell economists that a tax of a given percentage disadvantages the rich much less than the poor.  So a “flat” tax can safely said to be, in reality, a regressive one – one that provides more benefit to the rich than the poor.

Third, “simplification” and a “reduced cost of compliance” can’t occur without purging the tax code of its special treatments.  It costs a great deal to administer the tax system not because taxpayers are compelled to pay preparers, but because some taxpayers choose to pay vast amounts to capitalize on the availability of these treatments, starting with the idea that one “kind” of income deserves a different status than does another.

Fourth, saving is a good thing.  In fact, it’s so good that its importance should be more than a pretext for favoring traditional savers (the rich and profit-earning entities), and most of our efforts to promote savings have disproportionately benefited these groups.  But saving is the vehicle through which we provide a higher standard of living to future generations, by putting away resources that finance investments that embody invention and innovation.  Moreover, if a society wishes to invest, it has to save – the alternative is to rely on foreign savers and to take on the debt-service obligations their lending entails, as well as to give the lender a voice in U.S. economic policy, as we have China.

I am as pessimistic as the next fellow about resolving all of this in anything remotely resembling a rational fashion.  But I am hopeful that we can have a discussion that lets a true center emerge in this debate, even if many lawmakers have little interest in coalescing around a center.  Unlike health care, there is a center in taxes, and it could be reached.

In my next entry, I’ll try to take these goals and criticisms and use them to construct a program that could allow both the Left and Right to see their handiwork in it.  Beware the pennies on your eyes!  Come back and let’s continue then.