THE BEAR'S LAIR How will we pay for it all?
By Martin Hutchinson
As the world awaits with bated breath the revised US Congressional Budget
Office projections for the federal budget deficit in 2009, 2010 and beyond
(expected to be released on Tuesday), one thing must remain perfectly clear.
There is no way that the capital markets will put up with sustained US budget
deficits over 10% of gross domestic product (GDP). Since the current political
class is incapable of cutting spending (indeed it appears to want to spend
still more, in yet another "stimulus plan") taxes will go up, no question. The
interesting question is: which tax?
I wrote last week about one tax that could usefully be imposed which would
actually do some economic good: a Tobin tax, by which transactions in stocks,
bonds, commodities and foreign exchange would be subject to a very small
transactions tax on
each deal carried out. The purpose of this would be to limit "high velocity
trading", computerized trading with millisecond lead-times by which Wall Street
sucks value out of the economy while destabilizing prices and making markets
more dangerous and unstable for long-term investors. The yield of such a tax
would be only a few billion dollars, but every little bit helps, and it would
assist in rediverting economic activity from Wall Street rent-seeking into
If I believed in global warming, I would regard a carbon tax as another such
economically beneficial impost. By taxing carbon emissions, it would divert
energy usage into less carbon-dependent forms and encourage conservation,
therefore preventing the dangerous long-term warming of the planet. The problem
is, the evidence does not appear to me to justify belief in global warming;
certainly the effect is dwarfed by decades-long natural fluctuations, which
have caused global temperatures in the last few years to be significantly below
their 1998 peak.
Imposing heavy government regulations because of an unproven but hysterically
maintained popular fad is disgraceful. However, a moderate carbon tax would be
no more economically harmful than any other tax and might be worth imposing on
the "precautionary principle" that every now and then, hysterically maintained
popular enthusiasms turn out to have a modicum of truth behind them. Currently,
I don't see it, but you never know.
A carbon tax would meet with enthusiasm among the chattering classes and do
little harm. There are other taxes that would also do little economic harm,
possibly even some good, but would be met with huge opposition from "opinion
formers". Two of these were proposed by the Barack Obama administration in its
budget but were declared dead on arrival in Congress.
One was a reduction in the tax deduction for home mortgages for those with
incomes above $250,000. The US political penchant for subsidizing housing,
including the fearsomely expensive rescues of Fannie Mae and Freddie Mac, has
been hugely damaging in the past decade and promises to continue being so going
forward. It diverts resources from productive investment to building and buying
houses that are both larger and more dispersed than is economically optimal.
When Tim Geithner, a career bureaucrat whose earnings have rarely if ever
exceeded his current Treasury secretary's salary of US$191,300, has difficulty
in selling his $1.6 million house in Larchmont, New York, you know that even
the smartest of the US middle classes have got their spending and investment
priorities impossibly skewed. Removing the home mortgage interest deduction, or
at least capping it at $10,000, would reverse this distortion.
Running silver stakes through the hearts of Fannie and Freddie would help too,
of course. Needless to say the Ginnie Mae direct government guarantee program,
supposedly responsible for $1 trillion of mortgages in 2009, is another
accident waiting to inflict itself on taxpayers.
Another noble but doomed effort by the Obama administration was the attempt to
cap the tax deduction on charitable donations. The ability to deduct such
donations is an enormous and unjustified loophole in the US tax code, protected
by sentimental affection for everybody's favorite charitable cause. In reality,
it has spawned a gigantic nexus of political agitation organizations, which
have stretched the definition of "charity" beyond all meaning in order to
attain favorable tax status. These unpleasant outfits are also granted other
favors, such as exemption from the "do not call" regulations protecting
citizens from telephone harassment.
Many of these tax-advantaged organizations are hostile not only to the free
market but to the kind of sustained middle-class values that are essential for
a society to prosper, both economically and socially. Far from deserving
special favors from the taxman, these groups, both domestic charities and
international non-government organizations, would in a well-run society be
tightly regulated and prevented from diverting public resources to
value-destroying activities. Both US society and the unfortunate developing
world would thereby be greatly enriched.
The above discussion has I hope illuminated the options for raising necessary
revenue without doing significant economic damage. If the revenue thus raised
proves insufficient, other revenue sources are possible, but they are likely to
prove economically damaging. Some of them however are more damaging than
The most tempting source of revenue to lovers of big government is a value
added tax. It is tempting because, falling as it does on sales transactions and
being incorporated into sale prices, it is much less visible to voters than an
income tax. It also has the virtue of being largely self-enforcing, since every
business organization, including retailers, has the incentive to report every
penny of VAT "inputs" they incur, and to charge VAT on their outputs, so
evasion becomes very difficult. Political conservatives groan that VAT is
especially burdensome on informally run small businesses; this is because most
other taxes are easily evaded by them.
VAT also has the virtue of taxing consumption, not income, thereby encouraging
production and saving. In the US economy, devoted as it has been to excessive
borrowing and consumption, this is no bad thing. Its main disadvantage is that,
added to an income tax, it allows government to increase spending to French or
Swedish levels, with consequent corrupting and debilitating effects on the
economy and society.
Tariffs are universally despised by economists, but the economists are wrong.
Government must raise revenue somehow and there is no obvious reason why modest
taxes on imports are more damaging than income taxes, rather the reverse.
Certainly a great deal of economic and societal damage was done by the
"unilateral disarmament" of British economic policy between 1846 and 1932, in
which tariffs were abolished without regard to the fact that foreign countries
still had them. By that foolish policy, British agriculture and its
rural-dominated society was almost wiped out, while the hollowing out of
British industry, barred from its natural imperial markets by tariff-protected
foreign competition, was delayed only a few decades.
Nevertheless, there are real global benefits from "comparative advantage" by
which goods are produced in the most efficient market. Moreover the political
temptations are irresistible for governments to raise tariffs in economic
downturns, producing the kind of economic death-spiral caused by the 1930
Smoot-Hawley Tariff and fortunately avoided this time around. International
mechanisms for preventing unilateral tariff increases, such as the World Trade
Organization, are thus beneficial. In an ideal world, such organizations would
allow uniform modest tariffs, by which revenues could be raised without huge
distortion of "comparative advantage". In the real world, raising tariffs is
probably too dangerous.
Finally, we come to income taxes and social security taxes. These have two
principal problems. First, high marginal rates, significantly above 50%, have a
large disincentive effect and almost certainly yield no net revenue or even
reduce revenue and damage the economy in general. The 90% rates common in
Britain before 1979 were thus both counterproductive in terms of revenue and
hugely damaging to economic growth; they were a product of pure political spite
and envy. An economically competent Conservative government after 1951 would
have reversed them forthwith, thus preventing 30 years of relative economic
decline. This adverse effect happens for rich and poor alike; high marginal
rates from phase-out of negative income taxes (the "earned income tax credit")
and social security contributions is just as damaging as high marginal rates on
Second, if as in the United States today, less than half the population pays
effectively all the income tax, political incentives can become distorted. Even
if social security taxes and sales taxes are paid by the great majority of
people, an income tax levied at high rates on a minority is subject to
incessant agitation by the majority for unjustified increases.
Hence an increase in income tax rates significantly beyond their present levels
(the marginal rate of which including state taxes and social security rises
above 50% at several points in the income scale) would be economically
unproductive. Sadly, politics being what it is, it will almost certainly be the
first resort of politicians when further borrowing becomes difficult. As
discussed above, there are many superior alternatives if revenue must be
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)