A Tax Policy Primer

As I have mentioned before, I practiced tax law for 25 years.  I moved on to other pursuits over the last decade but I still believe I know more than most about the subject.  When I practiced tax law I always had a very keen interest in tax policy.  In fact, I spent a considerable amount of time in Washington over the years working on tax policy issues for my employer and for industry groups.

The current campaign of President Obama for the so-called "Buffett Rule" requires an understanding of basic tax policy concepts to evaluate the issues intelligently.  President Obama keeps repeating the argument that millionaires are paying a lower tax rate than plumbers or secretaries.  As I have discussed before, this is very misleading.  However,  I also showed how it can occur if almost all of the income of the millionaire is comprised of capital gains and qualified dividends that are taxed at a maximum rate of 15%.

From a tax policy perspective, why have these two classes of income been given a preferential tax rate?  If you listen to President Obama he clearly does not agree with the tax policy behind the lower rate.  Here are the facts.

First, consider the history of the federal income tax.  John Steele Gordon provides "A Short History of the Income Tax" in today's Wall Street Journal.

Steele explains that the corporate income tax (profits tax) was originally enacted as a stop-gap measure while the 16th Amendment (which granted the federal government the authority to enact an individual income tax) worked its way through the ratification process in the states.  The 16th Amendment was ultimately ratified in 1913 just as President William Howard Taft was leaving office.

The new president, Woodrow Wilson, and the strongly Democratic Congress promptly passed a personal income tax. It kicked in at 1% on incomes above $3,000 (a comfortable upper middle-class income at the time) and reached 7% on incomes over $500,000. But there were many deductions, bringing the effective tax rates down sharply from the marginal ones—a feature of the tax system ever since. 

Unfortunately the corporate income tax, originally intended as only a stopgap measure, was left in place unchanged. As a result, for the last 98 years we have had two completely separate and uncoordinated income taxes. It's a bit as if corporations were owned by Martians, otherwise untaxed, instead of by their very earthly—and taxed—stockholders.

This has had two deeply pernicious effects. One, it allowed the very rich to avoid taxes by playing the two systems against each other. When the top personal income tax rate soared to 75% in World War I, for instance, thousands of the rich simply incorporated their holdings in order to pay the much lower corporate tax rate.

Therefore, profits of a corporation are taxed once at the corporate level and are taxed again when these profits (dividends) are distributed to the individual shareholders.   Therefore, a dollar of corporate profit first bears a 35% corporate tax and is potentially subject to being taxed as high as another 35% at the individual level.  That is a total tax of 70% on a dollar of profit.  It is effectively double taxation.

The 15% qualified dividend rate is in place from a tax policy perspective to limit the overall tax rate to 50% rather than 70%.  Many tax policy experts argue that dividends should not be taxed at all since the source of the income has already been taxed at the corporate level.   Alternatively, the corporation should be provided a deduction for dividends paid as it is allowed for interest expense.

When the individual income tax was originally enacted there was no capital gains rate.  It was not believed to be necessary with the top tax rate of only 7%.  However, the top rate was increased to 15% by 1916 (incomes over $2 million) and was 73% by 1919 (incomes over $1 million).   In 1922 the preferential capital gains rate was first introduced at 12.5% as part of an overall tax cut that also reduced the top rate to 58% on individual income on income over $200,000.  The lower rate was only allowed for assets held more than 2 years.

The holding period of a capital asset is the important distinction to consider here from a tax policy standpoint in the preferential rate.  When you receive wages for your labor there is usually a small gap in time.  A week or two for most people.  However, when you make an investment in a capital asset it can be years before you are rewarded.  If you bought a stock in 1991 and sell it in 2011 how much is your real gain?  If you paid $10,000 for the stock and you sell it for $20,000 20 years later should this be taxed the same as your wage income?  Nominally, you have a $10,000 gain but about 70% of that gain is just inflation.  It is a phantom gain.  Should that income be taxed the same as your wages? The input and reward are close in time with your wages and do not involve much risk?   The same is not true when you are putting your money down on a capital investment.  Why should government receive an inflation windfall?

In a perfect tax policy world, the taxpayer should be able to remove the inflation effect on these long lived assets.  Without some protection from this perverse impact it is easy to see why someone would not want to part with their hard earned money and invest it for any long term purpose.  There is a risk element that is not present with ordinary income.  The lower capital gains rate is designed to protect against this disincentive.

A few common sense thoughts from a tax policy standpoint.

• If the ordinary income tax rate is reduced there is less need for a preferential capital gains rate.  History has shown that as the top ordinary rate goes up it becomes necessary to establish a lower capital gains rate.  In fact, when the top tax rate was 28% under President Reagan the capital gains rate was eliminated.  It was re-established when ordinary rates went up under President Bush (41) and President Clinton.
• President Obama is going in the wrong direction on both counts.  He wants to raise both the ordinary income and capital gains rates at the same time.
• Allow an inflation deduction for capital assets and you have a stronger argument for treating capital gains the same as ordinary income.
• If the corporate income tax rate is reduced there is not as strong an argument for the preferential dividend rate.  It is the total tax of the combined total that should be considered.  If the corporate income tax was eliminated there would be no argument at all for a lower dividend rate.

It's Math

President Obama recently defended his calls for massive tax increases by stating that his proposals are "not class warfare, it's math."

Let's look at the math of the federal budget.

The Congressional Budget Office's last budget projection for the upcoming 2012 fiscal year projects that the federal government will have about $2.5 trillion in revenues and $3.6 trillion in outlays.   This is a $1.1 trillion deficit.

The CBO projects that in 2021 total revenues are projected to be $4.4 trillion.  This assumes that the current Bush Tax cuts continue, the AMT is indexed for inflation and the estate tax changes that were made at the end of 2010 continue.  In other words, without any tax increases taking place,  revenues are still projected to increase by $1.8 trillion in the next 9 years according to the CBO.  That is an annual compound rate of about 6.5% per year.

The current CBO projection for federal outlays estimates that we will spend $5.7 trillion in 2021.  That is a $2 trillion projected increase in outlays.  Therefore, we are looking at a $1.3 trillion deficit in 2021.  However, if we could limit our spending increase to a mere $800 billion over the next nine years, we would have a balanced budget in that period of time without increasing taxes.

This means that if we could limit overall annual spending to 2.25% per year between now and 2021 we could be within striking distance of a balanced budget according to the CBO projections.  Let's be generous and commit to a 2.5% annual increase in spending which should get us where we need to be in 10 years.

I am not proposing inhumane cuts.  I am not proposing taking a meat ax to the defense budget.  I am just saying we need to limit spending increases to around 2.5% per year between now and 2021.

The CBO is projecting that revenues are going to grow at about 6.5% per year.  If we increase income by 6.5% per year and limit spending to no more than 2.5% we can close the deficit within 10 years.  We are currently borrowing 40% of every dollar we spend so that is the hole we need to climb out.  An excess of 4% of income over expenses for 10 years gets you out of the 40% hole.  (4% x 10 years=40%).

It's simple.  It's math.  It's the math the President should be working on.

Three Things I Learned Last Week

Greece


Greece's financial problems continue to threaten the European (and world) financial system.  What are the chances that they can solve their problems without defaulting and/or a massive bailout from the other Euro countries?  Zero, in my opinion.

Two key facts that show how difficult it will be for them to turn things around:

1. Greece's Social Security tax is 28% on the employer and 16% from the employee.  A total of 44%! This covers pensions, unemployment and care insurance.    Is it any wonder that the unemployment rate is over 16% in Greece. 
2. The Greek birth rate is only 1.38 children/woman.  A rate of 2.10 is necessary just for full replacement.  Mark Steyn notes a more interesting stat describing Greece's demographic problem.  For every 100 grandparents in Greece, there are only 42 grandchildren!

Energy Subsidies

We hear all the time about the subsidies that go to oil and natural gas from the Obama Administration.  Here is chart prepared by the House Budget Committee that shows the dollar value of federal subsidies for various forms of energy per megawatt hour of electricity produced from an analysis done by the U.S. Energy Information Administration:

Subsidies for renewable energy production have surged since the Obama Administration and the 111^th Congress dramatically increased taxpayer support for these sources of energy with the stimulus law and other appropriations. In 2010, $11.9 billion was recorded in total federal subsidies for electricity production, according to a report from the EIA. Of this nearly $12 billion in subsidies, renewable-energy sources received $6.6 billion, or 55.3%, even though they accounted for just 10.3% of the electricity generation. Wind plants alone accounted for 42% of total electricity-related subsidies.

Total subsidies for renewable energy, including biofuels, rose from $5.1 billion in 2007 to $14.7 billion in 2010. Much of that increase was due to stimulus spending, the report noted, a 188% increase.

The Department of Energy has issued $40 billion in new loan guarantees for private sector loans for renewable energy projects since the 2009 stimulus bill.  $535 million went to Solyndra which is now bankrupt.  We can undoubtedly expect more to come.

Paying for the Jobs Bill


President Obama keeps campaigning for his $447 billion job bill and keeps saying it is paid for.  Let's see how it is paid for.

• $400 billion from limiting the itemized deductions for charitable contributions, mortgage interest and other deductions for individuals making over $200,000 and families making over $250,000.
• $40 billion from closing loopholes for oil and gas companies
• $18 billion from higher taxes on fund managers for so-called carried interest
• $3 billion from changing the tax treatment on corporate jets

Therefore, 90% of the jobs bill is paid by taxing the 3% of the people in this country who earn more than $200,000 per year.  Their share of total income is about 25% but they pay 50% of the nation's income tax already.   This is fair?

Palestine and Israel

We often hear of the plight of the Palestinians and we see the utter hatred of Israel and the Jewish people by Muslims.  Sitting here in the United States it is hard for the average person to figure out what is going on.  I came across three recent stories that provide a little context.

The first is "Debunking the Palestinian Lie" that I found on PowerLine.  We often hear about how Israel has pushed the Palestinian people from their rightful country.  The fact is that they never have had their own country. Their statehood was never even recognized when the Palestinians were part of the Turk's Ottoman Empire.  They were given plenty of opportunities to have their own country over the last 90 years.  They simply refuse to allow the Jews to be anywhere near them and have their statehood as well.   They have made it perfectly clear they have no interest if they cannot also obliterate Israel.  View the short video if you are not aware of the history.

You might also want to read this story, "A Century of Palestinian Rejectionism" by Fred Siegel for some historical context.

The third story is a column by Diana West where she writes about "The Jihad is Against the Bible".  Ms. West says make no mistake, it is Israel in which the axis of Islamic Jihad turns.  Why Israel?  West quotes Bat Ye'or's new book "Europe, Globalization and the Coming Universal Caliphate".

Why Israel? Ye'or asks. "Given the immense territories conquered and Islamized over thirteen centuries of expansion and war," she writes, "why would Muslim countries keep plotting to destroy Israel?" And further: "Why does the immense oil wealth of Muslim nations nourish a flood of hatred that poisons the heart of humanity against such a small nation? Why is Israel considered so alarming?"

The well-read global citizen might regurgitate something about land, modern Zionism and the post-1948 "plight of the Palestinians," but these are stock narratives overwriting the age-old reason. "What Israel possesses," Ye'or explains, "is the Bible."

To appreciate the depth and breadth of this perhaps obvious but seldom pondered explanation, it's essential to realize that Jewish and Christian Bible characters, from Abraham to Moses to Jesus, pop up in the Koran as Muslim prophets who actually preach Islam, not Judaism or Christianity. This is the time-wrinkling, religion-morphing way in which Islam repudiates what it regards as falsifications in both the first (old) and second (new) testaments. Given that the Jewish and Christian religious books long predate the Islamic religious book, it's not surprising that in their Koranic guises the biblical characters "wander," as Bat Ye'or writes, "in uncertain space with no geographical or temporal references." Still, Muslims claim that these same "Muslim" characters lived in "Palestine," Bat Ye'or writes, on the basis of the "Jewish and Christian scriptures that they reject."

The land of Israel itself -- whose "every region, town and village is mentioned in the Bible with historical and chronological precision" -- is thus "sacrilegious" to Muslims, she explains. "They observe with destructive rage this unfolding return of history that they claim as their own. ... Any confirmation of the veracity of the Bible is seen as an attack on the Islamic authenticity of the Koranic figures taken from the Bible."

So much for those slivers of real estate as being the driver of war on Israel. It is, in fact, a jihad, a religious war against Judaism and the land of the Bible, root of Christianity. As Ye'or puts it, "Israel, in the land of its history, towns and villages, resuscitates the Bible, the book the Koran must supplant."

The bottom line according to West is that the war on Israel is also a jihad against the Bible and Christianity.  The real story is that Muslims believe that Christians have gone astray by placing themselves in the lineage of the Hebrew Bible when there real origin is Islam.  Getting rid of Israel and the sustaining Jewish roots is seen as necessary to facilitate the Islamization of Christians which is the final goal.

Pants On Fire

President Obama made the following statement the other day.

“It is wrong that in the United States of America, a teacher or a nurse or a construction worker who earns $50,000 should pay higher tax rates than somebody pulling in $50 million.” 

I practiced tax law for 25 years.  I know something about tax rates, capital gains rates, marginal tax rates, effective tax rates and a lot of other tax trivia.  I don't want to call the President of the United States what Rep. Joe Wilson called him but his pants are pretty close to being on fire with that statement.

Let's assume that there is a nurse, teacher or construction worker who earns $50,000, is single and claims the standard deduction.  They have no other income.  This would result in the highest income tax cost you could have.  $50,000 of adjusted gross income less a $3,700 personal exemption and $5,800 for the standard deduction would leave $40,500 of taxable income.  This would amount to a $6,250 federal income tax bill=an effective tax rate of 13.5%.  The effective tax rate is your income divided by the total tax.  The marginal tax rate is the tax rate on each additional dollar you earn.  For the worker here, the marginal rate is 25%.

Contrast that with someone earning $50 million per year, even if it is assumed that they took $5 million in itemized deductions for mortgage interest, state taxes and charitable contributions, and $49.5 million in qualified dividends and capital gains and just $500,000 in ordinary income (salary and interest income for example).  This would potentially mean that about $44 million could be taxed as low as 15% assuming no adverse minimum tax consequences.  I will make that BIG assumption.

The remaining $500,000 would be taxed at ordinary rates of $110,017 on the first $379,150 according to the 2011 tax tables with a 35% marginal rate on the balance.  This would be an additional $42,298 in additional income taxes.  Thus, the total income tax bill would be $6,752,315-also an effective tax rate of 13.5%.  The marginal rate is 35% for ordinary income like salaries and interest income but 15% for capital gains and dividends.  This is what keeps the effective rate low in this example.  Almost all of the income is from investment income.  Of course, that investment income comes by way of this individual risking their investment capital.

I talked about this previously in my post "The Person Behind The Tree".

The biggest difference between the wealthy and the middle class is the investment income they are deriving from risking their capital.  This is really driven by capital gains income.  It is the big differentiator between the rich and the middle class. As my father used to tell me, "You don't get rich working.  You get rich when your money works for you."

Of course, to get your money working for you, you need to put it at risk.   Money is much like seed. Seeds don't do anything if they sit in a drawer, cabinet or bag in the barn.  However, if they are properly planted, nurtured and cared for, one seed can grow into an enormous tree which can bear a lot of fruit. That tree can begat an entire forest. 

Right now we don't have enough people willing to plant seeds.  Is this the time to tax the person behind the tree that has the seeds for the next tree?

The President is clearly playing games here as a lot of stories have pointed out including this one from the Peter Ferrara in The American Spectator and this op-ed from the Wall Street Journal. The WSJ  shows the average effective federal income tax rate on various income levels in the chart below. The reality is that the average tax rate on millionaires is 3 times the rate on workers making $50,000 when you look at actual tax return data.  As the Journal points out, there are very few Buffetts in the country.

As Ferrara points out in his article, the top 1% already pay more than the entire bottom 95% combined.  How much more should we expect them to pay?  What is a fair share?  Who determines it?

Another problem with the President's assault on millionaires concerns the dynamics of income in the United States.  The fact is that the income of many of these people flucuate considerably from year to year.  A lot of people who have $1 million in income in one year have it because they sold a business or a farm that they might have worked their whole life for.  They have that income in one year but not in the next.

The Tax Foundation studied the issue of Income Mobility and the Persistence of Millionaires in a detailed study last year that looked at IRS data for the tax years 1999-2007.  These were the key findings.

• Concerns over increased income inequality should be tempered by the fact that a substantial number of households move up or down through the income distribution over time.
• Nearly 60 percent of households in the bottom income quintile in 1999 were in a higher quintile in 2007, and roughly 40 percent of tax returns in the top quintile in 1999 were in a lower quintile in 2007.
•  Roughly half of millionaires during the 1999 through 2007 period attained this status just once during those nine years. Only 6 percent of this group were millionaires in all nine years.
• The volatile nature of capital gains realizations appears to be a major explanation for the transiency of millionaires.

In reality, only 9% of the "millionaires" had that level of income in each of the nine years of tax data.  50% of the "millionaires" only achieved that level once duing the nine years.  Just as interesting is how much mobility was found in all income levels.  Nearly 60% of the taxpayers in the bottom quintile of earnings in 1999 had moved higher by 2007.  Proving this is a land of opportunity.  However, 40% in the highest were in a lower quinitle 9 years later.  Proving it is hard to stay on top in a country that encourages innovation, ingenuity and ideas.

There is always someone who should want to replace you on top of the hill.  When we lose that we have really lost everything in this country.

President Obama has apparently decided that it is easier to engage in class warfare than to encourage people to scale the hill.  Ronald Reagan always worked to foster an aspirational society.  Our current President is focused on a distributional one. He seems to have no interest in encouraging people to scale the hill.  He is only focused on forcing the people on the hill to throw money down the hill.

What Is A Fair Share?

Liberals like to say that people need to pay their "fair share" of taxes.  What is a fair share?  How is it determined?  Who decides what it is?

Congresswoman Jan Schakowksy(D-IL) was asked that question on WLS radio is Chicago this week.  Here is the transcript.

Host: So Jan Schakowsky, out of every dollar that I earn, how much do you think I deserve to keep?

Schakowsky: What is really your question here? Do you think you should not contribute to firefighters?

Host: No, no, it’s a very simple question. Out of every dollar I earn, how much do you, Jan Schakowsky, think I deserve to keep? 

Schakowsky: No, it’s not a simple question. No, it is not a simple question. I’ll put it this way. You don’t deserve to keep all of it.

Host: Why?

Schakowsky: It’s not a question of deserving. What government is, is those things we decide to do together.” 

“I think you need to pay your fair share for things we’ve decided are our national priorities,” Schakowsky added.

Host: So who decides what a fair share is? 

The host never got an answer other than taxes should be increased.

So how do we determine what a fair share is?  How do we determine our national priorities?  To Schakowksy and other liberals everything is a national priority if you listen to them.

I suggest that we look at the U.S Constitution for starters.

The preamble to the Constitution lists five significant priorities in order "to from a more perfect Union".  Our founders specifically stated that they wanted to "establish Justice", "insure domestic Tranquility", "provide for the common defense", "promote the general Welfare" and "secure the Blessings of Liberty to ourselves and our Posterity".

Of these five priorities note that four of them have strong words attached.  They want to establish justice.  They want to insure that there is domestic tranquility.  They want to provide for the common defense.  They want to secure the Blessings of Liberty.   There seems to be no doubt that they see all of these as important national priorities.

However, when it comes to the general welfare, they only want to promote it. There is no mention of establishing it, or insuring it, providing for it and securing it.  They also do not say anything about individual welfare.  They refer only to the general welfare.  This seems to suggest that when they referred to general welfare they were considering those things that would be generally available to all.  They were not considering items that would make some people winners and other losers at the hand of the federal government.  What are items of general welfare?  Roads, post offices, the coining of money, standard weights and measures and the regulation of international and interstate commerce are specifically mentioned in Article 8 as is the erection of forts, dockyards and other needful buildings.

You could probably also consider the national park system, public health programs, public transportation  and other broad-based programs available to the public at large to clearly be within the spirit of promoting general welfare.

How much of the federal budget is spent on defense, justice, police and internal security and other programs that benefit the population at large?  Only about 1/3 of the budget is spent on what the Constitution established as the big priorities.  In 1945, we spent 97.6% of the budget on these items.  In 1970, we spent about 70% on these priorities.

Direct payments to individuals now account for 66.2% of all federal expenditures in the federal budget.

This chart from the White House's 2012 Budget shows the trend.

Our principal national priorities have become taking money from one person and giving it to someone else. The federal government's primary purpose seems to have evolved into picking winners and losers and transferring money around between citizens as it sees fit.  We seem to have forgotten about promoting the general welfare of our citizens and are more concerned with individual welfare.

If we want to determine what a "fair share"is I suggest we begin by looking to the U.S. Constitution to determine what are supposed to be our true priorities.  We need a fair system of justice.  We need to be safe in our homes and on our streets.  We need to be safe from attack.  We need protection of our individual rights.   These are the most important priorities.  It was true over 200 years ago and it is still true today.  If Ms. Schakowsky needs help in answering the question of what is a "fair share" I suggest she should start by reading the Constitution.

Over The Tax Cliff

I don't know if President Obama has planned it this way but we are heading over a tax cliff on January 1, 2013.  What is so troubling is that we are on automatic pilot heading for the cliff.  If nothing is done there will be gigantic tax increases beginning in 2013.  With a Presidential election year in front of us and both parties thinking they may end of in a better position come 2013, there is a real risk that nothing will be done. The result-huge tax increases automatically take place as a number of tax cuts and benefits expire at the of next year. 

The Wall Street Journal summarizes what we are looking at when the calendar reaches January, 2013 under current law.

President Obama unveiled part two of his American Jobs Act on Monday, and it turns out to be another permanent increase in taxes to pay for more spending and another temporary tax cut. No surprise there. What might surprise Americans, however, is how the President is setting up the U.S. economy for one of the biggest tax increases in history in 2013.

Mr. Obama said last week that he wants $240 billion in new tax incentives for workers and small business, but the catch is that all of these tax breaks would expire at the end of next year. To pay for all this, White House budget director Jack Lew also proposed $467 billion in new taxes that would begin a mere 16 months from now. The tax list includes limiting deductions for those earning more than $200,000 ($250,000 for couples), limiting tax breaks for oil and gas companies, and a tax increase on carried interest earned by private equity firms. These tax increases would not be temporary.

What this means is that millions of small-business owners had better enjoy the next 16 months, because come January 2013 they are going to get hit with a giant tax bill. Let's call the expensive roll:

• First comes the new tax hikes that Mr. Obama proposed on Monday. Capping itemized deductions and exemptions for the rich would take $405 billion from the private economy for 10 years starting in 2013. Taxing carried interest would raise $18 billion, and repealing tax incentives for oil and gas production would get $41 billion.

• These increases would coincide with the expiration of the tax credits, 100% expensing provisions and payroll tax breaks in Mr. Obama's new jobs program. This would mean a tax hit of $240 billion on small business and workers. That's the downside of temporary tax breaks and other job-creation gimmicks: The incentives quickly vanish, and perhaps so do the jobs.

So even if the White House is right that its latest stimulus plan will create "millions of jobs" through 2012, by this logic a $240 billion tax hike on small businesses in 2013 would cost the economy jobs. This tax wallop would arrive when even the White House says the unemployment rate will still be 7.4%.

• January 2013 is also the same month that Mr. Obama wants the Bush-era tax rates to expire on Americans earning more than $200,000. That would raise the highest individual income tax rate to about 42%, including deduction phaseouts, from 35% today. Congress's Joint Committee on Taxation found in 2009 that $437 billion of business income would be taxed at higher tax rates under the Obama plan. And since some 4.5 million small-business owners file their annual tax returns as subchapter S firms under the individual tax code, this tax increase would often apply to the same people who Mr. Obama is targeting with his new tax credits.

The capital gains and dividend taxes would also rise to an expected 20% rate from 15% today. The 10-year hit to the private economy for all of these expiring Bush rates: about $750 billion.

• Also starting in 2013 are two of ObamaCare's biggest tax increases: an additional 0.9-percentage point levy on top of the 2.9% Medicare tax for those earning more than $200,000, and a new 2.9% surcharge on investment income, including interest income. This will further increase the top tax rate on capital gains and dividends to 23.8%, for a roughly 60% increase in investment taxes in one year.


Of course, The Wall Street Journal is assuming that the Bush tax cuts for those making $200,000 and less would be extended.  However, these are also scheduled to expire on December 31, 2012.  Unless an extension is signed into law these cuts would also end.

The only prudent course is for Congress to seriously tackle major tax reform early in the coming year.  The looming tax increases at the end of the year should provide the incentive to get something done.  This is particularly the case if tax reform is also paired with the work of the Super Deficit Committee to reduce spending. 

We should be looking to broaden the base of both individual and corporate taxes.  Get the federal government out of the business of picking winners and losers with deductions, credits, allowances and exemptions.  Simplify the Internal Revenue Code and lower rates across the board.  It is time to use the tax laws to simply raise revenue and stop the social and economic engineering that has become the essence of tax policy.  That is the tax reform we need to keep from going over the tax cliff at the end of next year.

Greece, France, Ponzi and Perry

A couple of interesting factoids to give you some context for some of the news of the day.

It looks increasingly as if Greece will default on its debt.  That is a big problem for Europe generally and France in particular. The three largest French banks have almost $57 billion in Greek loans on their balance sheets according to this op-ed by Nicolas Lecaussin in today's Wall Street Journal.

BNP, Société Générale and Crédit Agricole together hold nearly $57 billion in Greek sovereign and private debt, versus $34 billion held by the largest German banks and $14 billion at British banks. French banks also held more than €140 billion in total Spanish debt and almost €400 billion in Italian debt as of December, according to the latest figures from the Bank for International Settlements. If either of these latter two governments were to default, their banking systems could collapse and take the French system with them.

Lecaussin quotes a bank executive from BNP to show the dimensions of France's banking and fiscal problems.  As I always say, it important to keep things in context.  Bank of America may have recently announced that they will be laying off 30,000 employees but consider the position that the French banks are in.

"Look at the French banks' debt holdings versus those of U.S. banks," he continues. "The total debt of the three big U.S. banks (Bank of America, JP Morgan and Citigroup) is $5.86 trillion, or 39% of GDP, while the debts of BNP, Crédit Agricole and Société Générale come to €4.7 trillion, or 250% of French GDP."

Rick Perry has also captured the headlines with his frontal assault on the Social Security System by calling it a Ponzi scheme.  Social Security dominated a good bit of the Republican debate last night and it appears that it is certain to be a major issue through the rest of the Republican primary.

This article provides some context on the Perry comments.  As you should know by now, Social Security was designed as a pay-as-you-so-system.  This means that the money for the benefits paid today comes from payroll taxes on today's workers.  Today's workers are going to have to depend on tomorrow's workers to pay their benefits.  There were about 42 workers paying into the system for each retiree back in 1945.  Today there are less than 3 workers for each retiree and that number includes part-time workers and government workers who get the money to pay their social security taxes from other private sector workers.

As the article points out, there are now only 1.75 full-time private-sector workers in the United States for each person receiving benefits from Social Security, according to data from the Bureau of Labor Statistics and the Social Security board of trustees.   This is calculated by taking the 94 million full-time private sector workers and dividing it by 53 million Social Security beneficiaries. If you and your wife work, it is as if someone else has moved in with you and you are paying their bills.

I don't know what you call it but the math will not work much longer.

I think I need to again refer you to my post from last February, "What Would FDR Say?" to remind you of FDR's vision for Social Security when it was first introduced.  FDR would be considered a conservative Republican today.

Lost in history is this quote from Franklin Delano Roosevelt in his message to Congress on January 17, 1935 asking Congress to enact the Social Security program.  It is clear that Roosevelt understood that the program he was asking for was unsustainable and had to be replaced by a "self supporting system" in 30 years or so. Unfortunately, that was 45 years ago.

"In the important field of security for our old people, it seems necessary to adopt three principles: First, non-contributory old-age pensions for those who are now too old to build up their own insurance. It is, of course, clear that for perhaps thirty years to come funds will have to be provided by the States and the Federal Government to meet these pensions. Second, compulsory contributory annuities which in time will establish a self-supporting system for those now young and for future generations. Third, voluntary contributory annuities by which individual initiative can increase the annual amounts received in old age. It is proposed that the Federal Government assume one-half of the cost of the old-age pension plan, which ought ultimately to be supplanted by self-supporting annuity plans."   ----- Franklin Delano Roosevelt

To make matters worse, Social Security only collected $545 billion in taxes in 2010 but paid out $577 billion in payments-a deficit of $32 billion.  This is without considering the $112 billion in Social Security payroll taxes that were cut in 2011 as part of the payroll tax holiday for 2011.  President Obama now wants to extend and expand the credit into 2012 and also include some employer payroll tax cuts as well.  It is effectively a doubling down strategy.  The cost of his proposal is estimated at $240 billion in reduced social security tax collections next year.  That is reducing Social Security collections by over 40% compared to what was insufficient to cover benefits in 2010!  As I wrote in my last post, Have You Been Framed?, this is a classic desperation move.  When you are running out of options you are more likely to do some really risky things. 

The less money people have, the more willing they often become to take on extra risk, just as a quarterback will throw a "Hail Mary" pass last in the fourth quarter or a basketball player will launch a deperate shot from half-court just before the final buzzer sounds.

When Social Security is already in such poor shape how can it make any sense to take $240 billion out of it on top of the $112 billion that has already been skimmed away?  Sure, they say that this will be "paid back".  Who is going to do that?  Young workers, hold on to your wallet!

I have little doubt that politics being what they are that the payroll tax holiday will be passed.  However, that is sad testimony to how things work in Washington.  We are way beyond any Ponzi scheme involving Social Security.  This Social Security payroll tax holiday is outright theft with no effort to even conceal the crime.

Have You Been Framed?

USA Today reports that lottery ticket sales have surged across the country recently.  You might think that the tough economy would actually dampen sales with falling disposable incomes.  However, neuroeconomic research suggests that this is exactly what you would expect.  Neuroeconomics is a new scientific field that combines neuroscience, economics and psychology in the study of how the human brain evaluates risks, rewards and probabilities in making decisions.

Financial records for 41 state lotteries that end their fiscal year in June show 28 had higher sales than the year before. Seventeen of those states set all-time sales records.

California had the highest percentage gain over 2010 — 13.2% — to $3.44 billion, just shy of a record $3.6 billion set in 2006, spokesman Alex Traverso said.

Arkansas's growth was higher at 21%, but its lottery didn't start until September 2009, so the comparison with fiscal year 2010 was not over a full previous year.

Arizona posted a record $583.5 million in ticket sales and Missouri, topped $1 billion for the first time.

Jason Zweig in the book, Your Money and Your Brain, writes about how animals that are running low on food, water or warmth have what ecologists call a "negative energy budget". Simply stated, when these creatures are hungry, thirsty or cold they rarely will waste their energy on small but steady gains. They simply cannot take the chance that slow and steady will keep them alive.  When they are in a state of deprivation they are more willing to risk getting nothing if it also means they have a feasible way to get a big boost to restore their depleted energy.

Humans seem to operate the same way according to Zweig. 

The less money people have, the more willing they often become to take on extra risk, just as a quarterback will throw a "Hail Mary" pass last in the fourth quarter or a basketball player will launch a deperate shot from half-court just before the final buzzer sounds.

This often leads to the result that those who can least afford to lose what little they have are the most prone to put it at high risk by taking a flyer with long odds.  I have done it myself in the casino.  It seems that the lower I go with my pile of chips the more willing I am to place a bigger bet. 

Consider these examples from Your Money and Your Brain that illustrate the point.

• When more than 1,000 Americans were asked to pick the most practical way to become wealthy, 21% said "win the lottery".  Among those with incomes of $25,000 or less, nearly twice as many felt their best chance at getting rich was a lottery ticket.
• In the second half of the year, mutual funds with below-average returns become up to 11% more volatile than those that had above-average returns in the first-half.  Consciously or not, the managers of funds that lagged in the first six months buy riskier stocks in an attempt to salvage their returns by year-end.
• Blacks and Hispanics are more reluctant than whites to take moderate financial risks-yet nonwhites are between 20% and 50% more willing to take substantial financial risks.  Black and Hispanic households, on average, have roughly one-fourth the total new worth of the typcial white household.

Another neuroeconomic principle that drives lottery sales is the surprisingly big difference in the way we react to odds expressed as percentages (such as 10%) compared to how we respond to odds expressed as frequencies (such as one out of every ten).  The brain does not process percentages very well.  They are abstract and hard for most people to comprehend easily.  Numbers are easier to understand and to relate to.

Consider if a surgeon tells you that your surgery has a 95% success rate.  How soon can you do it, Doc?  On the other hand, what if the surgeon tells you that you have a 5 out of 100 chance that you will die?  Can I think about this, Doc? 

Zweig quotes psychologist Paul Slovic to explain the difference in how your brain processes the information.

If you tell people there's a 1 in 10 chance of winning or losing, they think,"Well, who's the one?  They'll actually visualize a person."  More often than not , the one person you will visualize winning or losing is you.

That is another reason why lotteries do well.  Perhaps the odds of winning that $300 million Powerball drawing were 1 in 50 million but you actually saw the winner on tv picking up the check. That could be you the next time.  At the same time, if you are asked to choose between a $100 deductible health care plan and a $5,000 deductible plan and are told that only 5 out of 100 will benefit from the lower deductible after taking account of the premium costs, you will still most likely avoid the higher deductible plan.  After all, this could be the year that you get hit by that bus and you will be one of the five. Why take that risk?

People's judgments about risk are very flexible and subjective.  A minor change in context or description can make a big difference in how risk is perceived. This is called "framing" by psychologists.  It is all about context.  Almost every decision is made in reference to something else whether we are consciously aware of it or not.

You see the same effect in the current budget deficit debate.  We keep hearing about trillions of dollars in cuts.  We keep hearing about the effects this will have on children, seniors, the needy and disabled.  Trillions of dollars is a lot of money.  Who would want to hurt these people who need that money to live on? 

You never hear it framed this way...

"The federal government is projected to spend almost $50 trillion over the next 10 years.  Our goal is to save just 3% of this amount."

This is actually what the Super Committee  on the Budget Deficit is charged with doing. It's hard to argue with this modest goal when it is framed this way, isn't it?  The Republicans need framing lessons if they are to be successful in getting our budget under control.  Of course, if it gets much worse the federal government can just start buying lottery tickets. We are getting close to "Hail Mary" time.

Who Is Working, What Is Not Working

I reviewed the recent Bureau of Labor Statistics jobs data over the weekend as well as several reports on unemployment (and employment).  On Thursday night we will hear the long-awaited address by President Obama on how he proposes to create more jobs.

I wrote about the employment rate back in March in "Employed Or Unemployed" where I made the point that while the unemployment rate was an important statistic, the labor participation rate is actually a better indicator to monitor.  It is really about the percent of people that are employed than the percent that are unemployed.  The unemployment rate was 8.9% when I wrote that blog back in early March.  We are at 9.1% in the latest report.

Here is a chart from the Calculated Risk Chart Gallery that shows the drop in the labor participation rate (blue line) as well as the precipitous decline in the employment-population ratio (black line) and how it compares to prior years.  The employment-population ratio is the percent of the population 16 years or older that is currently employed in the civilian work force.  At the end of August that percentage is 58.5%.  9.1% are officially unemployed meaning they are actively seeking a job but can't find one.  That means that an additional 32.4% is not working and not looking.  This may include students, stay at home parents, retirees and those who are simply discouraged and have quit even looking for work.

Here is another view of this statistic that isolates the employment population ratio and shows its history since shortly after WWII.

Let's compare the overall % to different demographic and age groups and also to the comparable numbers in 1950, 1975 and 2000.

• In total, 58.5% are working today vs. 59.2%(1950), 61.2%(1975) and 67.1%(2000)
• Men, ages 25-54, 81.9% today vs. 96.5%(1950), 94.4%(1975) and 91.6%(2000)
• Women, ages 25-54, 68.3% today vs. 36.8%(1950), 55.1%(1975) and 76.7%(2000)
• Both sexes, 55 and older, 37.3% today vs. 43.0%(1950), 34.7%(1975) and 32.4%(2000)
• All, Ages 16-19, 28.6% today vs. 47.0%(1950), 46.0%(1975) and 45.0%(2000)

I could not find data on the African American employment-population ratio dating back to 1950 but here is a chart showing the ratio since 1972.  It is not a pretty picture.

Walter Williams writes about black unemployment in last week's Washington Examiner.

Overall U.S. unemployment is 9.1 percent. For white adults, it's 8 percent, and for white teens, 23 percent. Black adult unemployment stands at 17 percent, and for black teens, it's 40 percent, more than 50 percent in some cities, for example, Washington, D.C.

Chapter 3 of "Race and Economics," my most recent book, starts out, "Some might find it puzzling that during times of gross racial discrimination, black unemployment was lower and blacks were more active in the labor force than they are today."

Up until the late 1950s, the labor-force participation rate of black teens and adults was equal to or greater than their white counterparts. In fact, in 1910, 71 percent of black males older than 9 were employed, compared with 51 percent for whites.

Williams cites the biggest factor in keeping blacks jobless are minimum wage laws.

Good intentions motivate most Americans in their support for minimum wage laws, but for compassionate public policy, one should examine the laws' effect.

That's seen by putting oneself in the place of an employer and asking, "If I must pay $7.25 an hour to no matter whom I hire, does it pay me to hire a worker who's so unfortunate as to have skills that enable him to produce, say, only $4 worth of value an hour?"

Most employers would view hiring such a worker as a losing economic proposition; therefore, a minimum wage law discriminates against low-skilled workers by reducing employment opportunity.

Being unemployed has significant negative social consequences, one of them noted in the 1960s by Sen. Daniel Patrick Moynihan, D-N.Y., who raised the alarm about the link between joblessness and the decline of the black family, saying that men without work become less attractive as marriage partners.

Between 1890 and 1940, a slightly higher percentage of black adults had married than white adults. Today, black marriage rates have fallen precipitously, where 72 percent of black children are born to unwed mothers.



Good intentions are behind most liberal policies. Like the minimum wage laws. It is almost impossible to argue against them in spirit. It is only when you see the practical result of their impact on what they do in the real world with real human beings that you see the fatal flaws. Are the minimum wage laws having an impact on the high unemployment rates of teens and blacks? I don't know but the federal minimum wage increased 37% from where it was in mid 2007 to where it is today. This is also when employment started to drop rather dramatically for these two demographic groups. To put this in context, the minimum wage only increased 42% between 1981 and 1996.

It has been said that the road to perdition is filled with good intentions. We are likely to hear about a lot of well intentioned ideas from President Obama on Thursday night. Further extend unemployment benefits. Extend the Social Security payroll tax holiday. Tax credits for this and that. It will likely be more of the same we have seen before. Throwing a lot of money around that we don't have.

We don't need good intentions. We need jobs. What we have been doing is not working. Why would we want to travel that road of good intentions again? We should be traveling the road to results.