A Simple Discussion on Deductions and Exemptions

As someone who works in the tax policy field, I understand where the frustration comes from when people look at the massive schedules of deductions available to both individual taxpayers and businesses.  As such, since tax code simplification is a popular subject these days, some just throw up their hands and say, "Get rid of them all and tax every dollar of income!".  It's an emotionally appealing argument in times like this, but let's remember some theoretical bases behind why we set up the tax code the way we did.

First, I would like to remind people of how businesses are taxed in this country.  Except in a few states where either gross receipts taxes or some form of value added tax exist, businesses are taxed on their net income.  Net income is a defined term that doesn't correlate with cash flow, except in some cases by accident.  For tax purposes, it is the business' gross receipts - deductions for various expenses or bonus deductions for certain activities.  As a general rule, though, the idea is to impose a tax on what is available to the business after it has paid for all of its normal operations.  Businesses not keeping their heads above water don't play taxes.

The same principal is applied in a different way to individuals.  Individuals do not have a "net income" as we commonly understand it.  Individuals have a great deal of latitude in how to incur expenses and pretty much anyone can expand their expenses to fit any income.  However, there are certain minimums that people can't go below and this is the basis of the baseline deductions and exemptions.  A certain amount of income will not be subject to tax in order to allow individuals to pay for baseline expenses without having to pay taxes.  This is to avoid taxing beyond their ability to actually pay their bills.  The effect is to try to create a parallel to business net income for individuals and in so doing not taxing them beyond their ability to pay.

I would be the first to admit that we have far too many specialized deductions and credits that serve very particular interests or that have outlived their usefulness, but to simply rid the tax code of deductions and exemptions is not the answer.  It doesn't even make good theoretical sense.  The reason that more and more people are falling of the tax rolls is because the indexing of exemptions and deductions continues to push people with stagnant nominal incomes below zero taxable income. What this reflects is that the cost of living is accelerating faster than their ability to pay.  Simply deciding to redefine the boundaries of the tax system to have those people pay more in taxes doesn't seem to make logical sense.

Tax Equity Turned on Its Head

There's been a reasonably common theme recently that low income Americans pay so very little tax compared to wealthy Americans that it's unfair to wealthy Americans.  Hell, Rick Perry even basically argued that the fact that 50% of Americans do not pay the federal individual income tax is a great sin.  This discussion seems to have melded into a single line of "Half of Americans aren't paying any taxes".  What some have suggested is slashing and burning the individual income tax deductions, exemptions and credits to make marginal rates more closely resemble effective rates, and this would be the revenue raising tax reform that might emerge from the deficit debate.

On the face of it, this argument has appeal, as does the flat tax argument.  Everyone pays the same percentage on all of their income.  It has a visceral effect on most people that hear it.  Without thinking anything more, it will tickle their hearts and their guts with a warm sense of justice.  No games or adjustments, just a single rate.

Well, first off, I think that one does have to look at the entirety of the tax system in the United States, from local taxes all the way up the spectrum.  After all, higher levels of government provide significant support to lower levels of government.  The federal government provides significant support to state governments in the form of Medicaid, child welfare, transportation, and environmental expenditures in particular.  State governments in turn provide significant aid to their local governments in the form of school aid and aids to counties and municipalities.  In 2008, state governments got close to $450 billion of their $1.6 trillion in intergovernmental revenue while local governments got $524 billion out of $1.5 trillion of their revenue from intergovernmental revenue.  However, excluding the state transfers to the locals, one can look at the Feds as giving $481 billion to both state and local governments together, or just shy of 1/5th of all state and local revenues.

As such, one must look at the entirety of public finance.  If you look at the whole thing, one must include not only federal income tax, but state income taxes, state sales taxes, local property taxes and even user fees.  Use fees and charges brought in $373 billion at the state and local level in 2008 and thus pay for a substantial portion of government services.  All of the state and local level taxes are, at best, a wash in terms of progressivity.  User fees are quite regressive as are gasoline taxes and other excise taxes as they do not discount their costs at all on ability to pay.  Taken together, the state and local side of public finance certainly does not spare the poor and the middle class from paying "their share".

Then let us move on to the federal level.  Here, FICA taxes bring in nearly as much as individual income taxes these days and most of that burden is borne by people earning less than $75k a year.  Indeed, with FICA the effective tax rates are higher on low income earners than they are on high income earners (those making more than $106,800) due to the wage cap on Social Security taxes.

I am not arguing that the tax system overall is not progressive, though the favorable rates of taxation on capital gains and dividends (both presently taxed at 15% regardless of income levels for long-term capital gains and qualified dividends) make the federal side slightly less progressive than it first appears. Except at the very high end, effective tax rates, all things being included, do tend to rise with income, but it isn't as simple as just looking at individual income taxes at the federal level.

Leaving all of that aside for the moment, let's just look at the individual income tax, which seems to be the focus at this time. The primary concern seems to be that low income earners, those earning less than $35,000 a year in particular, have it particularly easy as they pay anywhere between little and no tax, or even get a refund due to the child tax credit and the EITC. Coupled with deductions and exemptions, these credits mean that taxpayers up to a fairly high threshold will not pay taxes.

Working through the exercise, for a married couple the present standard deduction is $11,600. On top of that, there are exemptions of $3,700 per family member. Let's say that they have two kids, so a total of four times $3,700 for $14,800. Taking that together, $26,400 of this hypothetical family's income is not subject to federal income tax. If they have a total income of $40,000 (pretty typical), they will only have taxable income of $13,600. On this, a 10% tax rate is applied, or $1,360. However, the combination of the EITC, of which they would get a small amount, plus the child tax credit, will eliminate their federal income tax liability. Somehow, this is supposed to be a scandal. Some would look at the exemptions and standard deduction (and deductions more generally) and say "Well, there's the problem! Just get rid of those! We'd get a lot more tax revenue."

However, let's think for a moment why the exemptions and deductions are there. The idea is to shield a certain amount of income from taxation to cover certain basic expenditures.  For instance, why is there a $3,700 increase in exemptions per person on a return?  Well, it's an amount that correlates fairly closely with the increase in the poverty line per additional child, the idea being that a child will increase your baseline expenditures by about that much.  It seems reasonable to exclude that from tax.  As much as people pretend (hopefully they are pretending) not to understand the rational for the basic exemptions and deductions, there is a reason that they are there.  It simply costs a certain amount to just barely get by and a great many households are at or below that point.  As such, subjecting them to a flat tax of, say, 15%, on ALL of their income would dramatically increase their living costs ($6,000 in the example I used).

Using a 15% flat rate on all income as an example, a household with $40,000 a year in total income would pay $6,000 in federal income taxes while a household with income of $200,000 would pay $30,000.  Needless to say, the household with the $170,000 after tax is much better able to bear the burden.  As much as a flat percentage appears to be fair, it really isn't.  The tax code should be based on ability to pay.

This gets to a point I always try to make. Yes, it is true that the richest ten percent have 33.5% of the income and pay 45.1% of taxes. Similarly, filers with more than $1 million in adjusted gross income have 10% of AGI, but pay 20% of taxes. However, if you look at the share of income beyond that needed to cover basic living expenditures, those numbers are a good deal different. Then, when you look at the totality of U.S. public finance, including user fees and state and local taxes, these numbers become more regressive.

The simple point is that taking the burden that the wealthy pay and shifting it downscale to even out the tax burden as a percent of income by "simplifying" the tax code does not improve tax equity. As much as it appeals to a primal sense of fairness for everyone to pay the same percentage of all of their income and not have deductions and exemptions, things would get materially worse for them.  While an additional 10% on someone earning more than $300,000 hurts, it is not fatal.  An additional 10% on someone earning $40,000 could be devastating.

While the theoretical examples that I used here are simply that, "theoretical", the argument that we need to broaden the base and lower the rates generally means subjecting more of the total amount of income to tax, which seems to mean hitting lower income earners.  It could theoretically mean subjecting capital gains and dividend income to the same tax rate as earned income under a progressive system, but that doesn't seem to be the argument holding sway right now.  People seem to be buying into a tax equity argument that has been turned on its head.

Some thoughts on the debt ceiling debate

So, it would appear that the stage is set for some significant retrenchments in federal government expenditures. It's hard to say what spending categories will see the hammer fall the hardest, but aid to state and local governments is a likely category. It's also somewhat troubling as state and local governments have already been hit quite hard by the lag effect of the recession:

In fact, it really should be little wonder that the economy has run into such turbulence of late. The retrenchment in state and local spending appears to be accelerating at a time when private sector demand is not exactly robust either. In particular, local governments have been laying off workers at a steady and alarming rate as you can see in the graph below. Some 400,000 and the rate is only accelerating now. A few items are causing this. One is the growing loss of state aids to local governments. State aids to school districts and municipalities are one of the largest expenditure items for state governments, usually comprising a plurality or even a majority of their general fund budget. They are also one of the easiest items to cut compared to corrections or medicaid, the other two huge items in a state's general fund budget. The other factor hitting them now is a squeeze on their own revenue sources, particularly those with sales and income taxes. While those sources are turning up, there is a lag effect.

State governments, too, have been laying off:

Slightly over 100,000 jobs lost in state governments since their most recent high. Furthermore, automatic pay raises have been delayed and pay has even been cut in some cases. As real incomes have stagnated or declined, so too has real expenditures by government workers.

I would like to take this time to remind people of something regarding the analogy between households and government. People often like to say that government should behave more like a household in lean times and cut back when its revenues decline. That's all well and good, but I would feel constrained to remind them of the simple fact that there is an effect there. After all, when a household cuts back to bring its costs in line so that they can service their debt burden, their standard of living tends to decline. The family's does not become wealthier. When everyone does the same thing, the total level of spending in the economy declines. The same holds true for government. When it withdraws, there will be fewer services, fewer jobs, and fewer expenditures to businesses who provide services to the government. This will cause a decline in overall spending and employment. None of this should be earth-shattering. It was all laid out in the General Theory by John Maynard Keynes.

Indeed, government should not behave as households do, with  the common household's tendency to leverage up rising incomes in the good times while slashing and burning when incomes decline in recessions. All that does is exacerbate to underlying economic cycle by strengthening the booms and deepening the busts. If, instead, the federal government tries to keep a basic underlying level of growing spending and employment (whatever is deemed politically desirable) that uses the ability to borrow to smooth out its consumption, the procyclical effects of following the typical household's pattern can be avoided.

This logically follows from another perspective, which is that most government services either do not really vary with economic conditions such as education, infrastructure repairs, and basic bureaucratic licensing and oversight functions, or they tend to become more strained in lean periods, such as with UI benefits, TANF, and Medicaid. The former group a basic baseline level of expenditures that really should remain fairly stable and not be whipped around. The latter group is vital and designed to avoid destitution due to the various spasms of the business cycle. To have either following the pattern of the business cycle is nonsensical.

Furthermore, the argument that a reduction in government expenditures and employment will benefit the private sector is highly dubious at this particular moment. If interest rates were phenomenally high due to fears of a debt default, this might make sense. The mechanism there would be that a firm deal to reduce deficits would soothe markets, reduce interest rates, and thereby increase the affordability of capital, which has numerous positive benefits. However, this condition is not currently present. That interest rates continue to be as low as they are is indicative of capital not finding many productive outlets for investment. As such, that avenue is not open to us.

Another argument would be that we could reduce taxes on the private sector if only we could get government expenditures down, which would be stimulative. Due to the magnitude of the present deficit, that is not really an option. It's also a questionable proposition that reducing taxes and government expenditures at the same time produces a net positive economic effect as most evidence appears to support the opposite conclusion, but I'll just do a little bit of hand-waving on that one for now.

Then, we turn to the argument that business confidence would be substantially improved if there was greater clarity on the long-term trend in the deficit, public expenditures, and tax rates. To be perfectly honest, there is probably just about nothing to this argument. Very few businesses cite the long-term finances of the federal government as a factor in their decision-making. "Uncertainty" can, of course, have an effect as it did to some extent in the fall of 2008 when the solvency of major financial institutions was in question. Speaking for myself, I know a pulled in a little bit when all of that was going on, though largely so that I would have more capital to deploy for the buying opportunities to come. Furthermore, the evidence that the bulk of consumers and businesses take into account their future expected tax burdens when making decisions in the present is extraordinarily weak. There might be some marginal players on the fringes of society who do, but as a mainstream proposition, I very much doubt it.

Much more likely, consumers have continued to hold back on house purchases due to persistently declining prices. I know I have made my decision not to buy a house on that very proposition, though the rate of decline has slowed enough I am starting to consider it. This persistent drag has caused consumer spending to remain very modest as well as stunting growth in spending on new houses, which in turn is depriving businesses of the revenue growth that they need to "feel confident". There are other contributors as well, such as corporations and even small businesses that had relied on a steady flow of credit who had brushes with death in late 2008 and early 2009 deleveraging their balance sheets and accumulating cash to provide more certainty in a financial crisis. Very little of this has a whole lot to do with the federal government's financial position. Furthermore, if there is a stifling effect of government spending just being there, it would stand to reason that our economic performance would be improving rather than deteriorating as state and local governments, which account for the vast bulk of government employment and direct expenditures, have retrenched.

So, what does all of that lead to? Well, the basic structure of any grand deal would hopefully take all of the empirical and theoretical argumentation against what we seem to be careening toward. Rapid reductions in federal government expenditures to quickly close the deficit would likely derail the economy, particularly when joined with substantial contractions in state and local government expenditures, which cannot be avoided due to balanced budget requirements in the states. Further, there is no avenue by which this would benefit private sector activity at the moment. As such, it might make sense to enter into a long-term package to bring expenditures in certain categories down and taxes up, but in the short run the focus should be on continued stimulus. The general agreement should be that the stimulus not be removed until such time as the economy is on a solid footing. At that point, hopefully, we can abandon any talk of adopting the common household's approach to budgeting and instead engage in true counter-cyclical fiscal policies.

If there is some moral necessity that commands us to reduce the deficit, then so be it. However, policymakers should not delude themselves into believing that we will somehow see an economic boom due to that satisfaction of some moral need to have balanced books. If they proceed under that belief, the economic outlook will become considerably dimmer. 

Do Economic Growth Incentives Pay For Themselves?

As someone who works in public finance, I often get asked outside of my job a number of questions similar to the title of this post. Recently, I negatively commented on tax incentives given out by the state of Kentucky to build a young-earth creationist theme park. I had two basic objections. One was that I thought it promoted an unscientific view of the world, which is ironic since the state spends so much money attempting to property educate its young people in the public school system in the ways of science. The other is another point, which is the primary focus of this discussion, centering on whether or not this use of tax incentives is appropriate from a public finance perspective. Advocates of these sorts of projects almost invariably say, "Oh, but it will pay for itself.". Republicans do the same thing with tax cuts more generally while Democrats do it with transportation infrastructure and education.

Since this is such a common phenomenon, let's actually work through the math and see if it works out. First, let's confront the basic constraint, which any project or tax break must contend with: the basic laws of mathematics. Taxes, particularly on the state and local level, only capture a small fraction of economic activity. Let's be generous at the federal level and say that the government current collects 20% of GDP in taxes. It doesn't, but let's just say that it does. This means that, in a single year, for every dollars you cut taxes or increase spending, it has to produce $5 in order to recoup its cost. At the state level, it's even worse than that. Because states typically collect in the mid-high single digit percentages of tax revenue as a percent of GDP, let's pick 7% for the sake of argument, it has to generate a whopping $14 of new economic activity for each dollar forgone in revenues or increased expenditures.

Now, you might say, "Aha! But what about the later years as well?". Fair enough. Let's work through that exercise, remembering that we have to discount future revenues. Click on the image below to see the entire table. I used a theoretical economy with the government collecting 20% of GDP in taxes and did a 1% reduction in tax rates, which could also some kind of long-term economic development incentive of equivalent magnitude. This tax rate reduction is maintained through-out the ten year period since, if it is taken away the year after it is implemented, the short term boost is lost and demand was just essentially brought forward.

Even assuming a 2.5x multiplier, which is quite generous, not only does the tax cut not pay for itself initially, it never, in any given year, does so. I solved the equation to see what multiplier is needed in this long-term example, and it is 5.26x. That is simply unheard of. Using the tax rates that a state has, this becomes even more intractable. Here I show the multiplier on the table for what is needed to finance a 0.5% tax cut.

A 15.4x multiplier is simply preposterous. I would challenge anybody to find an economic paper that claims to have found anything like that for any policy.

It's actually even worse than this in many respects when you consider the opportunity cost of what else you might have elected to use an equivalent amount of money for. Basically, what you find is that the marginal impact of this in your revenue projections compared to continuing to spend it on, say, public infrastructure is that you are even further behind. That's because if that 1% of tax revenue forgone was current being used to finance some ongoing expenditure, you can no longer finance that ongoing expenditure and thus lose the GDP associated with it. This simplified example basically was meant to demonstrate what would happen if you took a budget surplus of 1% of GDP and gave it out in an ongoing tax cut or long-term economic growth incentive of some sort that came out of current tax revenues. We could work out a similar exercise for a long-term spending increase, but I don't want to clutter up this post too much. The results are very nearly the same.

Now, some programs are more effective and more cleverly structured than others and can obtain significant leveraging of private sector dollars if done properly. There are instances where the dollars deployed have a particularly powerful marginal effect where they may possibly get a development over a certain threshold of financing it would otherwise not have crossed. In those circumstances, a small amount of government financing can achieve bizarre levels of leverage. It must be noted, though, that those cases are not as common as many claim.

As a general proposition, most tax cuts and economic development programs do not "pay for themselves", but that's not necessarily an argument that they shouldn't be done. There are plenty of reasons to undertake a project or policy beyond whether or not it actually pays for itself. However, the basic rule should be that one does not undertake a project or policy because policymakers think it pays for itself.

Is there a material problem from losing "AAA" status?

In short, the AAA status will be lost or not lost in the marketplace long before a credit rating agency actually decides to downgrade U.S. treasuries. Markets always are about two or three steps ahead of the rating agencies. Look no further than any of the recent sovereign debt crises or the 2007-2008 debacle with mortgage backed securities.

The one material effect is in the investment policies of pension funds and endowments where there are certain requirements as to the percentage of AAA assets that need to be held as a portion of the portfolio. If U.S. treasuries aren't considered AAA, it would be hard to imagine what would step into the void.

As far as the likelihood of a downgrade, that is hard to say. If Congress actually decides to grow up and face the long-term deficit problems like it has a spine, these are not insurmountable issues. A few modest tax increases and well balanced spending cuts would do the trick in a hurry. However, an unfortunately large number of representatives have decided to invoke moral absolutes, which should almost never be part of this process. As a result, we are not looking too good at the moment. Perhaps the S&P warning may have been enough to get people thinking a little more clearly.

Is the Ryan Plan a Serious Budget Proposal?

I will give credit where credit is due in the Paul Ryan did lay out a proposal that does indeed tackle, whether one agrees with it or not, the problem of runaway Medicare spending. Eventually, Medicare, as well as Medicaid, will render the federal budget unable to be balanced. However, the revenue side of the proposal is horridly lacking. Simply waving your hand about the amount of revenue that will be collected is a nice trick, but hardly one meriting serious attention. My short answer to the title of the post would be "No.".

Bruce Bartlett has some good thoughts on it as well.

I'm not sure that Obama's budget proposals will be any more serious in terms of actually truly proposing the changes of the magnitude that need to occur in order to balance the budget, but then again I am not entirely convinced that the budget needs balancing at this particular point. I'm reasonably convinced that the President will propose possibly a more balanced set of proposals, more along the lines of a "shared sacrifice", but my guess is that they will still be half-measures.

Government Compensation's Effect on Private Sector Compensation

You might scoff at the very notion that there is an effect, unless you have an understanding of economics. I assure you that what follows is not just because I work in government, but it is in the spirit of good analysis.

It is useful to think of the labor market as being two discrete parts: a public sector and a private sector. This is a gross oversimplification as there are sub-sectors in each that are more numerous than a blog post can readily accommodate as a forum for discussion, but it will serve our purposes. The demand schedules for labor in both are driven by the demand for their services as well as the ability of both to compensate workers for those services. Nothing earth shattering there. Their supply schedules, too are fairly similar, and they are functions of each other to a certain extent.

To explain that point a little more clearly, it can be fairly reasonably said that if public sector compensation is increased, all other things being held constant, that workers at the margin will go to the public sector instead of the private sector. In that shift, what you will see is that the marginal workers that shift from the private sector to the public sector are of a talent level that the private sector would otherwise liked to have had, assuming both markets were in equilibrium previously. In order to secure the same quality of labor that the private sector had previously, private firms, on average, will increase wages to drive a shift in labor supply back to the private sector. Conversely, a decline in government compensation that is determined exogenously (by elected officials, for example) will shift the labor supply for government in while shifting the labor supply for the private sector out, which reduces wages in the private sector.

The illustration of this is fairly simple in the event of an exogenous reduction in public sector compensation (CLICK ON PICTURE FOR LARGER IMAGE):

Some might say that a reduction in public sector wages will simply reduce the amount of labor supplied in the public sector and there will be no additional bleed-over. The problem with that is that labor supply is not all that elastic. It's part of the reason that tax cuts don't generate more revenue than they cost and why tax increases actually do raise revenue. In extreme cases of, say, a 90% tax increase or a 50% wage cut, you will see the supply of labor decline. Interestingly, it is unlikely that private sector employers would increase their demand for labor since the primary determinants remain mostly unchanged.

As I said at the outset, this is fairly over-simplified as there are a lot of little nuances here and there. For instance, many in the public sector are trained in fields that do not have, in the terms of private sector human resources advisors, "transferable" skills to the private sector. For instance, fire fighters and teachers both would have a difficult time finding equivalent private sector jobs, though teachers would find a narrow number of opportunities in private sector schools. As such, many public sector workers may have a difficult time switching between the two sectors.

The long and the short of it is that the recent efforts to roll back public sector compensation at nearly all levels will likely further add to the deflationary tendencies in the labor markets that exist right now.

More Nonsense About Public Pensions

http://www.nytimes.com/2011/03/11/business/11pension.html?src=busln


What follows does not represent the views of the State of Wisconsin, the Department of Administration, or the State Budget Office. 


Let me be blunt. Joshua Rauh, the Northwestern University professor behind nearly all of the scare-mongering on public pensions, is a malignant tumor and a fairly heavily metastasized one at that. His basic premise has been that public pensions are much more poorly funded than they look because they use unrealistic assumptions about rates of return. He claims that you should use a risk free rate of return, rather than a balanced portfolio's rate of return (historically nearly 8%), to discount future pension liabilities. For the uninitiated, discounting future liabilities at a lower interest rate makes your future liabilities a good deal larger. 


His real claim to fame was an article he published, along with a University of Chicago professor, at the pits of the stock market's decline in the most recent bear market where assets of the pensions funds were measured at fair market value (artificially depressed by nearly 50%) and compared it to liabilities discounted using 10-year treasury rates at the time (roughly 3.5%). I'm not actually sure that I need to explain what is wrong with this, but I will anyway because it actually offended me. In essence, what he did was take an artificially depressed portfolio and then assume an artificially low return from an artificially low level and say "My God! These things are horribly underfunded!". I would actually be curious what the fair market value measures would look like right now.


In any case, we all know that the assets of these funds have recovered sharply. That is evident in the Federal Reserve's Flow of Funds Report. Since Q1 2009, the assets of state and local government pension funds have recovered nearly $800 billion, or over 35%. What is more troubling is his bizarre assertion that pension liabilities should be discounted at a risk free rate of return. My simple response is: Why? That actually makes no sense. Why should long term assets be discounted at a rate that would only make sense if we expected to need them at short notice? His choice quote is “If you don’t want to count on the stock market to pay for all this, this is what you’re going to have to contribute.”. All I have to say is "Huh?!".


I wonder what the "unfunded liabilities" of 401(k)s look like if you compare current balances to future liabilities (i.e. your retirement expenses) if you discount them back at 10-year treasury rates. They are absolutely dependent on stock market returns after all. All of these plans rely on the stock market. Nothing else provides the returns reliably enough (yeah, I know what the response to this is). No person earning up through an upper middle class income could possibly afford to save enough through fixed income securities, even if they lived like a monk. If Rauh was honest, that's what he would say, but he doesn't. 

Let the States Go Bankrupt?

As I work for my own state's budget office, this headline got my attention: http://www.msnbc.msn.com/id/41188877/ns/business-the_new_york_times/

I think that those pushing this have a hidden agenda and are not as "concerned" about the fiscal health of the states as one might think. At the end of the day, very few states are in what I would call real fiscal stress in that very few sit around and wonder on a regular basis whether or not they can pay their upcoming obligations. Illinois and California are probably the only two.

The argument is, mostly, predicated around the discussion of future pension and healthcare obligations. Some studies have greatly exaggerated the level of underfunding for pensions and this is something I was hoping to address in a post this weekend and I still might.  However, if you believe those studies, then you might say that we have to let the states have a mechanism to jettison these obligations.

I will address this in further detail this weekend. Understand that anything I say is not the official position of the State of Wisconsin, but rather my own view of the larger issues here.

71% of Americans Want a Crippling Financial Crisis

http://www.reuters.com/article/idUSTRE70B38620110112

So, 71% of Americans don't want to raise the debt ceiling, but they also don't want meaningful spending cuts or tax increases. In that case, the only inevitable result is default. Luckily, Congress will likely ignore the will of the people, as it should, and do the right thing here. This was an issue that many demagogued on during the recent elections, but really is not a legitimate issue unless you have a meaningful way of reducing the budget deficit.

Oh well.

Illinois and the state of local government debt

http://www.washingtonpost.com/wp-dyn/content/article/2011/01/12/AR2011011206436.html

I think that Illinois' dramatic tax increase (which is larger than I have ever seen a state do) is evidence that state and local governments that face insolvency have the willingness and the means necessary to address their problems. Among major state and municipal governments, I really haven't found any that have so overexerted themselves to the point that they cannot reasonably increase their tax burdens or decrease spending by enough to make up the gap. As such, Meredith Whitney's assertion that there will be between 50 and 100 major municipal defaults is a little questionable.

Well, looks like we avoided a sharp fiscal contraction

http://www.nytimes.com/2010/12/07/us/politics/07cong.html?partner=rss&emc=rss

That payroll tax cut in particular is an immensely expensive, and therefore stimulative, provision. On the other hand, all talk about a sharp fiscal contraction to be more fiscally responsible just went right out the window. This is a statement by the US Congress that they do not give a damn about the deficit.

The good news is that this lays the groundwork for a decent year economically next year. That payroll tax cut provides some real oomph for consumer spending and to businesses. I'll be curious about the impact on the Social Security trust fund, but that's another discussion. Of course, this raises my concerns about the long term deficit and debt picture. Tax rate reductions are more permanent in their fiscal effect than spending increases. Spending can much more easily be frozen at current levels than tax rates can be increased. In that sense, it is much easier to work off the deficit impact of spending measures than tax rate cuts.

Tax rates will have to be revisited soon if there is to be any serious discussion of the deficit.

Some people should not talk about public finance

Ugh. W. Kurt Hauser wrote a piece in the Wall Street Journal that nearly gave me an aneurysm.

He asserts that no matter what you do with taxes, tax revenue comes in at 19% of GDP because tax increases hurt economic growth and tax cuts increase it. Oh really?

If you average the Bush years versus the Clinton years, the federal government average taxes as a percentage of GDP nearly 2 full percentage points below the Clinton years. This was despite a huge run up in corporate tax receipts as corporate profits hit an all-time high that had just about nothing to do with tax policy since corporate tax rates were left at 35%. Comparing peaks in the business cycle we also have about a 2 percentage point gap. 

Not all of this is the static effect of taxes being at lower levels. It is also a function of the fact that the economy did not grow nearly as quickly in the 2000s as in the 1990s. However, that in of itself would seem to indicate that tax cuts don't generate additional revenue as there was nothing particularly remarkable about economic growth following two significant tax cuts in 2001 and 2003. 

Ah, but Mr. Hauser says that we can see that economic growth was revived by the tax cuts. He says the six quarters following the tax cuts averaged a GDP growth rate of 3.8% compared to an average of 1.8% prior to the 2003 tax cuts. First of all, he is ignoring that the larger of the two tax cuts was passed in May of 2001. Secondly, he is ignoring the fact that the Federal Reserve was substantially aiding the recovery from the recession with massive monetary stimulus. Thirdly, the recovery in the economy was led by residential fixed investment, which had little to nothing to do with tax policy changes. Fourthly, at comparable portions of the business cycle, tax revenues as a percentage of GDP were lower in a systematic way. So, not only did GDP not grow as fast, we collected less of it in taxes. 

Looking at the same comparison he attempted to make for just the 2003 tax cuts, we have 1.3% average growth in the six quarters following the 2001 tax cuts compared to the six quarters preceding them at 2.2%. Also, for the recent stimulus (which I am sure Mr. Hauser does not approve of), we have averaged 2.3% since its passage compared to -2.1% in the six quarters before it. Is this disingenuous? Oh heck yeah, but what he did also was. This sort of analysis does not constitute any form of economic analysis. It is selectively applied correlation analysis, but there is no systematic approach applied to compare the period he selected with other similar periods and other tax policy decisions, or to control for what other economic trends were at work (Federal Reserve interest rate decisions, reductions in oil prices, housing market trends, etc.), or... well... any kind of analysis at all. 

Incidentally, under a similar form of analysis I could point out that the six quarters following the Reagan tax cuts averaged -0.9% GDP growth, but that isn't fair since the Fed killed economic growth to subdue inflation. Similarly, you cannot credit the growth that started in Q4 1982 to the tax cuts entirely because the Fed was the primary agent stimulating economic growth at that point. 

If you make decisions on whether or not to invest on political pundits such as Mr. Hauser, who also apparently has an incredibly inflated ego, I urge you to reconsider. I would remind everyone that many Glenn Beck followers completely missed the largest stock market rally in recent history from the March 2009 lows because they were convinced that some Communist takeover had just occurred.