The Truly Flat Tax

What is a flat tax? A flat tax is one in which the marginal rate, the rate on an additional dollar, is constant regardless of the level of income. It just so happens that the flat tax proposals that you hear about in the media are not truly flat. This is because they utilize a personal deduction . . . below which the marginal tax rate is zero. So the marginal rate starts at zero and then jumps up to 20% or thereabouts.

So what is a truly flat tax like? Well, imagine that a person with no income would receive a subsidy or negative tax of some amount. As this person’s income increases, his subsidy would decline 20 cents for each dollar of income increase. Then at some income level (the maximum subsidy divided by .2), there would be no subsidy and no tax either. Beyond that income level, positive taxes would be owed. Again, the rate could be 20%. Obviously, you can substitute any rate that appeals to you as long as the rate for subsidy recipients is the same as for tax payers.

How could this sort of tax policy be relevant? The answer is that it only makes sense if you get rid of all other subsidy programs. There would be no unemployment compensation, no disability payments, no food stamps, no public housing, etc. That is, there would be no in-kind subsidies at all.

Who would hate this policy? People who want to control, or try to control, the services and commodities consumed by the poor would hate it. Bureaucrats that run these subsidy programs would hate it. Lobbyists who derive their livelihood from subsidy programs would hate it. You get the idea.

Who would love this policy? The poor subsidy recipients would love it. Economists who are troubled by the implicit tax rates associated with subsidy programs that have income tests would love it.

So what should the maximum subsidy be? This is a political question. Some would say that it should be zero. Others, might say that it should be on the order of $7,000 for an individual with no income. Let’s just explore the implication of the $7,000 maximum subsidy. With a 20% marginal tax rate, the income at which subsidies stop and positive taxes start would be $35,000. Now you can see that people of various political persuasions might argue about the parameters of this tax schedule. Nevertheless, it accomplishes a lot.

This proposal shrinks government. It makes the tax rate low and explicit so that it can facilitate the upward mobility of the poor.

Do the Math

President Obama has exhorted his Republican critics to “Do the Math” on more than one occasion. His point is that the Republican critics should see the need for increased tax rates in order to balance the budget. The purpose of this post is to do the math.

Over the past 60 years there have been a goodly number of tax policy regimes. However, over this entire period, total tax revenue has been between 15% and 20% of Gross Domestic Product . . . with only very brief exceptions. That is, the Laffer curve might be thought of as more of a plateau than a hill. There is no math that would suggest that by fiddling with the tax code we can reasonably expect revenues to rise in any sustainable fashion.

Thus, if you want to balance the budget you must get expenditures in this same range. Increasing tax rates simply will not do what the President wants to do.

Right now, expenditures are running at about 25% of GDP. We need cut expenditures down by about 28% if we want a balanced budget to be sustainable with expenditures at 18% of GDP. Static analysis from the Congressional Budget Office (CBO) is fantasy, not math; such analysis does not take the reactions of the economy into account. If you tax work at higher rates, you will get less work. If you tax investments at higher rates, you will get the nature of investments to change . . . investors will find instruments that are taxed at lower rates.

So what should guide the redesign of the tax code? We should focus on a tax code that does not favor certain lawful activities over others. Most importantly, we should focus on those features that provide incentives for hard work and creative energies.

World Peace – Finance 101

The purpose of this post is to propose a market solution to inter-group conflict whether it is tribal, religious, ethnic, or nationalistic in nature. For the market solution you need a reliable measure of well-being for the groups in conflict. For example, average income might be an appropriate metric. Then you need a futures market in the ratio of these measures of well-being. Continuing with the same example, you would need to create a market in the increase in average income of one group divided by the increase in average income of another group. These conditions are sufficient to produce world peace. Why would these conditions produce world peace? Well, this is the story to be told in this post.

First, inter-group conflict exists primarily because one group feels that it is being put upon by another group, and as a result, its prospects are not as good as the prospects of the other group. Usually, the same feelings go the other way too.  Ordinarily, the greater one’s prejudice against a group, the greater is one’s certainty that that group will outperform your group. Let’s call such people extreme pessimists.

Now suppose that a neutral third party creates a futures market for the change in average income of group A divided by the change in average income of group B. What will these extreme pessimists do? Well, the group B pessimists will go long in this futures market. That is, they believe that the ratio will increase as the A group will do better than the B group. The A group pessimists will go short in the futures market because they believe that the B group will outperform their group. Going long means that you make money if the index increases and going short means that you make money if the index falls. The more extreme the pessimist, the greater the futures market position he or she will take.

What does all this have to do with peace? As soon as the pessimists have taken a financial position in the welfare of the other group, their entire mindset changes. They are conflicted with regard to any hostile or discriminatory behavior that might have been their tendency in the absence of their futures market transaction. It is possible that some positive thoughts may even enter their heads regarding the opposite group . . . because they directly benefit from the success of the opposite group.

There is a problem with this proposal. You cannot allow A’s to go long or B’s to go short. Why? Because they might double down and be more antagonistic toward the other group. This would increase conflict.

Property Tax and the Laffer Curve

We all know the Laffer curve, right? If you raise tax rates, revenue rises initially, but if you continue to raise tax rates, revenue ultimately falls. This rule is absolutely true, but there is plenty of room to argue where you are on the Laffer curve given any specific tax rate. That is, we can argue about exactly where the hump is.

Did you ever think that the Laffer curve applies to the property tax? If raising the property tax reduces the proportion of land allocated to uses that are more price sensitive but are also more capital intensive, then . . . at some property tax rate . . . revenue will actually decline as you increase the tax rate. This is long run analysis and it relates to situations well outside of the Tax Hell described in my previous post.

Where is the hump in the property tax Laffer curve? In my simulations, the hump is a lot closer to a 1% tax rate than would make most city councils comfortable. On the other hand, I readily admit that the parameters in my simulations may not be representative of any particular city, so I would like to be rather modest about any claim in this regard.

The bottom line, one more time, is that we need to be aware that we do not have the ability to increase tax revenue by simply raising rates willy-nilly.

Tax Hell

It is fairly clear that as property values have declined, tax assessments have not declined apace. As a result, the effective tax rate has risen in many property tax jurisdictions. In almost all US jurisdictions, there is an ad valorem property tax. This means that the property tax rate is applied on all property value across both land and capital that is “permanently affixed” to the land. But in the long run, you cannot tax capital because it is mobile. The long run here is when we must redevelop land because fixed capital is deteriorating and/or its uses are changing. So the long run is not very long.

You cannot tax toilets, kitchen sinks, windows, and lumber in the long run. What happens when you apply a tax to the value of this physical capital? The impact of the tax falls instead on land. The value of land moves toward zero. That is, developers will not pay for it to redevelop property. The jurisdiction ends up like East St. Louis. This is Tax Hell.

How much property tax is too much? There are probably different opinions about this, but I would say that between 1% to 2% is generally tolerable. Here I am writing about dividing the tax bill by the market value of the property; don’t fret about assessment ratios and all that technical stuff. Lately, I’ve been noticing rates that are MUCH higher. Jurisdictions that engage in using inappropriately high property tax rates will be unsustainable.

Regardless of the method of taxation, we should always think about our capacity to actually increase tax revenues. For example, when thinking about taxing the 1 percenters, the millionaires and billionaires, we cannot think in terms of static analysis. Who better can convert their income from dividends to capital gains? Who more easily can leave their income in foreign assets? Who is more mobile? Who is better suited to hiring tax avoidance specialists? Do you really think that we have the ability to add taxes on this group with no consequences in terms of lower growth and less-than-expected revenues?

Money and Ships

I was going to post about a crisis of confidence among monetarists, but on the way I had a crisis of confidence. So I thought that I would write about some of my thoughts regarding monetary policy and ships. You might wonder if you do something a little bit and get a result how it could be that if you do it a lot the result is not more of the previous result. Now comes the ship metaphor. If a ship is moving and you turn the wheel slightly, the ship changes course . . . admittedly with some lag. But if you turn the wheel all the way over so that he rudder is perpendicular to the length of the ship, the ship slows. The implication is that if you increase the rate of money growth from 2% to 6% we would call that an expansionary monetary policy posture. But if you double or triple the money supply, the result may not be a hugely expansionary or even inflationary impact.

What is going on here? In order to be effective in turning the ship, the rudder must produce lift (not just drag) as water passes around it. There must be a connection between the rudder and the water that speeds up along the side opposite to the direction of turn. In order to be effective in turning the economy, there must be a link between monetary base and money. If excess reserves grow seemingly without limit, you can forget about the effectiveness of monetary policy.

This is not to say that you can forget about money. The Fed has created a tinderbox of inflation that could be set off by a recovery.

Now getting back to confidence, we should all be a bit modest with our predictions and advice. There are no historical parallels to our current mess. The money stock suggests that nobody’s models are calibrated to handle the current situation. Anybody who asserts that their model predicts something has no sense of the concept of prediction errors.