Buy it Up--Break it Up--Fund it Right!

The new president has hit the ground running and I wish him well. But I have my doubts. He is not at all like the stumble-bum he replaces, of course. Rather, he is a thoughtful and intelligent man. And on economic matters, “The audacity of hope” is backed up by an economic team of truly impressive credentials. Indeed, this may be the most highly qualified group of people ever to serve in government.

And that's the problem. All of them are super-competent to be sure, but they are competent in the very techniques that caused the problem in the first place. They will attempt to solve the problem at the level of thinking that created it. Their plan is for a massive stimulus, and it is easy to see why. They believe it will work for the simple reason that it has worked. Indeed, since at least the 30's, and certainly since the 40's, the economy has been dependent on massive government expenditures—a permanent stimulus economy. And in general, this approach worked for a long time; the economy was more or less stable and prosperous, and the periodic shocks were mild and short-lived by pre-war standards. Given that record, they may well be excused for believing that the Keynesian magic will work yet again.

But in truth, it will not work because, for some time now, it has not worked. No one since World War II has practiced fiscal stimulus as much as did George Bush. Think on this: In only eight years, Bush took all that debt accumulated from Andrew Jackson (the last time our debts were paid) through Bill Clinton, and doubled it. He added more than $5 trillion to the debt. Under such a tremendous stimulus package the economy should be booming; there should be labor shortages and resource scarcity and real—rather then merely monetary—inflation. But the economy is not booming, but bombing, and instead of inflation we have deflation, which is far more damaging. Instead of a real expansion, we got a mere credit bubble in housing. People thought they were richer because their homes cost them more, a strange kind of wealth.

In opposition to Obama's plan, the Republicans want more of the same. But the Republican stimulus plan differs only in the details. Stimulus by “tax cut” is still stimulus. And it really isn't cutting taxes because it doesn't really cut spending. It is not tax-cutting, but tax-shifting, from the current generation to the next; it is charging our children for benefits we receive. This is not only uneconomic, it is immoral at the deepest level.

The bubble did not make people richer (save for a few insiders), it just meant they were maxed out. Maxed on their mortgage payments, their credit cards, their car loans, their student loans. Their wages did not keep pace; in fact, the median wage declined and the economy was sustained by oceans of debt. The stimulus plans have introduced structural abnormalities into the economy such that it will no longer respond to stimulus. Reliance on the government as consumer of last resort has resulted in a structure that favored global production over national income, the FIRE economy (“finance, insurance, and real estate”) over the real economy (real production of goods), low wages over fair ones, and gargantuan size over human scale. It is this last point that is particularly troubling, since this gargantuan institutions have proclaimed themselves to be “too big to fail,” and exercise economic blackmail over the whole republic.

The problem with this claim is that it is correct. But the proper response is not to give into the blackmail, not to negotiate with crooks, but to make sure that the blackmailers are never in a position to control the whole economy, to demand trillions in ransom whenever they get themselves (and us) into trouble. Now, it would be mere carping by distributists to point out the problems if we could not offer solutions. But we do have solutions, and it is time to offer them, time to end the era of big business that depends on big government, on subsidies from the general public to private profits. I have nothing against profits—when they are earned; I have everything against profits that are the result of subsidies and privileges. The distributist solution to all of these problems can be summed-up in a few words: Buy it up! Break it up! Fund it right!

Too Big to Succeed

Citibank, the nation's largest bank, has received a $20 billion bailout, along with government guarantees for $300 billion of shaky assets; in addition to giving the bank an enormous amount of money, the public assumes all of the risks of being a banker, while Citibank gets to keep all the profits. That is to say, the profits are privatized but the risks are socialized, combining the worst features of capitalism and socialism in a toxic combination. Citibank is no ordinary bank. Together with JP Morgan/Chase, it owns the controlling interest in the New York Federal Reserve Bank, which in turn owns 53% of the Federal Reserve System. This makes the entire banking system sensitive to the needs of two New York banks. The President of the New York Fed has a permanent position on the board of the Federal Reserve. And who is that outgoing New York Fed President? It is none other than the new Secretary of the Treasury, Timothy Geithner.

But the banking system is more than New York and more than the Fed. Most of the regional banks did not engage in the risky behaviors of the New York banks. They made sensible loans. But Citi had no reason to be sensible; with their size and influence, they knew that they could not be allowed to fail. No matter what happens, they must be protected from the consequences of their own actions. Yet, their actions weakened the whole economy, which is weakening the books of even the most cautious banks; with the economy failing, even formerly reliable borrowers cannot repay their loans. The solution is not to bail out failure. Rather it is to ensure that no entity every again can be large enough to hold hostage the public purse. Don't bail it; that just reinforces a power structure that can no longer succeed. Rather buy it up and sell it piecemeal to the regional banks. The market capitalization of Citi was only $19B as of yesterday, or less than they received in the bailout. The toxic loans can be sold for whatever the market will bear; the healthy parts will make the remaining banks stronger, but none of them will be strong enough to dominate the banking business. Buy it up and break it up.

Of course, they may not want to be bought, and if they can find private investors to draw them out of this hole, that's fine too. But I doubt if they can find buyers without the government providing guarantees. In other words, everybody has found out what the distributists always knew: they are too big to succeed without the help of big government. They believe they can blackmail the public, but the truth is just the opposite: they are dependent on us and we may do as we wish.

The same plan holds true for other enterprises that need bailouts, such as the Big Three automakers. The obvious problem with these companies is that they are too big and there are only three of them. Japan, a much smaller nation, supports nine auto companies. The market price of GM was only $2.1B yesterday. If the public is taking their debts, then let us take possession as well. Buy them up, and then re-sell them to the workers in exchange for some of the long-term commitments. Break them up into the various sectors: engine companies, transmission companies, body works, etc. They could be converted over time into worker-owned companies.

Then, anybody who wanted to enter the automobile business could do so with a comparatively small investment; instead of manufacturing the whole car, they could purchase all the parts and assemble them according to their own designs and perceived market needs. Indeed, the auto companies have already laid the ground work for this by outsourcing so many of their parts and selling off so many of their plants. At some point, the central office losses any real power and its remaining functions can be duplicated by any number of start-ups for a relatively modest investment. At that point there is no reason we couldn't have nine automakers, or 19. Choices would go up, prices would go down, and local manufacturing would increase.

Fund it Right

In our industrial system, government is the consumer/employer of last resort. Government spending is $5 trillion of a $14 trillion economy, or more than one-third. Much of this spending constitutes a huge system of subsidies to large businesses, subsidies that are so in-grained that we no longer see them as such. For example, The “freeway” system is a huge subsidy to shippers and privileges global and national production over local and regional manufacturing. Indeed, without these subsidies, it would be difficult for global producers to compete with locally-made products, even with absurdly low-wages. But the transportation systems are the least in need of subsidies. It is easy to allocate these costs to the users through weight-based tolls. The “weight-based” portion is important because the greatest damage to the roadbeds comes from heavy trucks. With costs allocated to the cost-causers, subsidies disappear, and the dynamics of production change.

The most immediate result of tolls would not be a success, but a failure, namely the failure of the “big-box” retailers such as Wal-Mart. The distribution model of these companies depends on the current system of subsides and would not survive without them (see http://distributism.blogspot.com/2007/10/subsidizing-wal-mart.htm).

This huge system of subsidies also imposes high transaction costs on the economy. Even hiring a nanny requires a vast amount of paperwork and the payment of employment taxes. These transaction costs work against small businesses and in favor of giant ones. The transaction costs make it more difficult for start-ups to get started, but they are a mere nuisance to big corporations. The form an entry barrier which protect big businesses from competition. The greater part of the burden of taxation falls on labor and capital, when it should fall on the rentier (see http://distributism.blogspot.com/2009/01/chapter-xv-taxes-economic-rent-and.html)

But Will it Happen​?

Clearly the Obama administration is not thinking along these lines, and are unlikely to adopt any of the solutions of distributism. Does this mean that the discussion is merely theoretical with no chance of implementation? Not at all. The current system has reached its limits, and the attempts to save it will only make it worse. Distributism, in one form or another, is the wave of the future. The only question is how long and by what means will we get there. Distributists need to organize now, and to join whenever possible with similar and allied movements like Mutualism, Georgism, coop movements, and the like.

The current system has no future, and attempts to “stimulate” it will only result in an economic monster even more unstable than what we have. The “bail-outs” will only subsidize failure, and cannot long endure. There will undoubtedly be a time of great turmoil, with all sorts of solutions proposed. In such times, nearly anything can happen, including many unpleasant things. But we need to be in a position to show the nation the way forward, the only way that will work.

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Chapter XV: Taxes, Economic Rent, and Externalities

What Should We Tax?

We began our examination of government by looking first at proposals to reform the tax system and noting their deficiencies. We then looked at both the purpose and cost of government and noted that government has exceeded its legitimate purposes and hence its reasonable costs. We can now return to the question of tax reform, and determine how this should be done, because at the heart of governmental reform is tax reform. It is evident by now that the “starve the beast” strategy was a failure; under this strange diet, government “bulked-up” rather than “slimming-down.” Only by identifying the proper sources of public revenue, and insisting that government stay within these limits, can we hope to achieve any real reform. So the central question is, “What should we tax?”

There is a bromide about taxes that goes, “If you want less of something, tax it.” Currently, the burden of taxation falls on capital and labor. Now, I can't think of any reason why we would want less less labor or less capital; therefore, the fairest and best tax on labor and capital is a flat-tax of zero percent, with some notable exceptions, discussed below. But if we eliminate taxes on labor and capital, is there anything left? Is there anything in the economic universe that we want less of? I believe there is. In fact there are two things that can be taxed, one with no impact on economic development, and the other with the deliberate goal of limiting adverse impacts. The first thing is economic rent and the second is taxes on externalities.

Ground Rent

I repeat here our discussion of economic rent from Chapter X: Economic rent is an amount paid to a factor of production that is more than necessary to keep that factor in production in its current use. It is the very essence of economic inefficiency. For example, the price of steel must be enough to pay for the raw materials in the steel and to compensate the labor and capital that went into making it. If, however, the price rises very much above this amount, then steel claims an economic rent. This rent acts like a tax on all users of the steel, a tax that really doesn't buy anything, but only transfers money from one group (the consumers) to another (the owners). In the case of elastic, reproducible commodities (like steel), this is only a short-term problem, since (in competitive markets) the higher prices attract more labor and capital, the supply is increased, the prices fall, and the economic rent disappears. In the short-term, and for normal commodities, economic rent serves a purpose.

But this does not happen in the case of land; there, the rent is chronic and distorts the returns to both capital and labor. Recall the discussion of the law of ground rents from Chapter IX. Ground rent has the first claim on all incomes, and returns to labor and capital (“the wage line”) can only be paid after ground rent is satisfied. Moreover, this ground rent represents unearned income. Property increases in value because of the growth of population, improvements in technology, or off-site improvements. None of these things are attributable to the land owner; he merely reaps where he did not sow. All ground rent is economic rent. Land costs nothing to keep it in production. Capital and labor are consumed in the process of production and must be replaced; the land endures.

Consider a case where a landowner leases out a piece of property to an entrepreneur to build a factory. The factory lasts, say, thirty years, and at the end of the time it is “used up.” It is torn down and hauled away. But the land remains and is ready for the next use. All this time, the landlord has been receiving an income, and all the while the property has been increasing in value (assuming an increase in population and advances in technology). Yet the landlord did nothing to earn this income; it is strictly a reward for owning the property, not for using it. The income is due to the community, and by rights should go to the community.

Note that we are speaking of taxing only the ground rent; the improvements would not be taxed at all. The improvements to the property represent capital and labor, and their work should not be taxed. Only the ground rent, the portion provided by the community, would be taken, and taken at something close to 100% of its value. This is not a new idea. It was the form of taxation favored by economists from Adam Smith to Milton Friedman. It was most famously popularized by Henry George, a name that is forgotten today, although he was the most well-known and popular of the economists of the late 19^th and early 20^th centuries. Some measure of his popularity can be gathered from the fact that at his death, 100,000 people filed past his coffin, and thousands of others waited outside and could not get in to pay their last respects. Can you imagine the general public lining up to for the funeral of any other economist?

George's theory is often called a “single-tax” theory, because it reduces all taxes to ground rent alone. However, this is a misnomer, since it should be called a “no-tax” theory. A tax is a cost added to a price or subtracted from an income. A sales tax is added to the price, an income tax deducted from the income. And these taxes tend to get passed along to the final consumer. But the Georgist “tax” simply appropriates the income of the rentier, the person who lives off other people's work. Nor can this “tax” be passed along. Ground rent already tends to absorb all values over the margin of production; the price cannot be increased beyond this.

The major question is whether such taxes are just, whether the major burden of taxation should fall entirely on the rentier. Two points are important here: One is that the value of ground rent is due to the community, not the owner (Chapter IX). It is but justice that the community be funded from its own natural revenues. The second point is that ground rent always represents wealth without work, the primary source of both economic inefficiency and economic injustice. Wherever one person gets wealth without work, another must provide work without wealth. Clearly this is unjust, but it is also inefficient. The maldistribution of incomes affects such technical measures as the velocity of money and the incentives to invest, and thereby destabilizes the economy. But further, it leaves the community without a source of revenue for public purposes; the community therefore has no choice but to go after the returns to labor and capital, which negatively impacts both. Taking the ground rents impacts neither—any further than rent does, anyway. Therefore, we can assert that ground rent is the natural income of a community. Rent derives its power strictly from a legal claim to property; that is to say, it is a creation of government power, a power that recognizes no limits to property. But property, like any other natural thing, has natural limits. And the natural limit to property is that one should profit from its use and not from mere ownership.

Taking ground rent would have profound macroeconomic consequences. For one thing, land speculation would be unprofitable. The only way to make money off of land would be to use it, to employ it in providing a useful good or service to one's neighbors. The whole problem with the speculative rent line and the resulting land bubbles and subsequent contractions would disappear. The economy would be far more stable. For another thing, wages and investment would get their full return; both are now burdened by both rents and taxes. Without taxes on either, the work and investment climate would be very much improved.

But is it Enough?

Although many economists generally concede the superiority of ground rents, they also doubt that it is adequate, especially when the total government expenditures come to $5 trillion. In this critique, they are absolutely correct. It is unlikely that ground rents could support a government establishment that takes one-third of GDP, an amount that is growing, especially during this current crisis. But that is not so much a critique of the land tax as one of its greatest advantages. Under a land tax, the public revenues would be fixed and known. Government at all levels would be confined within the limits of their funding. But how much would that funding be, and is it adequate to a reasonable level of government?

Empirical studies are hard to come by, since local taxing authorities are not overly concerned with separating the price of the land from the price of the improvements. The best studies suggest that ground rent revenue would come to about 20% of GDP, or about 60% of funding at all levels of government.¹ This would certainly leave a big hole in the current level of government, but this might not be as big a problem as it appears at first glance. It would force government to consider what should be funded from general revenues, and what should come from user fees. We have already discussed how the highway system is the obvious example of an expense that can be moved from general revenues to tolls. But there are many items in the budget that are in fact services to particular clientèles. For example, the Food and Drug Administration is a service to the pharmaceutical firms, among others, and its entire budget should come from user fees. By cutting the bloated defense budget, going to debt-free money, eliminating useless departments such as education, charging public works to the properties that benefit from them, and such like measures, the federal budget could easily be cut by 40% without compromising any current services.

I suspect that the same rules would apply to state and local governments. The lion's share of these budgets are consumed by an ever-more-expensive education system. However, while it is certainly a duty of government to ensure that every child has the same opportunities to get an education, there is no reason for the state to actually run any schools, a task which they do not do well. A system of vouchers to parents would likely bring both great diversity and great economies to the educational system, while allowing the public to recoup their investment by selling the schools and putting the land back on the land-tax rolls. Support for education should also include some modest support for home-schooling.

Political Effects

Political power tends to flow to the greatest funding source. When the Federal Government gained the power to tax incomes, power naturally flowed upward, so that today senators and presidents routinely handle matters that are best left to the town council or the statehouse. A land tax, however, is most efficiently collected at the local level. The apparatus for doing so is already in place, since localities collect property taxes, though under widely varying rules and rates. The rules and methods would have to be standardized across the nation. But a land tax would entirely change the nature of government in the United States. With taxes collected at the local level, and divided in a fixed proportion among local, state, and federal authorities, we can expect that power will begin to flow back to the states and cities. And with a fixed budget, it will be easier to confine the federal government within its constitutional limits.

I suspect that the two great debates in a land-tax system will be how to split the revenues and which programs should be funded or subsidized from general revenues and which should be funded by user fees. As matters currently stand, states and cities have an incentive to “kick problems upstairs” to the federal government, where the money is. Relying on the federal budget allows local entities to claim a bigger share of the income taxes their citizens pay, and to isolate the local tax base from these responsibilities. But a land tax reverses these incentives; since the tax base is the same for all levels of government, only the division of the revenues is at issue. Local entities therefore have an incentive to accept greater responsibility and hence claim a greater share of the revenue.

Further, they have an iron-clad argument when dealing with the federal government; they merely need to ask about any particular program, “Where in the Constitution is this authorized?” Of course, they have that argument today, but they are not inclined to use it because the funding argument will always trump the Constitutional one. Under a land tax, both arguments will work in favor of the local entities. The land tax will therefore advance the distribution of power which is an essential part of distributism. It will also encourage leaders at all levels of government to offload as many programs as possible from general revenues to fee-based services.

The Land Tax and Distributism

In advocating the land tax, I am not advocating something without historical precedent or current practice. In fact, the majority of tax systems before the modern age were based on land. The English feudal system was essentially a land-tax system. And in the modern world, highly successful states like Singapore, British Hong Kong, and Taiwan are “Georgist” land-tax states. However, these states also indicate the problem with the land tax. In theory, the value of land should be easy for the authorities to calculate, since there is always an active market in land. And this is true, so long as there are no tax implications in separating the price of land and the value of the improvements. Two problems arise: One is that since improvements are not taxed, there is an incentive to attribute as much value as possible to the improvements and as little as possible to the land. The second is that when land ownership or control is concentrated, the landowners exercise considerable influence in setting the rules. Thus, a “pure” land-tax system has been difficult to establish or maintain over time. It tends to degenerate into a mere property tax which is insufficient to fund the state and becomes supplemented by income and other taxes (although usually at a much lower rate than in non-Georgist states). Large landowners like to see other taxes, because these are easier to avoid or to pass on to the final consumer.

The land tax works best where ownership is well divided and property not concentrated into large estates or tracts; in other words, in a distributist state. With land well distributed, political power is also well distributed, and the incentives to “off-load” the taxes from land to labor are decreased. On the other hand, a distributist state needs the land tax to prevent property from re-aggregating; without a land tax, the distributist state tends to degenerate into a capitalist state, and no one is better off. Therefore, a Georgist polity needs distributism for its implementation; distributism needs Georgism to maintain itself.

Other Forms of Economic Rent

Land rent is not the only form of economic rent, even if it is the most obvious and important one. Other rents arise from monopoly or oligopoly control of economic resources, from patents, from control of scarce commodities, and from occupying positions of power with large institutions, mainly the corporation. This rent manifests itself in various ways, but the most obvious way is suspiciously high returns to capital. To deal with these other forms of rent, I suggest that the corporate income tax be maintained, but only assessed when the return to capital gets to be outsized. I suggest that we adopt some figure as a “normal” return to capital, say 8%, and start a modest tax when double that return is reached (16%), a high tax when it is tripled (24%), and a punitive tax when it is quadrupled (32%).

This would not impact the willingness to invest. While in general high returns attract investment, such returns, like every other economic quantity, have a “marginal utility.” That is, at some point, higher returns do not attract additional capital, and at a higher rate, the returns actually act as a perverse incentive to discourage further investment. This is especially true in monopolies or oligopolies. When returns are so high, why invest to increase the supply and thereby lower the returns?

In the same vein, high-level executives often collect an economic rent in the form of perversely high salaries and bonuses. These salaries seem to be paid whether or not the enterprise is successful, and indeed some of the highest bonuses are paid for failure, such as when a CEO with a “golden parachute” is fired. These bonuses come out of the rewards that rightfully belong to the workers or the investors. One or two generations ago, a CEO would typically make 20 to 40 times what the line worker made; now CEO salaries run 300 to 500 times that of the line worker. The simplest solution is to require corporations to pay a tax penalty for such salaries. When a salary reaches some multiple of the line worker's salary, say 40 times, the company would pay at least a modest tax, a tax that at some point, say 200 times the average, becomes punitive, in the 75-90% range. Note that this tax would be on the company, not the executive. It would entirely change the nature of the negotiation with that executive, would be certain, and would be easier to collect.

Externalities

Aside from wealth without work (economic rent), the other great economic evil is forcing some portion of the costs of a transaction on some third persons who are not a party to the transaction. Firms, and especially large corporations, do their best to externalize as many of their costs as possible. The obvious example of an externality is pollution, by which a company will treat the common air, streams, and ground as a free sewer. This sewer will have no cost to the company, but surrounding communities will pay the cost in declining health, increased medical expenses, and shortened lifespans.

Externalities take many forms. One common form is subsidized infrastructures. The “free” transportation systems, for example, are actually subsidies to businesses that depend on wide distribution and supply networks. These subsidies work to the disadvantage of local businesses and suppliers, because they unfairly lower the transportation costs of national and international competitors. “Big-box” stores like Wal-Mart could likely not survive if their transportation costs were not subsidized. This is especially true since the greatest amount of damage to roadbeds is done by large trucks. If there were weight-based tolls for using the roads, it is likely that the Wal-Mart model would simply be uncompetitive with local and regional producers and retailers.

Externalities distort the price system and give companies that can externalize their costs a competitive advantage over those who cannot. As it works out in the real world, it is large, international companies that can more easily take advantage of externalized costs, leaving small and local competitors at a disadvantage.

Aside from going to fee-based services, like tolls, government should use its taxing power to force companies to internalize all of their costs. The current “big idea” for controlling pollution is “cap-and-trade” systems. But such systems convert pollution into a property right, and then give the right to the wrong people, to the polluters rather than those harmed by the pollution. Clearly, if you want more of a thing, turn it into a “right,” especially a marketable right. You may take it for granted that the producers can produce more forms of pollution, and therefore more property rights, faster than you can print the new deeds. The best method is a scale of taxes on pollution that increase over time so as to “encourage” a firm to internalize all of its costs.

In general, government should be vigilant to detect and eliminate externalities. No price system can function properly if firms are freely allowed to externalize their costs either to government budgets or to the public “commons.”

But Should We Cut the Budget?

We have assumed throughout this discussion that cutting government expenditures and eliminating economic rent and externalities are good things. The reality, however, is a bit more complex. The current industrial system actually depends on large government expenditures, economic rent, and the ability to externalize costs. So while cutting the budget in the abstract would be a good thing, in reality it would destroy the current system of industrial production and global trade.

So before we take our scalpel in hand to perform surgery on the budget, we need to understand what we are doing and where we are going. We need to couple fiscal reform with a reform of the industrial system itself. Otherwise, our surgery may be successful but the patient will die. What a new industrial system could look like, one not dependent on government largesse, is the subject of the next chapter.

1Fred Foldvary, “Intellectual Tyranny of the Status Quo,” http://www.econjournalwatch.org/pdf/FoldvaryIntellectualTyrannyApril2005.pdf.

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Comrade Buchanan

Pat Buchanan has an article in TakiMag today entitled Comrade Barack. Mr. Buchanan opines:

If Barack Obama is not a socialist, he does the best imitation of one I’ve ever seen.
Under his tax plan, the top 5 percent of wage-earners have their income tax rates raised from 35 percent to 40 percent, while the bottom 40 percent of all wage-earners, who pay no income tax, are sent federal checks.
If this is not the socialist redistribution of wealth, what is it?

This is certainly a fair question. There can be no doubt that taking money from some and giving it to others constitutes redistribution of incomes, which many consider to be the essence of socialism. One problem, however, is that the program already exists. It is called the “Earned Income Tax Credit (EITC),” or “Negative Income Tax.” And if it is socialist, it has a rather strange pedigree. It was proposed by Milton Friedman, supported by President Nixon, signed into law by President Ford, and vastly expanded by President Reagan. This is certainly the oddest collection of socialists I have even encountered.

Comrade Pat has been a life-long Republican partisan and a former speech-writer for Ronald Reagan, whom, I suppose, we will now have to refer to as Comrade Ron. But the obvious question is why did Comrade Pat all of a sudden discover the latent socialism in the Democratic candidate, while missing it, for so many years, in his Republican heroes? Okay. Maybe that's not even an interesting question; maybe it is self-evident that a partisan would apply different standards to members of his own party. Nevertheless, Comrade Pat is an intelligent man, and there is a question that an intelligent man, as opposed to a mere partisan, ought to have asked. And the question is this: “Why, in this day of pervasive income taxes, do 40% of all wage-earners earn so little that not only do they pay no tax, but need a supplement from the government?” The answer is a bit more interesting than mere charges of socialism.

The first answer is that they do pay taxes, and at a high rate. They pay the payroll taxes, which amount to more than 15% of their income. Indeed, without the EITC, these workers would pay a larger proportionate share of their income in taxes than does Warren Buffet, as Mr. Buffet himself acknowledges. In truth, we have two systems of income tax, one for the rich and one for everybody else. The rich, whose incomes often derive mainly from capital gains, are taxed at a preferential rates. Long-term capital gains are taxed at 15%, or less than payroll taxes that the poorest workers pay. McCain thinks that even this is too much of a burden for the rich, and wants to cut the rate in half. Of course, both McCain and Buchanan are victims of a flawed economic theory which believes that only capital creates wealth, while labor is, at best, a mere nuisance that should be gotten rid of whenever possible by outsourcing. I won't here go into the flaws in this theory; those who want to examine it more critically can buy my book, The Vocation of Business: Social Justice in the Marketplace. Here we can merely note that if one adds up the costs of tax preferences, the advantage goes to the rich, not the poor.

But there is another reason for the negative income tax, a reason that impressed the Nobel economist and the Republican presidents alike: It helps to stave off economic collapse. The hard, economic truth is that when incomes accumulate at the top to an unreasonable degree, there is a failure of demand. A CEO may make 500 times what the line worker makes, but he cannot eat 500 times the amount of food, wear 500 times the shirts, shoes, and socks, live in a home 500 times larger, etc. This means that purchasing power is lost to the economy, and must be restored. Nor can the rich man find profitable investments for his excess wealth, since the mere excess itself causes the market to be restricted. Instead, he ends up “investing” it in speculative instruments like CDS's, which add nothing to the productive capacity of the economy. They are mere bets, where one man's winnings are measured precisely by another man's losses.

Now, I don't think Reagan was a socialist; we don't have to call him Comrade Ronnie. And one can make a judgment about whether he really cared one way or another about the poor. But he certainly did care about keeping the economy together through the next election. And if that involved running up huge deficits, or transferring a bit of wealth to the poor, then so be it. As Belloc pointed out, capitalism will always result in collectivism and statism, because it has no other way of stabilizing itself.

In truth, the federal budget is mainly about transferring wealth. However, it is largely a transfer of wealth from the bottom and the middle to the top. Farm subsidies penalize the city at the expense of the country, the military budget is less about defense and more about enriching people like Cheney, the road subsidies give an advantage to suburban homeowners over city dwellers, etc. So if in all of these upward redistributions of income, we find a small space for movements in the opposite direction, than people like Comrade Pat should not be scandalized.

Or at least, that's what Reagan thought.

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Distributism and Henry George

Before reflecting on the relationship between Distributism and Georgism, a few observations about Henry George himself are in order. Economic historians tend to conveniently forget that, with the possible exception of Adam Smith, he was the most popular of all the modern economists. By any standards, his books were bestsellers and made economics accessible to the public. One measure of his popularity is the fact that at his death, over 100,000 people filed past his coffin, and thousands were left outside, unable to get in. It would be difficult to imagine such an outpouring of grief for the death of any other economist. Yet, this very popularity was the cause of resentment on the part of “professional” economists, who have, in the main, attempted to marginalize George, if not to ignore him entirely.

But this hostility is difficult to understand. There is nothing in George that is incompatible with Smith or Ricardo or Mill, or even with most of neo-classical economics (the one economist he really takes to task is Thomas Malthus.) Indeed, there is no particular part of Georgism that is original to Henry George; rather, his genius consists in taking what was already out there and drawing out the implications. Smith had already favored the land tax (see Taxes: Advice from Adam Smith), Ricardo had developed the Law of Rents, and even Walras and Marshall, founders of neo-classicism, recognized the special status that land had in economic theory. What George did was to base his political economy on the fact, a fact not really disputed in economic theory, that land derives its value not from the landlord but from the community. No reasonable economist disputes this. Yet, all the values created by the community are appropriated by the landlord. It is the classic example of economic rent, a value paid but not earned.

Socialism recognizes only public values of land, and capitalism recognizes only private values, and hence both provide an incomplete description of land, which has both public and private values. George's solution is elegance itself: he socialized ownership of land while privatizing its development. By “taxing” the full value of ground rent, he made speculation unprofitable. At the same time, the use of land, that is, improving it by farming, mining, or building, gets its full value without any taxation at all. In other words, the community gets what the community creates, and the individual gets what the individual creates.

Nor is Georgism without precedent in history, or even the present moment. Indeed, before the advent of the modern capitalist and socialist nation-state, land taxes tended to be the main support of the state. As Adam Smith noted, the “customary rents” of the English feudal land system functioned more as taxes than as rents, that is more as amounts paid for services to the property, and less as Ricardo's “economic rent.” Moreover, there are modern states which attempt to be Georgist. In Hong Kong (under the British) all the land was owned by the government and leased out to developers. In Singapore, the government owns 76% of all the land using the same system. Taiwan, Korea, and Japan, are all, in one degree or another “Georgist” and they are all successful economies. (The popularity of Georgism in the orient traces to the fact that Sun Yat-sen, the father of Chinese Nationalism, was a disciple of Henry George.) So we are not dealing with a mere abstract theory, but one with precedent and example.

However, it should be noted that none of these states are examples of pure Georgism, and therein lies the key to the relationship between Georgism and Distributism. In theory, in a free-market economy, it should be easy to determine the ground rent of any piece of property. But in practice, in places where there are vast concentrations of ownership, this task becomes impossible. Large landowners use any number of subterfuges to hide the true value of the land, since this is the basis of their taxes. Hence, in the modern world, actual Georgist states tend to consist of half-measures and compromises.

Distributists and Georgists have often exhibited a certain hostility towards each other, as if they were pushing rival theories. But they are not. In fact, the theories are complimentary. Rather, it is a question of priorities, which comes first. In my opinion, (being a distributist), a system of well-divided property is prior, and without this Georgism cannot really and truly be implemented. But in a system of well-divided property, a land tax is needed to ensure that the worker gets the full value of his work and to maintain the division of property. This is to say that Georgism requires Distributism for it implementation, while Distributism requires the land-tax, or else property will merely re-accumulate. As a further point, Georgism provides Distributism with access to a sophisticated political economy and tools of economic analysis, for which we do not have to apologize to the “orthodox” economists; in fact, the analysis and the tools are much better.

It would be better for both views to have a better understanding of each other, as they are complimentary theories, and each adds something that the other tends to lack.

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Taxes: What Should they Buy?

Fourth in a four-part series on taxes.

“Taxes are theft!” judges one reader of this humble blog, and more than a few libertarians would agree with him. As near as I can tell, this judgment is based on a view of man as a completely autonomous individual, dependent on no one but himself, answerable to no one, and subject to compulsion by no one. Under this view, to the degree that taxes are compelled they cannot be just.

My problem with this view is that it does not describe any man or woman I have actually met. Every person of my acquaintance emerges not from autonomy, but from dependence. We are all called into being by the ready-made community of the family. Most of what we are comes not by an individual “consumer” choice but by gift. Along with the gift of family, there are the gifts of language, nationality, religion, community, city, state, and nation. Our values are socially formed by these gifts of social context and only after that formation do we find ourselves in a position to accept or reject these received values. What “freedom” we have consists mostly in decisions about how to use the gifts we are given; how to re-arrange them and pass them on. Our very being itself turns out to be already a “being-in-community” which mirrors in some fashion that ultimate community of persons that is at the root of all being, namely the Trinity. At their most basic level, humans are social beings, already formed by institutions “outside” themselves.

And since man is a social being he has social obligations; the gift demands a return if it is to survive to the next generation. Hence, each man has obligations which may, in certain circumstances, be compelled of him. Individual goods are themselves the product of social goods and are dependent upon such social goods; if there is a break-down in the social goods, no individual goods will survive. We are all dependent upon each other; the common good precedes any individual good. A philosophy of pure individualism contradicts the social nature of man. Clearly, there are common goods which no individual (or very few) could provide by themselves. The obvious example is the common defense, but there are others, and they are normally supported by taxation.

But if this rule of the common good gives us the ground for legitimate taxation, it also gives us the ground for judging when taxes are illegitimate. For if the legitimate purpose of taxes are to pay for those things necessary for the common good, then taxes are illegitimate when they purchase not the common good, but individual and particular goods. That is, when good money is taken from all to provide goodies for a few, goodies not connected with the common good, then they are illegitimate.

When we examine the actual expenditures of the modern state, we have ample grounds for questioning whether all of this money, or even most of it, goes to the common good, or are just private goods paid for by the commons. And while we should never (in my opinion) proclaim that “All taxes are theft!” we have more than ample grounds for shouting, “Most taxes are theft!” The one-word difference is crucial.

Of course, there can be different judgments on what constitutes the common good. But there can be no doubt that the system of special bills for special friends (“earmarks”) which burden every budget bill are nothing but theft. And even things that fall in the common good can be used in such a way that much of the money goes for other purposes. For example, we certainly do need an army for defense, but does our defense really require troops stationed in more than 130 countries? Certainly there are private contractors on whom the military is dependent, but do we really need the army of parasites and mercenaries provided by Halliburton and Blackwater? I tend to doubt it.

To take another random example, we can note farm subsidies. Now, a secure food supply is in the common good. As someone who likes to eat three or more times a day, I want to see secure and prosperous farmers, as my own security depends on them. Further, I have no objection (and much praise) for a fund which insures the farmer against the vicissitudes of the weather and the market, since the farmer himself cannot control these things. This fund ought to be largely supported and controlled by the farmers themselves, and it is not unjust if this fund receives a contribution from the general taxes, or at least, from those tax-payers who actually eat. But the current system is not an insurance program at all, but a subsidy, and one not so much to the “farmer” as to the giant “agri-businesses” such as Archer-Daniels-Midland and the like.

Further, we can note that not every common good needs to be paid for by general taxes. Take transportation, for example. Certainly it is a common good, and a prosperous people need a good transportation system. However, it turns out that most expenditures for particular forms of transportation constitute a subsidy for private persons. We build highways, but the only ones who can use them are those who can afford the high capital costs and operating expenses of an automobile. And when we invest so much public money in highways, we privilege one group of users over another, and force people to buy a car whether or not they want to, or whether or not it makes economic sense for them to do so. Now, its not that I think the government should get out of the transportation business; there are good arguments for public roads, since every particular route would have to be a monopoly anyway; you could not efficiently have two competing roads operating on the same route. However, these roads should be paid for by user fees (tolls) and not by general taxation. Indeed, subsidizing the roadways turns out to be both contradictory and self-defeating (see Free Markets, Free-ways, and Falling Bridges.)

We can also note areas where the free market has proven itself incompetent. Modern medicine is one of these areas. Indeed, so long as we are talking about a market that is so dependent on licenses and patents, there cannot be, even in principle, a free market at all (see Sicko-phancy!) We did have a free market in medicine, in the 19^th and early 20^th centuries, and it was a disaster. Hence, there is ample justification for a public system of health care. The specific taxes applied to this can certainly be debated. I will not here enter into that debate, but I will merely note that such a system ought to be supported by taxes dedicated to that purpose, such that if the costs rise, the public will have instant feedback via an increase in those specific taxes.

Our other big problem is retirement funds. Now, in days gone by, there were two sources of social security: have a lot of money or have a lot of children. We have made the latter unfashionable and the former damned near impossible (median wages haven't risen in 30 years). As a practical matter, we cannot do away with the system in any near term without causing social chaos (besides, the old folks vote.) Nevertheless, the system itself is not sustainable and in reality constitutes a surtax on labor incomes that is now used to support the general fund. In other words, it is just an additional income tax on one class of workers but not on others (see Social Insecurity.)

Looking over the budget as a whole, it is my unscientific judgment that at least one-third to one-half of the expenditures are for things that are mere subsidies, or that could be moved from the general taxes to special funds and user-fees. Hence taxes could be cut, conservatively speaking, by one-third to one-half, and could be done without harming, and indeed improving, things that really contribute to the common good. However, cutting taxes depends entirely on cutting expenditures. Candidates don't like to talk about cutting expenditures because each cut cuts into a constituency, either one that contributes a lot money or a lot of votes. We are left with vague promises of cutting “waste, fraud, and abuse” only to see all three increase. Or we get nonsense like Huckabee's “revenue neutral” plan, which on inspection turns out to be “all taxes on the rich are theft; everybody else pays 30%.” And all will end up continuing the program of borrowing to pay for “tax cuts” while spending like drunken sailors. Such “cuts” are not cuts at all, since borrowing is not tax-cutting but tax-shifting; taxes are shifted from the current generation to the next one. We are, quite literally, spending our children's money.

It is unfortunate that Ron Paul, the only actual Republican in the race, has taken the “all taxes are theft line.” It is not merely that it prevents him from getting elected (since most sensible people don't believe that), but more importantly it prevents him from speaking about the more important issue, namely, insisting one fiscal discipline. Spending only as much as you take in, and spending it only for the common good. That platform might actually win, if backed with sufficient funds for a credible campaign. But win or lose, it would certainly be a great moment of political education.

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Taxes: Advice from Adam Smith

Third in a four-part series

When considering any subject relevant to government and economics, I always like to consult Adam Smith. Now, there are many who would disagree with this. Smith gets attacked from both the right and the left, usually for all the wrong reasons. Worse, he gets “defended” for all the wrong reasons; his “supporters” often attribute to him opinions he never held and against which he used his strongest arguments. For example, Smith was not a mindless supporter of “big business,” but in fact fulminated against it. For more on this theme, see my The Forgotten Agrarian: On Rereading Adam Smith. It may be Smith's fate to be among the most often quoted but least actually read of the modern philosophers.

It is not that I consider Smith infallible, but I usually find him sensible, and even when he is wrong or incomplete, he usually highlights the correct issues. In Book V of the Wealth of Nations, Smith has an extensive discussion of taxation, one that still serves us well today. Smith begins his discussion by laying out four maxims by which any particular tax can be judged.

The Four Maxims

• Taxation should be proportional to income. Smith seems to mean this in a negative sense, namely that taxes should not be regressive, because he praises taxes that fall disproportionately on the rich.

• A tax ought to be certain and not arbitrary. That is, “The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor and to every other person.”

• A tax ought to be levied at the time and manner in which it is most convenient for the contributor to pay it. For example, a tax on rents ought to be paid when the rent is paid and not before.

• The cost of collection should be as low as possible. Under this heading, Smith includes four points:

1. The tax should require as few “officers” as possible to collect it.

2. It should as low an impact on industry as is possible.

3. It should create as few temptations to evasion as is possible. Where temptations to cheat are high, the law should be lenient.

4. A tax should not be such as to subject the people to “odious investigation” of their affairs.

Using these four maxims, Smith examines a wide variety of taxes. We shall confine the discussion to those taxes most relevant to our situation, income, sales, and land taxes. One note about Smith's methodology: he discusses issues based not only on theoretical considerations alone, but examines, in great detail, actual examples of taxes as they function both in England and other countries. His method, therefore, is a combination of theory and practice, which saves it from the dry abstractions of the Austrians as well as the pointless empiricism of Chicago School Friedmanites.

Taxes on Labor and Incomes

Taxes on lower wage workers can only have the effect of raising wages sufficiently to accommodate the tax. This is because a worker needs a certain amount to live, and will not work for less than that. Hence, a tax on low-wage labor is, in effect, an increase in the cost of production and is passed on to the consumer.

When a tax is levied on profits fall, for Smith, into two parts, a tax on interest and a tax on the labor of the entrepreneur. The entrepreneur must earn enough above the interest to make his living, or he will simply cease operations. Thus a tax on his profit about interest is equivalent to a tax on labor. A tax on interest payments, however, cannot have any effect on the rate of interest, since that will be set by the market. However, a tax on interest has two problems: one, the amount is difficult to ascertain (this was before the extensive reporting requirements of the modern era), and; two, capital is mobile, and high taxes will cause it to seek other climes.

In all cases, a tax on incomes must involve a severe inquisition into the circumstances of private persons. We all understand what that means. For myself, I do not object so much to the paying of the tax (which Smith regards as the duty of a citizen and the badge of a free man), but to the “severe inquisition” of the tax filings.

Consumption (Sales) Taxes

Smith divides consumption taxes into two parts: that on necessities and that on luxuries. By necessities, he does not mean “the poverty line” or what is merely necessary to sustain a man in subsistence, but that which is necessary for him to participate in a meaningful society. Smith uses the example of shoes. In some societies, it is perfectly acceptable to go barefoot, but not in England. A man who goes barefoot to a job interview in England (or America) is not likely to get the job, is not likely to be counted as a full participant in his society. Therefore, necessities for Smith means a lot more than subsistence.

A tax on necessities works in exactly the same way as a tax on labor. By raising the cost of necessities, one must necessarily raise the cost of labor by the same amount, with the difference passed on to the consumer. The consumer therefore gets a double whammy: an increase in the price via the taxes and an increase in the cost by the necessary rise in wages.

As for a tax on luxuries, Smith has little objection. It will discourage useless consumption by the poor and derive revenue from the rich. But all such taxes are difficult to enforce and the higher they are, they more they encourage what we would call “black markets”. Sales taxes, when they are high, often lead to lower revenues for the government, since the cost of collection is high and the inducement to fraud even higher. Smith's intuitive division of sales taxes into necessities and luxuries is recognized by most taxing authorities, which exclude things like food, housing, medicine, etc. And the taxes are kept relatively low so that the cost of avoiding them will not exceed the cost of paying them.

Taxes on Land

Smith distinguishes between agricultural land and land used for buildings or houses. I will not here take up his discussion of agricultural land. As for developed land, Smith divides the rent into two portions: ground rent and rent paid for the improvements. Any amounts above what gives a reasonable profit on the improvements goes to ground rent.

Ground rent is likely a new concept to many people, but it was of extreme importance in the economic debates of the 19^th and early 20^th centuries. Smith, Ricardo, Mill, Marx, Marshall, Walras, Clark, Senior, Henry George, and many other luminaries debated the issue at great length. Unfortunately (from the standpoint of a complete economic theory) the subject died after J. B. Clark subsumed land into the general “capital fund” theory. Ground rent is the price or rent of land that underlies any improvement on it. It rises with the population of the surrounding area. That is, a parcel of ground in a densely populated city will cost more than than an equally good parcel in a smaller city, which will cost more than a similar parcel in the country. In other words, it is not anything the landlord adds to the land, but what others add to it that raises the ground rent. Peace, prosperity, and population increase raises the price of land without the landlord actually having to do anything. Such increases in the rent or price of land are unearned increments, involving no effort whatsoever on the part of the owner.

For this reason, Smith found that ground rent was the most appropriate subject of taxation.

Ground-rents...are altogether owing to the good government of the sovereign....Nothing can be more reasonable than that a fund which owes its existence to the good government of the state, should be taxed peculiarly, or should contribute something more than the greater part of other funds, towards the support of that government.

Taxes on house rents, Smith held, would fall most heavily on the rich, but he held that to be an advantage. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.

To sum up, we can arrange Smith's taxes in order from most appropriate to the least in this way: taxes on ground rent, house rent, luxuries, incomes, and necessities.

From Smith's principles we can evaluate the tax proposals before us. Of course, the present system of reliance on income taxes violates most of Smith's principles. However, the most touted alternatives are generally worse. The Flat-tax involves all the inconveniences of the current system, plus makes the system highly regressive. This is because it maintains, on top of the flat tax, the FICA taxes, which will give most people a much higher marginal rate than they currently have. However, FICA stops at about $90,000, which means the marginal rate for the highest incomes will be cut in half. The middle class will pay the marginal rates of the rich, while the rich will pay the marginal rates now paid by the middle class. It is hard to think of a tax plan more poorly planned or more unfair.

Unless it is the “Fair” tax. For the majority of people, who must convert all or most of their incomes to consumption, it will function as an income tax with high marginal rates. For the rich, who convert less of their income to consumption, it will be a tax reduction, while for the very rich it will come near to tax elimination. In addition, it will require massive collection and enforcement bureaucracies and encourage cheating on a massive scale. Of all the proposals, it violates just about every one of Smith's maxims.

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Taxes: Fair or Foul?

The second in a series on the principles of taxation.

Somewhere in the Analects of Confucius, the Master says that the first step in solving a problem is to call things by their right name. When things are mislabeled, it is very difficult to think about them correctly. On the other hand, if you do not wish people to think correctly about an issue, the first step is to mislabel things. If you deliberately wish to confuse people, you can start in no better place than to give things the wrong name. A name describes what a thing is, and if you wish to conceal from people what that thing is, then call it something it is not.

However, mislabeling things does give a clue to the fact that someone is trying to mislead you. If someone is afraid to call something by its right name, then they are afraid that people will find that thing fearful. Which brings us to the 30% National Sales Tax. I use this name because it describes what the thing is. But if you have not heard of it before, it is because the supporters of this idea do not call it by this name. They are afraid that any name which accurately describes it would certainly cause people to fear it. And I am afraid that they are right. The name they have chosen is one that gives an opinion about the tax, rather than describe what it is. One is certainly entitled to one's opinions; one is not entitled (this side of Karl Rove and George Bush) to misuse the language. And the opinion they have rendered on their own plan, the mislabel they have chosen for it, is the “Fair” Tax. I am not concerned, for the moment, with whether this opinion, rendered as a “name,” is accurate. My concern for the present moment is why they chose this particular bit of propaganda for their moniker.

The reason is simple: they have perceived, quite correctly, that fairness is a basic principle of a just tax system. Now, I do not know what standards the backers of this tax use to render the judgment of fairness on their plan. I have searched their web site (www.FairTax.org) in vain for a definition of “fairness.” So I will have to supply my own. And I believe that we can define fairness as justice.

But what is justice? Obviously, there are many different notions of what constitutes justice, but I believe that they all have one thing in common, namely the idea that what one gets should be proportional to what one gives, that one's rewards should be commensurate with one's contributions. There is not much dispute, I believe, about this principle. However, the devil is in the details. No one will quarrel with the proposition that if you spend a dollar, you should get a dollar's worth of goods; if you pay for a pound of ground beef, you should get a pound, and it wouldn't be just if the butcher had his thumb on the scales. This is justice in exchange, or what Aristotle called commutative or corrective justice. This kind of justice deals with exchanges between individuals or between firms acting like individuals.

But there is another kind of justice called distributive justice, which deals which how collective entities (a family, a company, or a state) distribute their corporate products to the individuals that make up that collective entity and contribute to it. And it is a fairly well established principle that rewards from the corporate entity (the state, in this case) should be distributed in proportion to the contributions each individual makes. Now, there are many different kinds of contributions to the common good (which is, or should be, the “product” of the state). There are soldiers to protect us, nurses and doctors to heal us, mothers to give us life and serve as our first teacher, entrepreneurs to create new wealth, and so forth. It is difficult to judge the relative merits of each of these contributions, but we know that life would be more precarious, or even impossible, without the contribution of each of these people. Hence we know that it is in our best interests to see that each person is properly rewarded for their contribution to our comfort and well-being.

There is another kind of contribution to the common good that we all make, one way or the other, and that is the contribution of money to pay for the whole thing. This brings us (at last) to the question of taxes. Who should pay, and how much? I think the answers are: “Everyone,” and “In proportion to the benefits they receive.” Now, we don't have to worry too much about the first point, since many taxes will be passed on, one way or another, in the prices we pay for things. Hence, everyone will pay, even if taxes are not directly collected from everyone. It is the second point that is the interesting one, since we receive different levels of rewards from society and from government. For example, the police are there to protect us in our persons and our property. Now, we all have the same “property” in ourselves and receive the same benefit (in theory) from police protection. But we have differing amounts of property in “things.” Some have very little, but others have a great pile of things, and derive greater benefit from the protection of those things. Clearly, they receive a greater benefit and should pay a larger proportion of the costs of police protection.

Now, even with a flat-tax, the rich will pay a greater amount, but should they also pay a greater proportion of their income? This brings us to the great debate about taxes: Should they be regressive (the poor pay a larger proportion of their incomes), flat (everybody pays the same percentage), or progressive (the rich pay a larger proportion of their income)? Each of these answers embodies a different ideal of justice. Here we cannot reduce things to a rule (as we could in the case of simplicity) but must make a judgment about what constitutes justice.

A regressive tax embodies the ideal of the ruling class as the leaders of society who should receive the bulk of the rewards. At its most extreme, regressive taxes express the ideals of a slave society, since you can regard the slave as someone who is taxed at a 100% rate, minus some “prebate” equal to the level of subsistence the that the master is willing to give to the slave. One would think that regressive taxes are excluded from a democratic society, but in fact many of our tax structures are regressive. Sales taxes are one example. Another is the differential rates of taxation for income from capital and labor. Labor is taxed at a higher rate than capital gains, which is regressive because the rich tend to make a higher percentage of their income from their capital rather than their labor.

A flat tax embodies abstract ideals of economic and political equality; each person is deemed to be rewarded by the economic system in a manner proportional to his or her efforts. As such, the flat-tax has some appeal from the standpoint of the ideals of equality. However, the evidence that people are rewarded in exact proportion to their contributions and productivity is weak at best, and flat contradicted at worst. Look at the following chart (click on the chart to get a clearer view).

What it shows us is that median wages (adjusted for inflation) have been flat since 1973. Yet in that same time-frame, productivity for all classes of workers has increased dramatically. What has happened is that one relatively small group has appropriated to itself all the gains arising from increased productivity; the connection between contributions and rewards has been broken. Now, while there may be good arguments for a flat tax in the case of taxes on wealth (land taxes, for example), these arguments are weak when applied to incomes, at least in the concrete situation in which we find our society. This is not only a violation of basic justice, but has deleterious practical consequences as well (see The Investor's Dilemma and The Investor's Dilemma II).

This would seem to leave progressive as the only system that would meet the standards of fairness and justice, at least, in our current situation. Those who receive a disproportionate share of the rewards should contribute a disproportionate share to the upkeep of the commonweal.

Both the 30% National Sales Tax and the Flat-Tax proposals make a nod in the direction of progressive taxation, the former by establishing a universal welfare program that prebates the sales taxes up to the poverty level, and the latter by a standard deduction equal to the poverty level. In the case of the Flat tax, the degree of progression is trivial. Further, since the tax only replaces the income tax and leaves the FICA taxes in place, it ends up being regressive. A worker will pay the 17% flat tax, plus the 7.65% payroll taxes. A self-employed person (like myself) will get a flat tax of 32.65%, which is close to the marginal rate for the richest Americans, and I am by no means rich. Further, since the FICA taxes stop at about $90,000, the resulting structure is regressive.

In the case of the National Sales Tax, "progression" is an outright lie. The “progression” comes only if you assume that the rich convert all of their income to consumption, which is patently untrue. At the extreme, a man like Warren Buffet has difficulty converting even 1% of his income into consumption; therefore his tax rate will equal 23% of 1%, or 0.0023% of his income. This is a rate more compatible with a class-based or even a slave society than with a democratic nation.

Obviously, there can be different judgments about justice; it is not something that can be calculated, but must resolve itself back to some basic, but “unprovable” notions about the kind of society we want. But I do believe that any discussion will have to take into account the factors that I have mentioned here, namely the proportion between the benefits one receives and the contributions one makes.

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Taxes: The Simple Life?

This is the first of a four-part series on the principles of taxation. In the next year, the public will be besieged by various claims about taxes. These claims cannot be evaluated without enunciating principles that apply to all taxes of any type. Without foundational principles, we can get no further than ideology and propaganda, and shrillness rather than reason must dominate the discussion. This first post deals with the question of Simplicity in taxation. Reader comments are welcome.

In spring a young man's fancy may turn to thoughts of love, but in winter they turn to darker thoughts indeed, and none darker than the thought of filling out his income-tax returns. That season is hard upon us, and the joy of the Christmas is inevitably followed by the gloom of the tax season, as Santa Claus is replaced in our imaginations by Uncle Sam. The former giveth, the latter taketh away. And while one is awash in receipts and W-2s and 1099s and forms of every sort, it is natural to cry out, Why can't we have a simpler tax code? And even more damaging to our perception of the tax system is the knowledge that the tax-code is laden with “gifts” for special-interest groups large and powerful enough to purchase a legislator or two; the corporations expect a return on the 100's of millions they pour into politics, and special tax treatment is part of that return. So along with a desire for a simpler tax comes a cry for a fairer tax.

Such a cri de coeur creates a demand for schemes which are “simpler” and “fairer.” And with such a great demand, there comes any number of plans from both reformers and charlatans alike willing to supply the demand. And, of course, it gets harder and harder to tell the reformers from the charlatans. Indeed, there may not be much of a difference between them on this issue; every attempt to simplify the tax code has made it more complex; every attempt to make it fairer has made it more unfair.

To be sure, the tax-code is laden with bounties for special interest groups which could easily be removed and so greatly improve the tax code. But even removing these would not greatly simplify the code. The plain fact is that the complexity of any tax code arises from the complexity of the thing being taxed; no code can be simpler than the thing to which it applies. And in the case of an income tax, the tax code cannot be simpler than the concept of income. In truth, there is no single or simple definition of the concept of income either in economics or in accounting. Or rather, there are any number of contending definitions, each of which has some validity in a given situation or for a given purpose. In the accounting trade, the rules for defining income (or profit) are given by the Generally Accepted Accounting Procedures (GAAP) which is governed by the Financial Accounting Standards Board (FASB). The GAAP manuals currently run to five volumes. Thus, no tax-code that deals with income can be shorter than these five volumes.

But in reality, the code must be very much longer than the five volumes of GAAP. Why? Because GAAP allows a wide variety of methods for calculating income since it covers, in theory, every possible situation. Using GAAP, a business firm could simply select its level of income by combining the most advantageous methods. This is not really a problem when it comes to most uses of financial statements. For each type of business, the users expect a certain type of accounting, and a business that violates these expectations will likely be punished by investors, bankers, and financial analysts. But the opposite is the case with the tax code; selecting the method that most understates income will result in rewards for the firm and an intrinsic unfairness in the tax-code. Therefore the simplest possible code will not only be as long as GAAP, but must be some multiple of the five volumes, since it must state the allowable accounting methods in each situation. We can know state an absolute principle for any income tax-code: An income tax-code cannot be, even in theory, any shorter than the Generally Accepted Accounting Principles that define income and must be, in fact, some multiple of these procedures.

We can apply this principle to a specific “tax simplification” proposal, the Flat Tax. Former congressman Dick Armey has proposed this tax with a simplified business tax return that fits on a post-card. Basically, there is one line to state the firm's “income,” another to state its cost of goods sold, which is then subtracted from the income, and a 17% tax rate is then applied. That's it. Pretty simple, no? Well, no, it is very complex. Each of the lines, “income” and “cost of goods sold,” would have to be backed up by forms which are in fact every bit as complex (if not identical to) the current forms. For example, when is “income” recognized? At the time the order is booked? At the time delivery is made? At the moment payment is received? At each stage of completion for works-in-progress? For different kinds of businesses, each one of these methods has a certain validity and is used in different situations but not in others.

The complexities that apply to “cost of goods sold” are even greater. Should inventories be charged when they are purchased or when they are consumed? Should capital equipment be charged off in the first year or over the life of the asset? These, and literally thousands of other issues are covered in the GAAP manuals and must be specified in the law and detailed on the tax return. Armey may be able to summarize the forms on half a page, but the supporting forms would be just as lengthy as they are today. They cannot, even in principle, be any shorter.

At this point, the alert reader might interject, “yes, that might be true for business taxes, but certainly personal taxes can be just as short as Dick Armey says: state your income from the W-2, apply the flat rate, and that's that!” The problem with this is that the amount on the W-2 is already the result of complex calculations covering several volumes of the tax-code. Certain amounts one does not actually receive (like the FICA tax) are counted as income, while certain amounts one does receive (like health benefits) are not counted. The return that Dick Armey is proposing already exists; it is the 1040EZ. This form is “simple” only because the complex accounting has already been done by somebody else and because all other possible deductions are denied in advance. The flat tax “simplifies” only a few pages of the tax code: those pages which deal with the varying rates of taxation. Of the thousands of pages, it addresses only a few; everything else would have to remain in place.

This brings us to our second principle of taxation: Whatever the government taxes, it must also measure, regulate, and control. If the government taxes income, it must be able to define, measure, track, and audit income. There must be a bureaucracy and a both a legislative and judicial process to accomplish this task. If it taxes consumption, it must be able to define consumption, and track every transaction that fits that definition. The oft-advanced claims of “reducing bureaucracy” ring hollow because the bureaucracy must be co-extensive with the thing taxed. One can “abolish” an income-tax bureaucracy like the IRS only by replacing it with a bureaucracy as large and complex as the thing you choose to tax; if that thing is simpler, the bureaucracy can be simpler; if it is more complex, the bureaucracy will be more complex. There is simply no way around this principle. By selecting the thing taxed, one must, at the same moment, select the size and scope of government. A simpler government can be obtained only by taxing something simpler.

Next Post: Fairness.

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Social Insecurity

The ENRON Corporation was supposed to be an energy company, supplying the nation, in creative ways with the energy we need to heat our homes and cook our food. As it turns out, most of their creative energies went into cooking the books. Thousands of workers and investors saw their fortunes and their pensions wiped out, while the nation heaped well-deserved scorn on the perpetrators. However, the accounting chicanery of ENRON is small beer compared to the accounting trickery practiced by the federal govmint.

It is sad enough that the President can “boast” that he has reduced this year's deficit to a mere $163 billion. Alas, even this boast is a lie. But in truth, the real deficit is a staggering $497 billion. Nearly half a trillion dollars. How is this done? Scott Burns in Sunday's Dallas Morning News puts it this way:

The September statement shows that the "on-budget" ran a deficit of $344.3 billion in fiscal 2007. The "off-budget" ran a surplus of $181.5 billion. (The off-budget is dominated by Social Security, Medicare and other programs with trust funds.) Add the two figures and you get the "unified budget," that $162.8 billion.

But that's only part of the story.

In the last eight years, we've had two years of reported surpluses and six years of reported deficits. Altogether, the total reported deficit has run $1.3 trillion. But if you examine another figure – gross federal debt – you'll see something strange. First, it has increased in each of the last eight years, even though in two of the years surpluses were reported. Second, gross federal debt (which includes the obligations held by the Social Security and Medicare trust funds) has increased much faster than the deficits – $3.3 trillion over the same eight-year period.

That's $2 trillion more than the reported $1.3 trillion in deficits over the period.

How do they manage to under-report the deficit by $2 trillion? That's easy (Ken Lay would have been proud of this trick): they credit the various Social Security and Medicare “Trust Funds” with interest payments that aren't actually paid. Instead, they just place “non-marketable” securities in the funds. The budget therefore doesn't take a hit, while the Trust Funds show an accounting increase, even though no money is received. Thus they can perpetuate the fiction that Social Security is “sound” for the next 34 years; in fact, it will run out of cash in six to nine years. Indeed, the disability fund has been running at a cash loss since 2005 and Medicare part A (The Hospital Fund) ran out of cash this year.

I am not (for once) blaming George Bush alone for this deception. Clinton, the elder Bush, and Ronald Reagan all engaged in the same chicanery. It began on Reagan's watch with the “voodoo economics” of the Laffer Curve. That famous, and famously discredited, curve was supposed to raise revenues by lowering taxes. But, according to a report by the Treasury Department, it was a dismal failure. Reagan had to scramble to raise revenues, and tinkered with the tax laws nearly every year (this was before the Chinese government decided to simply lend us whatever amount we wanted—too bad for Ken Lay that he wasn't on better terms with the Chinese). The most lucrative source of new income was raising the Social Security taxes by 25%. No doubt such a move could be justified, if the SS funds really got the money, which they didn't; it was merely used to cover the big losses from “supply-side” economics.

Next year, the first wave of post-war baby-boomers will be eligible for early retirement, and for full benefits within four more years. The next president will not have the use of the trust funds to balance the budget; in fact, they will be a big source of imbalance, as the general revenue funds will have to pay out actual cash to retirees, just as retirees had paid actual cash to make the deficits look smaller. The worthless paper in the Trust Funds can only be redeemed by increasing taxes, lowering expenses, inflating the currency, or by a combination of all of the above. Or it can simply default.

My guess is that the government will not be able to meet its obligations; it will have to default on its debt. This default can take one of two forms: the government can default to public and foreign holders of its debt, or it can default on the debt held by the trust funds. I suspect it will do the latter, since some of the foreign governments holding the debt are great powers who don't like being cheated. So we will cheat our own people. What else is new? Mind you, I am not totally opposed to some adjustment. I am 60 years old, and it seems incredible to me that someone as young and as good-looking as I am (that's my story, and I'm sticking to it) will be too old to work in a mere five years. I wouldn't mind working a few years more to help relieve my children of an intolerable tax burden. But I don't think that even that will help. We have played by the rules of voodoo economics for too long, and we are about to conjure up a fiscal demon.

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