Inequality

Why is income inequality higher now than it has been? First, it is higher. But why is it higher now? The answer is simple. Income inequality is directly related to the level of unemployment. So if unemployment falls, as we all hope it will, inequality will decline. Unfortunately, it is becoming more likely that those who are poor will remain poor as a result of public subsidies intended to help the poor that have income tests keeping them trapped in poverty. More subsidies of this type mean more permanent poverty.

This might be a good opportunity to put in a good word for measuring income inequality carefully. It is measured by applying the Lorenz curve. This is a curve with the horizontal axis measuring the cumulative proportion of population and the vertical axis measuring the cumulative proportion of income. You always start with the lowest income group and progress to higher and higher income groups. This causes the Lorenz curve to always get steeper and steeper as one proceeds. The single number which indicates the level of inequality is called the Gini coefficient. The Gini coefficient is the number one minus twice the area under the Lorenz curve.

Romney’s Tax Rate

Gov. Mitt Romney may have missed an important teaching moment regarding his tax rate. He has revealed that his effective tax rate is on the order of 15%. Perhaps this is because his income has been in the form of dividends and capital gains. After all, he has been running for the Republican Presidential nomination for years; he has had no time for earning wages and salaries. But is he thinking about his income and his taxes correctly? I think not. Of course, I have not seen his taxes (to be released tomorrow), and there may be issues that I have not fully anticipated.

By trying to get Gov. Romney to make his tax returns public, Rep. Gingrich implies that there may be something embarrassing in Gov. Romney’s returns. I suspect that Rep. Gingrich believes that a low tax rate will be an embarrassment to Gov. Romney. An editorial in the WSJ has indicated that a low tax rate will reveal that Gov. Romney cannot relate to ordinary people. I’ve heard numerous talking heads on TV indicate the same thing. Could all these people be wrong?

Gov. Romney owns shares of corporations. Those corporations earn income, and he has a claim on his proportionate share of that income. But the corporations pay income taxes for him. They pay 35% at the Federal level and they pay additional taxes at the state level. The average of this state tax might be something like 5%. So we are up around 40% if we add the Federal and state taxes on corporate income. Then when dividends trickle down to Gov. Romney, they are taxed once again by the Feds and the states. The Federal tax rate on dividends in Gov. Romney’s bracket is 15%, and Gov. Romney’s state of residence is Massachusetts where his state tax rate is 5.3%. So the sum of his Federal and state tax rate is 20.3%. On the other hand, he only pays the 20.3% on the approximately 60% of his corporate income that filters down to him. So this is a 12.18% rate on his corporate income. Adding the 12.18% that Gov. Romney pays directly to the approximately 40% that his corporations pay for him brings him to a total tax rate of 52.18%.

Now let’s consider capital gains. An increase in the value of a corporation is derived from anticipated increases in the future income flows to the corporation. These increases are diminished by Federal, state, and personal corporate income taxes. Of course, a dividend tax is a personal corporate income tax. So again, Gov. Romney’s tax rate is about 52%.

Among the issues that I have ignored are the role of retained earnings and excessive compensation to employee/shareholders. One would think that this latter issue would not relate to Gov. Romney.

The nominee from the Republican party should be aware of the double taxation issue and should be able to explain this issue to the voters. Explanations should surely put to rest the idea that corporations do not pay their fair share (you can count countries with higher corporate tax rates on one hand with fingers left over) as well as the notion the rich who pay taxes on dividends and capital gains are not paying their fair share. In addition, the nominee should have his tax proposals informed by his knowledge of double taxation. Finally, the nominee should not pass up an opportunity to explain all of this.

Negative Interest Rates

I am on record as asserting that there can never be negative nominal interest rates. Guess what? I was wrong.  German 3 and 6 month government bonds have been issued with negative yields. Folks, this is the height of irrationality, but there it is.

The reason that it is irrational to lend at a negative rate is that the prospective lender could just keep his or her money in his or her pocket and thus earn 0%.

This could be rational if the money is perishable, but money is not perishable in modern economies. If bananas were money, then if you put a banana in your pocket, you would have a rotten banana and a stinky, sticky pocket at the end of 3 or 6 months.

Wealth Transfers from Inflation

In a speech after the recent New Hampshire primary, Rep. Ron Paul offered the opinion that inflation transfers wealth from the poor to the rich. I disagree.

Let’s begin by setting the stage more precisely. We are talking about an increase in the rate of inflation that is unanticipated. In the credit market, an increase in unanticipated inflation transfers wealth from creditors to debtors. If creditors are more likely to be rich and debtors are more likely to be poor, then unanticipated inflation transfers wealth from the rich to the poor. This is one way to characterize the political parties. The Republicans represent creditors and the Democrats represent debtors. As a result, the Democrats are more interested in inflationary policies and Republicans are more interested in price stability. Of course, there are other ways to slice the two parties’ interests.

In every sphere in which there are contracts, unanticipated inflation disrupts those contracts. So in labor markets, unanticipated inflation injures wage earners and helps employers. In real estate markets, unanticipated inflation injures landlords and favors tenants. In business to business contracts, unanticipated inflation advantages buyers and disadvantages sellers.

I suspect that, on the whole, the poor are helped and the rich hurt by unanticipated inflation. Of course, this is contrary to the view expressed by Rep. Paul.