The Tax Reform That Isn’t

It is now tax reform season, which means that politicians are poised to unleash even more nonsense on the public than is customary. So perhaps it makes sense to frame some of the underlying issues that are involved. First and foremost: There is not a snowball’s chance in hell that taxes—properly understood—are going to be reduced. I repeat: there is no chance—none, nada, zero—that the total tax burden is going to be reduced. It is merely going to be redistributed, and to boot the total burden next year will be larger than this year, and the same condition will hold the year after that, and the year after that. Until the unavoidable default.

 

To see this it is imperative to define terms and do it properly because words that politicians and their sycophants use are designed to obfuscate rather than clarify. This, by the way, is not unique to arguments about the tax code. They do it all the time, pretty much about everything. So: how should we define the tax burden?

 

Definition: The tax burden is equal to the resources that government commands that would otherwise have remained in the private sector. That means that the real tax burden is not simply equal to the cash government collects from income taxes, sales taxes, other excise taxes, user fees, payroll taxes and various other sources. The real tax is equal to the total amount of money government spends plus the cost of regulatory compliance.   This definition differentiates between the government’s demand for economic resources and how it finances the demand.

 

The Income Statement: Revenues are equal to the cash taxes government collects directly plus the regulatory compliance costs it imposes on business that government would otherwise have to bear if it did the job itself. Expenses are cash disbursements. But government spends far more cash than it collects in direct taxes, so it has to make up the difference, which it does by borrowing the difference.

 

The Balance Sheet: Here is where it gets exceptionally tricky, because the government doesn’t publish a balance sheet. And it doesn’t do so for a very good reason. The Government is insolvent and doesn’t care to admit it.

 

Let’s consider: conceptually speaking what would the government’s balance sheet look like if it published one?

 

Assets = Implied taxing power, otherwise known as the tax base.

Liabilities = All the payments it has promised to make in the future. These include debt service and transfer payments, the largest being Social Security, Medicare and Medicaid. The present value of these unfunded liabilities (plus accumulated debt on the books) ranges from a relatively modest estimate of $100 trillion (from the optimists) to about $200 trillion from the not-so-optimistic. According to the Fed, total net worth of U.S. households is about $85 trillion. That leaves us short somewhere between $15 trillion and $115 trillion. (Corporate assets are largely included in household wealth through stock ownership.)

 

Since U.S. GDP is about $20 trillion, there is no possible way that the U.S. can grow its way out of this. In fact, its liabilities in the form of promised entitlement payments are growing at an increasing rate of speed, so the situation is getting worse rather than better.

 

The only reasonable conclusion is that the U.S. is inevitably going to default on its promises. The only question is when and to whom.

 

 

This conclusion is both inescapably correct and studiously avoided. Progressives have spent the last 100 years or so building a welfare state that is careening toward default by obfuscating the nature of the problem, which is, as Margaret Thatcher put it, Socialists eventually run out of other people’s money to spend.

 

Consider the current discussion over “tax reform” currently taking place. The discussion will carefully ignore the indisputable fact that total government spending and therefore the tax burden, is going to rise. The entire discussion about tax reform / tax relief is entirely distributional without so much as a nod to the underlying structural problem.

 

The Republicans will claim, as they always do, that reducing marginal tax rates a few percentage points will lead to an increase in economic growth sufficient to offset the loss from lower rates. They will propose taking a smaller piece of a much bigger pie. The problem is that there is scant evidence that the modest Republican reforms will have the desired effect because they are not going to address the underlying entitlements beast, which is in the process of devouring everything in its path.

 

 

For their part, the Democrats are still intent on increasing spending for entitlements and “paying” for it by taxing “the rich”. Here we note in passing that Progressives have exactly two solutions for all problems. Tax the rich, and appeal to “the international community”.

 

But let’s go on from here. The great project of building the welfare state, seemingly paid for by taxing the rich, has created a situation in which the financing of the welfare state is divorced from the actual cost of running the welfare state, at least in the public mind. And inevitably that means the public will insist on getting more and more “free” stuff. And because Progressives have convinced otherwise sensible people that they are victims of corporations and the rich, they will continue to demand all this apparently free stuff as a matter of right. It will not end well. They are rapidly running out of other people’s money to spend.

 

 

JFB

The Trump Tax Plan

As promised, the Trump Administration released the outline of its tax plan. Predictably and amusingly enough, it was greeted by cries of horror and anguish by Progressives. It would appear that the Trump plan would allow American taxpayers to keep more of their own money. This simply will not do. Bernie Sanders, Chuck Schumer and Tom Perez have made much better plans for it. Look at the job they have done already.

 

 

Before addressing the plan, let’s take a look at some facts, to put all this in context. First, let’s define the word “tax”. As Milton Friedman never tired of saying, federal taxes are not simply the checks that taxpayers send to the government. Taxes are equal to the resources that the government consumes. That is best measured, however imperfectly, by government spending. Taxpayer checks are merely part of the financing package. Borrowing to cover deficits is another. The real tax burden is a combination of the two. (It’s actually more, when you toss in unfunded mandates and regulatory compliance, but let’s leave that aside).

 

 

As the chart illustrates, spending is far more variable than tax receipts. In fact the standard deviation of receipts as a percent of GDP is 1.1% around a mean of 17.4%. That compares to a standard deviation for spending of 1.6% around a mean of 20.3%.

 

This still underestimates government resource use because it does not adequately capture things like regulatory compliance costs. Nor does it include loan guarantees or unfunded liabilities like Social Security.

 

This brings two subsidiary questions  to the fore. Who pays the taxes (defined narrowly in terms of revenue collections), and where is the money spent? The answer to the question of who pays the taxes is easy. It is the much-maligned rich. In 2013 (using the latest data available) the upper 1% of pre-tax income earners paid 38% of all federal income taxes; the upper 10% paid about 63%, and the upper quintile paid 88%. By contrast the bottom quintile paid a negative rate of 4%. In fact the bottom 40% got more back from refunds and “refundable credits” than they paid in.

 

These data are available from the Joint Economic Committee of Congress at this link.

 

So where does all that money go? Transfer payments and interest on the debt. In 2014, the government spent $3,883 trillion. Of that, $2,420 trillion (62%) went to transfer payments, mostly for Social Security ($834 billion) and Medicare ($587 billion). Interest payments on the debt amounted to $442 billion. All told transfer payments and interest on the debt captured about 74% of all federal dollars. These data are available at this link at the Bureau of Labor Statistics.

 

For all the talk about investing in infrastructure, the reality is that the modern Administrative state is really about income redistribution. Specifically what we are dealing with is an extraordinarily progressive tax-spend-and-vote regime that has created an entitlement culture that is all too ready to punish success and reward failure. And it has produced plenty of policy failure.

 

The Trump Administration proposes to cut both individual and corporate tax rates. Individual rates would go to a 3-bracket system (10%, 25% and 35%), and the corporate rate would go to 15%. The Trump plan would eliminate most deductions, except for the mortgage deduction and charitable giving. The plan also eliminates the inheritance tax.

 

Democrats are up in arms because the Party of Science refuses to acknowledge that flattening and simplifying the tax code has the potential to produce enormous gains in the private sector through greater efficiency, investment and innovation. They would rather continue to subsidize the failing models of the early 20th century—like the public school system and its teachers unions, for instance. But as tax reform goes, the Trump plan gets only a B minus. That is because the Trump plan—outline really—is a change on the margin when radical surgery is needed. A much better plan would be a flat rate of about 18% for all with incomes over something like $30, 000, with no deductions or exemptions at all, including the home mortgage deduction and charitable giving. Nor should the federal government be in the business of subsidizing child care through the tax code, as the Trump plan promises to do.

 

But the Trump plan is better than nothing. That said, among the worst arguments against the proposal is that the plan has to be “paid for”.  Taxes represent government’s use of what would otherwise be private resources.  The phrase “paying for” a change in tax rates under static analysis (which is what the CBO is required to do) is simply an attempt to redistribute the burden without addressing the underlying problem. A real reform of public finances would reduce the total amount of government spending, privatize Social Security and Medicare, and reduce and flatten tax rates.

 

That’s what real change would look like. Absent that, we are still headed down the path chosen by Greece.

 

JFB