Wednesday, April 22, 2009

Why the Income Tax is Bad

As I've explained in previous posts and in comments to previous posts, the federal government doesn't impose a tax to raise revenue per se. It does so to remove dollar financial wealth from the private sector, thereby curbing aggregate demand for goods and services. This dampens inflation and maintains the value of the dollar, which is important for economic stability and growth.

When discussing the efficacy of various tax systems, however, it is easier to speak in terms of tax revenue, and that's what I'll do here.

The vast majority of federal government revenue comes from the personal and corporate income tax. There have been proposals over the years to replace the income tax partially or completely with other types of taxes or revenue raising schemes. Other taxes that have been considered and used at various times and in various jurisdictions include import and/or export tariffs, head taxes, real estate taxes, personal property taxes, intangible property taxes, sales taxes, and value added taxes.

Below, I'll quickly run through the problems with our current tax system, most of which are unique to the income tax:

1) Income is difficult, perhaps impossible to define. Most people would agree that reimbursement for expenses, compensation for damages, money borrowed, return of money lent, return of capital on an equity investment, and de minimus gifts of goods and services should not be considered income for tax purposes. But if you try to craft rigorous rules that tax transfers of items of value between two entities and yet exclude the things that should not be considered income, you find loopholes and unintended consequences everywhere.

2) Because of (1) above, the income tax code is horribly complex and the cost of compliance is outrageous; estimates as high as 5-10% of GDP have been posited for the annual burden/cost of compliance; when one thinks about the brainpower dedicated to finding loopholes in the tax code as well as trying to close them and litigating them, it almost makes one despair.

3) The complexity leads to law-abiding citizens running afoul of the law by accident or because of the malice of government officials; just as damaging, the complexity tempts normally law-abiding citizens to become scofflaws, a slippery slope which probably undermines respect for the law in general;

4) The income tax is necessarily very intrusive; citizens must divulge to the state very personal details about their businesses, their investments, their families, and their spending and giving habits; the income tax strengthens the state vis a vis the individual and makes oppression far more likely;

5) From a purely economic perspective, there can be nothing worse than discouraging work and production, but that's what the income tax does, particularly a progressive income tax;

6) In addition to (5) above, the tax code can also motivate an individual or company to enter into inefficient transactions in order to maximize after-tax income, rather than pre-tax income.

7) The income tax is relatively inefficient because it is very easy to hide income; also, it is hard to predict how much revenue will be raised from an increase in the tax rate because the incentive to hide or shield income (or not to work at all) increases as the tax rate increases.

8) Because of the intrusion of the income tax into all aspects of the economy, it is tempting for lawmakers to use the income tax to encourage socially desirable behavior and discourage socially harmful behavior; as pointed out in (1) above, however, the complexity of taxing income makes the risk of harmful unintended consequences very high.

9) Since the time of the New Deal, taxes have been used to redistribute wealth from rich to poor; whether or not one believes the government should be redistributing wealth, income taxes are a bad way to do it; income -- particularly, taxable income -- is not a good measure of a person's wealth; some rich people have low incomes, and some not so rich people have high incomes; an income tax just taxes those who are the most productive, not those who have the most wealth (a wealth tax would be better), or those who use the most resources (a sales tax would be better).

Friday, April 10, 2009

Hennessey's Blog and Netting of Govt Assets Against Debt

Keith Hennessey was a senior White House economic advisor to President Bush. He recently started a very interesting and informative blog. On Wednesday, he discussed (and disagreed with) Budget Director Peter Orszag's claim that the effective government debt is smaller than the reported number because the government owns a sizable amount of assets that should be netted against that debt.

I've enjoyed Hennessey's blog, but he appears to be confused about the way a fiat currency system works. I don't think he's alone among top government economists. For starters, Hennessey refers to Treasury bonds as IOUs which need to be redeemed in cash, which he seems to imply is something tangible.

It is not only Treasury bonds that are IOUs, of course, but money itself. A little green piece of paper with Benjamin Franklin's picture on it is nothing more and nothing less than a government IOU. When the government redeems Treasury bonds, it is simply replacing an interest-bearing IOU (barely interest-bearing, in the case of short-term T-bills today) with a non-interest bearing IOU.

In the UK they are somewhat more explicit about the credit-based, fiat monetary system there. The 5 pound notes read "I promise to pay the bearer on demand the sum of 5 pounds." The "I" refers to the Bank of England, and if you take the note to the Bank, they will indeed exchange it for 5 pounds -- either another 5 pound note or a handful of smaller notes and coins which add up to 5 pounds.

The point is that a dollar, whether it is green or electronic, is an IOU of the United States government, where the government is somewhat vague about what it in fact owes the holder. The IOU is imbued with value by two things: 1) the willingness of the government to provide some real goods and services in exchange for those IOUs ; and more importantly, 2) the government's demand that certain people pay IOUs back to the government in exchange for staying out of jail (i.e. taxation). These two things create demand for government IOUs and make them valuable.

The government, of course, can create as many IOUs as it wants. Sometimes it does it in the form of interest-bearing Treasury bills, notes, or bonds, and sometimes it does it in the form of non-interest bearing numbers in a reserve account at the Fed (i.e. cash). Actually, sometimes it does it in the form of a promise to pay pension and medical benefits in the future (e.g. Social Security and Medicare), but that is a discussion for another time.

Of course, there is a practical limitation on how many IOUs the government can create before inflation becomes a problem. Inflation can be mitigated by tempting people to exchange some of their non-interest bearing IOUs for interest-bearing ones (whether Treasury bonds or deposits at the Fed) which can't be spent easily. The Fed does this by offering a higher interest rate on overnight repurchase agreements, thus reducing aggregate demand for real goods and services by incentivizing people to save rather than spend. But if the government continues to create IOUs much faster than nominal GDP is growing, it is inevitable that the IOUs will depreciate against the value of real goods and services, and we will have destabilizing inflation.

With all of that said, I'll address two points that Hennessey made with which I strongly disagree. First, he disparages Orszag's idea of netting out assets of the government with the outstanding stock of IOUs. Looking at the assets of the government as being available to pay claims, i.e. to pay off and extinguish IOUs, netting is certainly appropriate to some degree because the assets help to maintain the value (real and perceived) of the IOUs backed by the government. In the case of financial assets, particularly relatively liquid, relatively short-term assets which actually spin off cash flows, the fungibility with IOUs is apparent. Financial assets should clearly be netted, although the financial assets do need to be valued appropriately (i.e. not anywhere near face value).

Second, Hennessey claims that when the government borrows to buy financial assets there is a "crowding out" effect. This is pure rubbish. There is no such thing as "crowding out" due to the issuance of Treasury bonds, whether it was done to offset government spending, investing, or tax cuts. For every dollar the Treasury receives from the issuance of Treasury bonds, a dollar is sent back to the private sector, by definition. Net IOUs remains the same.

The fallacy embedded in Hennessey's Alan I. Gorp example is that Alan would have the $100. Alan either spends that $100, pays down his own bank debt with it, or deposits it in a savings account at another bank. As long as Alan doesn't put the money under his mattress, it ends up at a bank. If the money did end up under a mattress, then the Fed could inject (i.e. create) an extra $100 into the banking system without spurring inflation.

Expanding the example back to the government level, we see that if the government issues $1T of bonds to pay for $1T of so-called toxic assets, the next effect is that the private sector in aggregate has received $1T of low-interest government IOUs in exchange for $1T of toxic assets. No doubt this would make the private sector a lot more confident about the creditworthiness of financial intermediaries and counterparties. It would also provide $1T of good assets that could be used to collateralize lending. I'm not saying such a swap is the right thing to do, but it certainly would spur investment and aggregate demand, rather than "crowd" it out.

The only way for the government to starve the private sector of investment funds is to run a budget surplus. This removes IOUs from the system, thus reducing aggregate net financial wealth. The reduction in aggregate net financial wealth would tend to reduce aggregate demand and be disinflationary/deflationary.

Sunday, April 5, 2009

Government Spending and Other People's Money

A friend told me recently that Milton Friedman divided spending into four categories:

1) spending your own money on yourself;

2) spending your own money on other people (e.g. a gift);

3) spending other people's money on yourself (e.g. using a corporate expense account);

4) spending other people's money on other people (e.g. spending by government bureaucrats).

The first kind of spending is the most efficient. Since you are presumably aware of what you want, you will purchase goods and services which will make you happy. Since it is your own money you are spending, you will be careful about not over-paying.

The second kind of spending is certainly less efficient. To some extent you are guessing at what the needs of the "other people" are, and you are certainly not going to be privy to their utility function. It's your money you're spending, so you may try to spend wisely and not over-pay, but sometimes -- particularly if it's a gift -- paying above a certain amount of money is part of your goal. There is a lot of evidence that gift items (e.g. a bottle of perfume) will not sell at all if priced too cheaply. We've all had that experience. You see a great gift for $20, but decide not to get it because it's not expensive enough. If the same gift were $50, it would be perfect.

The third kind of spending is also less efficient than the first. You end up spending the money on things you need and desire, but you are less concerned with price. You end up buying things that you wouldn't if you had to use your own money. At least you know that the purchases will be enjoyed and thus not be a total waste. Furthermore, there is at least some incentive to keep costs down, since you will look greedy to other people if you spend too wildly.

The fourth kind of spending is the least efficient of all. You have all of the problems of both the second and third type of spending without any of the mitigating factors. Because you're spending money on other people and not yourself, you really don't have to worry about looking greedy if you spend too much.

Often there is a perverse incentive to overspend because a key metric used to gauge success is the amount of money allocated. How many times have you heard a politician boast about how much money he allocated for this or that project? You certainly never hear of a congressman boasting that he got $100MM for building a highway in his state but was able to cut costs and return $20MM to the federal government.

And the government bureaucracy is even more perversely incentivized. I've worked in a government research laboratory where at the end of the fiscal year we frantically spent any remaining money in our budget because if it wasn't all spent, we would be allocated less money the next year.

Milton Friedman's succinct categorization makes it clear why government spending should be minimized. If the solution to today's economic problems lies in the government getting more money into the private sector, it should be accomplished by tax cuts and/or transfer payments, not government projects.