Good Tax Policy

In a recent column posted at Forbes http://tinyurl.com/d3pg4eo, Peter Ferrara argues that President Obama is a socialist.  What label one wishes to place on another is of little importance to me.  Whether you want to call the President a socialist or a liberal is of little importance to me.  I think name-calling is immature.  Someone called me “Big Nose” once.  It hurt my feelings, but it didn’t facilitate an informative discussion of the issues.

But what I want to discuss here is a statement made by Ferrara that illuminates a common error in thinking among many economic hacks.

Tea Party Patriots national coordinator Jenny Beth Martin, right, with Reps. Michele Bachmann, left, and Louie Gohmert this March. (Chip Somodevilla / Getty Images)

 “Good tax policy is not guided by ‘need.’  It is guided by what is needed to establish the incentives to maximize economic growth.”

This is a good illustration of how pop-economics has deteriorated over the years.  This guy thinks that tax policy should be guided on incentives to maximize economic growth.

Tax policy should actually be guided towards allocating the costs of government services to those that benefit from them.  Ideally, all expenses should be matched against the revenue.  If this doesn’t happen, then resources can be misallocated resulting in a net loss to society.  For example, there was a sitcom where a boy was making burritos and selling them to his friends.  He would buy the ingredients at the grocery store and charge them to his mother’s account.  Then he’d sell the burritos for $1 each.  When the expenses were paid by his mom, he thought he was making a profit.  Thus, resources were allocated towards an unprofitable endeavor thereby resulting in a net loss to society.

The same for a business.  Part of the expenses of a business are the roads that the delivery trucks drive on, the cost of the court system to enforce contracts and the CIA agent in Afghanistan preventing terrorist attacks.  A perfect tax policy would allocate the costs of all government services to the individuals and businesses that benefit from them.  A toll booth or a gas tax allocates costs to those that use roads.  An entrance fee allocates costs of public parks to those that enjoy them.  However, a lot of services (like national defense, police protection and cutting the grass on the National Mall) are more difficult to allocate to those that benefit, but the objective should be the same.

But what’s been happening these past few decades is that mom, or perhaps I should say “Mǔqīn”, has been picking up a lot of the bill.  This is where tax policy can establish incentives to maximize economic growth.  The government can establish trade relations with foreign nations, spend billions to protect shipping lanes, build roads and bridges, and provide a judicial system to enforce contracts.  But if these costs are not appropriately passed on to those that benefit (i.e. consumers and businesses), then the costs are not included in the prices of the products and services generated thereby resulting in misallocation of resources resulting in a net loss to society as a whole.

Tell me.  Who should pay for your latte?  Should you pay for it?  Who should pay to protect us from terrorists?  You think you’re paying for it.  Truth be told you are paying for some of it, but a portion of it is being paid by whoever is going to inherit the national debt, most likely your children and grandchildren.

Let’s go back to the boy who was making so much money selling burritos.  Who should pay for the ingredients?  If the boy can convince his mom to make his little sister pay, then the boy can reap profits and enjoy a lavish lifestyle.  Meanwhile the boy’s mom struggles to pay her bills, and the little sister gets screwed.

Another result is that society produces more burritos than it wants.  Suppose it costs more to produce a burrito than a taco.  But because the boy’s mom picks up the costs, the boy can sell the burrito for less than the taco thereby putting the taco boy out of business.

A real world example of this would be transportation.  People want gasoline.  Americans like to drive their cars, and they want the gasoline to be inexpensive.  In addition, gasoline diesel fuel and gasoline are used to ship goods to market.  If the price of gasoline and diesel fuel go up, then the prices of many goods will increase from tomatoes to lumber.  What would cheap gasoline be without roads on which to drive.  Americans want pothole free roads.

The government spends hundreds of billions on securing shipping lanes and making deals with oil producing nations.  Seemingly uncountable amounts of money are spent by federal, state and local governments on road construction, repairs and maintenance.  When Bob Hamilton gets into his car to drive to the Starbucks to get a cup ‘o jo, he pays, let’s say, one dollar for the cost of the round trip in addition to his coffee.  However, if all the costs were included, it might cost, let’s say, ten bucks.  Thus the government is subsidizing this lifestyle.  If Bob had to pay the total cost, he might reconsider his plan.  He might pick up the coffee on the way home from work or combine his daily errands thereby reducing his costs.  To go to his job he might consider taking public transportation.  And he might buy a more fuel-efficient car instead of that Hummer.

Do Americans like their cars?  Yes, they do.  Should the government subsidize it?  That’s the question.  If you want to drive your car, then drive your car.  Get a Ford Excursion or a Hummer and drive just for the fun of it.  But should part of the cost be paid by someone else?

Deficits Suddenly Matter

In his column “Don't Cave GOP, This Time Deficits DO Matter” posted at Forbes.com on December 14, 2012, Jerry Bowyer argues that deficits do matter.  This is a sudden departure from his previous position.  Let’s take a look.

On page 60 of his book “The Bush Boom” Bowyer argues to forget the deficit.  In the column referred to above, he admits that he has in the past “downplayed the importance of deficits” thinking that a budget deficit is rendered harmless if GDP growth exceeds the growth of the deficit.  The problem was that (except during the mid to late 1990s) GDP growth did not exceed the growth of the deficit.

Bowyer argues that now the debt has grown “to the point where it really is unsustainable”.  He points out that the national debt as a percentage of GDP is “over 100% and rising” and that “for the past few years the deficit has hovered around nearly 10% of GDP”.  So basically the reason for Bowyer’s sudden change in position is that the debt and deficit have gotten bigger.

A little background: A key statistic in evaluating a nation’s financial position is the Debt/GDP ratio which compares the national debt to the nation’s growth domestic product.  Nations with higher incomes are more capable of handling higher amounts of debt than nations with lower incomes.  For the United States, a debt of $1 trillion is a small amount.  For Cuba, a $1 trillion debt would be unmanageable.  A person with an income of $500,000 could easily afford to pay the mortgage on a $1 million house.  But for a person with an income of $25,000 per year… I mean, forget about it.

The U.S. Debt/GDP ratio has historically been much lower than it currently is.  It reached as high as 30% after WWI.  Then after the Great Depression and WWII the U.S. Debt/GDP ratio peaked at 112%.  It was necessary to accumulate that debt to win the war.  But after WWII the nation was responsible and little by little year by year the ratio decreased back to below 30%.

Then along came the supply-siders telling us that deficits don’t matter.  We can grow our way out of it, they argued.  The only problem is that we didn’t grow our way out of it.  The Debt/GDP ratio nearly doubled during the Reagan/Bush years.  The W Bush years returned to increasing Debt/GDP ratio during what Bowyer refers to as the “Bush Boom”.  Debt kept piling on with a brief respite during the Clinton administration.

Bowyer and people like him who kept saying “Forget the deficit,” and “Deficits don’t matter,” are the principle cause of the dire situation that we’re in today.  Spending beyond our means and borrowing to finance the appearance of prosperity for three decades has resulted in this nation going from the world’s largest creditor to the world’s largest debtor nation and being told to “forget it”.  When the financial crisis hit and the inevitable Great Recession, we were not in a financial position to properly address it.  Instead of drawing on savings, we had to borrow even more to prevent the economy from collapsing.

Now suddenly Bowyer wants to change his position, and he does a song and dance to convince himself (he’s not fooling anyone else) that his original position was justified.  But his original position was wrong.  We didn’t grow out of the debt.  Deficits do and always did matter.  Unnecessary irresponsible spending and debt accumulation accompanied by accumulation of off-balance sheet unfunded obligations for three decades is not and never was a good policy.