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Monday, October 11, 2010

Basics of tax policy/ "Explain it to me like I'm a 3rd grader"

     In the movie "Philadelphia", the lawyer character played by Denzel Washington had great success asking opposing witnesses to "explain it to me like I'm a third grader".  Needless to say, they really couldn't, and the tactic was very effective.  I've found that it is frequently very helpful to go back to simple, basic issues when trying to analyze what to do in a situation.  It may not give you the answer; the answer may not be simple.  However, it often really does help define what the questions are.

So, let's start with (and beat to death) a third grade analogy which may be useful in analyzing tax policy:  The Goose (in this case Geese) Who Laid the Golden Egg(s).

In our example, the Geese are the citizens and businesses of the United States (The analogy can be used with any level of government, but let's just use the Federal Government here).  The Farmer (or Geese Herder or whatever) is our Government.  The Geese are all capable of laying Golden Eggs (creating wealth).  Some lay more Golden Eggs; some less; some bigger eggs; some smaller.  Individual output of particular Geese may change over time and some Geese (old, sickly or "other") may not lay any Golden Eggs at all.

The Farmer's primary goal is to take care of the Geese and to make sure they thrive and prosper as a group.  To do this, the Farmer has to take some of the Golden Eggs to pay for certain expenses;  some of these expenses may be for guard dogs to protect the Goose House from predators, for repairs to the Goose House, for feed, and for veterinary bills. (The analogy stretches here because these particular Geese can, at least in theory, take their own Golden Eggs and go out and buy stuff for themselves) The Farmer, of course, also has to take enough Golden Eggs to provide shelter for himself and his family.

Now, at least with our citizens (as opposed to real geese), there is a great deal of debate about what the Farmer should pay for himself and for the Geese and what the Geese should be responsible for paying for themselves.  However, everyone appears to agree that there are some things that should be paid for by the Farmer (Government).  We disagree as to how much and for what, but I have yet to hear a serious politician call for a total abolition of the Federal Government.

OK, so we are agreed that the farmer needs income to pay for whatever common expenses we determine to be appropriate.  In our example, the Farmer's only source of income is the Golden Eggs.  So, for a long time, the Farmer has taken a share of the Golden Eggs.   How much the Farmer has taken and from which Goose or Geese has changed over time, as has the type and nature of the "common expenses" the Farmer pays for.  There has been, still is, and always will be differences of opinion among the Geese themselves (who by the way, elect the Farmer) and the Farmer as to how much should be collected, from whom, and how it should be spent.  But to emphasize, all the Geese agree that the Farmer has to get some share of the Golden Eggs. 

Oh, and in our example, the Farmer (and therefore the Geese) has gone into serious debt.  He has put expenses (be they for Guard Dogs, feed, whatever) on the Farm's credit cards, and the Farm must pay interest.  Everyone agrees that too much debt is a bad thing and that the Farm cannot continue to increase its debt (as a percentage of its total output), at least over the long haul.

[See, we actually agree on some basic stuff]

In theory, at least, we can also agree on the Farmer's primary theoretical goals.  He likes his Geese.  He wants them to be happy.(either he's principled or wants to be reelected or both)  And one major factor in their happiness is usually tied to how many Golden Eggs a particular Goose has at the end of the day  - to get whatever other "stuff" it wants.  The Geese have lots of motivations (generally, they'd like to see the other Geese do well for various reasons), but a big motivator is to have more Golden Eggs. [Yet another thing on which I think we can all agree]

Ok, let's start getting to Tax Policy.  Most of the Geese also agree that the Farmer probably needs to take in more Golden Eggs, at least in the short to medium term,whether to buy more birdseed, get new and better Guard Dogs, or just to pay down those big credit card balances. (Some of the Geese believe that the Farmer can pay down the credit card bills without taking in more Golden Eggs in the short or medium term;  I think that those Geese are too "into" fairy tales)

The obvious solution is for the Farmer just to take a bigger percentage of the Golden Eggs.  How much and from which Geese can be debated, but taking a bigger share of the Golden Eggs will increase the income taken in by the Farmer, but only if doing so does not reduce the total output of Golden Eggs.

Remember , individual Geese are motivted by the prospect of more Golden Eggs for themselves, and to use an extreme example, if the Farmer takes all of the Golden Eggs, the Geese may completely stop laying Golden Eggs and both they and the Farmer will have nothing.

So one goal here is to get more Golden Eggs to the Farmer (at least for now), but to do so in a manner which will not reduce the motivation of the Geese.  That's easy, you say;  do something to motivate the Geese to lay more Golden Eggs!  Well another thing we can all agree on is that this would be a great thing!  The Geese would like more Eggs; the Farmer would like to keep the Geese happy.  If there are more Golden Eggs, everyone, probably even the Farmer, will have more.

So we all all share two goals:  1)get more money to the Farmer, at least in the short or medium term, either for "programs" or to pay down the credit card bills, and 2)increase the output of Golden Eggs in the long as well as short term.

Furthermore, I think that most of agree that the really important goal is the second one - we can fight about how to divide up the Golden Eggs, but only if they exist.  [Why capitalism seems to work better than anything else we've come up with so far].

This, unfortuately, is where we leave the Fairy Tale of mutual agreement and get into the realm of real disagreements aboout how to accomplish these goals through tax policy.  Even more unfortunately, this is where we seem to have wound up in a Land of Competing Fairy Tales, or at least very wishful thinking. The conservatives want to cut taxes; the liberals want to not cut services.  Unfortunately neither we nor the Farmer has the money to do both (or maybe either).   

The First, and, in my view, most dangerous, Fairy Tale is called the Laffer Curve.  It assumes that if we reduce the percentage of Golden Eggs we take from Geese, particularly the rich ones,  the Geese, now able to keep more of their Golden Eggs, will increase their production of Eggs to such an extent that, even given a lower percentage of the total output, the Farmer will get more Golden Eggs.  What a wonderful idea!  Gain, but with no pain!  Everyone gets richer. ["And, if elected, I'll make sure that there are two chickens in every pot!"] Unfortunately, attempts to increase production this way don't really seem to work well, for a variety of complex reasons.  It is almost certain that various targeted tax cuts or breaks may increase output, but an across the board income tax cut,  sorry Charlie, but that's not how the historical data looks to me. [Modification/correction:  At the suggestion of a reader, I looked again at the Laffer Curve, and realized that I misspoke.  I conflated the concept of the Curve itself with the idea of it being used as a justification for lowering tax rates as a means of increasing tax revenue.  The Laffer Curve is based on what seem like intuitively obvious assumptions.  While it still appears overly simplistic, the concept that taking a higher percentage of income as taxes will reduce motivation of taxpayers to create income is sound.  The problem is that the existence of this principle is used a a justification to cut taxes and somehow decrease the deficit.  The truth of that assertion would depend on the specific marginal tax rate which would represent the "tipping point" of the curve.  Most economists today believe that that "tipping point" is somewhere between 60% and 70%.  Current and proposed top marginal tax rates are between 30% and 40%.  Thus, reducing taxes will almost certainly increase the deficit, unless that reduction significantly and quickly gives the economy a big boost.  Therein lies the fairy tale.]  Moreover, if implementation of this Fairy Tale does not increase production, what it absolutely will do is cut the revenue of the Farmer (Government).  He will get a lower precentage of the same or lesser total of Golden Eggs.  This is exactly what has occurred recently.  Please compare the growth rates in the slightly higher tax rate Clinton years with those of the Bush years.  Compare them both with the growth and top income tax rates of 1946-55.  So the Laffer Curve is disasterous for Goal 1), while simply not helping Goal 2).

The Second Fairy Tale [sorry, fellow liberals] is that increased Government spending, as a general rule, while ignoring the increasing deficit ,will "kick start" Golden Egg Production by all of us private sector Geese.  Frankly, I am less sure about my negative reaction about this one.  Certainly, there is a lot of historical evidence for Keynsian economics as a whole.  I do think that there is certain Government spending that will help the economy.  I think that the measures that have been taken, such TARP and the Stimulus, while seriously flawed, have essentially kept the economy from disintigrating.  However, I also think that the deficit is a real and immediate problem, and that for reasons of public confidence if nothing else, we have to start taking a serious run at reducing it.  This would mean cutting programs, some good, some not-so-good, which do not have a fairly direct and positive impact on the overall economy.  I do not buy the argument that just "putting money in people's pockets" necessarily has a good effect on the economy, any more than I buy the conservative "keeping money in people's pockets by reducing taxes" has a good effect on the economy.  Both seem to be excuses for us to simply continue living beyond our means;  generally the conservatives want to make sure the richer people keep their  money, and the liberals want to make sure the less-well-off  have "enough" money or services.  I don't think we can really afford either one. [I am well aware that there are social policies/arguments on all sides of both of these questions;  but this Post deals with what I believe are economic realities, and both sides are trying to pretend that their social goals are somehow automatically going to have good economic results.]  Like I said, Fairy Tales.

Essentially, we have to put our collective money where it will do the most good in terms of attempting to increase Golden Egg production.  Lowering income tax rates across the board is, frankly, insane, given the desirability of both some targeted stimulus and of holding the deficit in check.  Even if one does not want any stimulus spendng, lowering taxes is almost guaranteed to increase the deficit, not reduce it.  I think we actually probably need to raise taxes.  Spending, without worrying about the deficit, also strikes me as an unrealistic way to say that we can avoid pain, at least now.  We are going to have to make cuts in some  programs - maybe unemployment or Head Start or even- Social Security or Medicaire [gasp]

Bad news, guys (and girls).  Times are bad, for lots of reasons.  And, as much as the politicians would like to make sure that their particular constituences are not hurt, if we do it right it's going to involve some pain for all of us. We can no longer afford the simplistic and, well, stupid, thinking that either Government spending or taxes are, as a general matter, "good" or "bad" for the economy.   No one wants to raise taxes.  No one really [even the Republicans] wants to cut the big ticket Government programs.  Fairy Tales are nice, but too many of us are still acting like children, and greedy children at that.  Enough.

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