The Braine Trust

It is fitting that a Spanish poet, novelist and philosopher has perhaps the most important quote with regard to the continually deteriorating European economic situation. The most recent European “deal” notwithstanding, the European situation is far from settled and will likely get far worse before it gets better. In fact, it will ONLY eventually get better when there are structural changes (e.g. real reductions in debt burdens) in the economies in question, most notably Greece, Spain, Italy and soon France. (In the Socialist spirit of “helping” to solve their problems, the new President of  France has promised to reduce the retirement age to 60 from 62 while raising the top income tax rate to 75%, both of which will only further exacerbate his country’s debt problems.)

For Spain, the recent “deal” was simply additional Euro loans to the Spanish banks with more Euro printing to fund this. Interestingly, Spain’s problems emanate primarily from an overheated real estate market which came crashing down with the 2008-2009 recession. (Does this sound familiar?) In fact, Spain’s official debt-GDP ratio of 68.5% is by European and US standards not that bad. (e.g.compared to the Euro area’s average of 87 percent, France’s 90 percent, Italy’s 120% and Greece’s even higher ratio).  However, Spain’s “official” data excludes many other liabilities to the ECB as well as the current bailout funds which moves it to a more stratospheric 146.6% ratio. The big problem is that Spanish banks are way undercapitalized and now hold huge amounts of bad mortgage debt. Unfortunately with 24% unemployment  and a 7% interest rate on 10 year bonds and a contracting economy, it wont be long before even Spain’s “official” debt-GDP ratio soars even further.

So what are the EU and the specific countries trying to do about their growing financial and economic problems?

While  some (most notably the Germans) are talking seriously about financial austerity measures, the de facto strategy that has emerged is more Euro Bonds (or the European Stability Mechanism-ESM which is now a permanent rescue funding institution). This was the essence of the “deal” that was reached last week that allowed the ESM funds to directly recapitalize banks in Italy, Spain and other ailing economies. (In exchange, the Germans got a Euro Bank supervisor to oversee all such activity, though it is still unclear how much power this supervisor will have).  Of course, these loans don’t come from thin air, instead they are backed by the printing of more Euros. Further, to help stimulate the EuroZone’s contracting economies, the ECB recently cut the lending rate to 0.25% from 0.75% ( meaning of course, still MORE printing of Euros). BUT because the problems in Europe are fundamentally structural (e.g. “fixed” pensions and retirement benefits are growing rapidly, the population is aging and working age population is declining and the economies are contracting or not growing much) only “structural” solutions involving substantial cuts in these benefits and efficiency improvements in the tax code will remedy the situation.  

There is also lots of talk about complete financial/fiscal integration of the EuroZone countries but this will take many years (if it happens at all) and is already being strongly resisted by Germany as well as by Finland and Netherlands.  This is very logical. Countries such as France, Italy, Spain, and Greece have very high debt loads and their economies are contracting with no immediate end in sight, so the debt will keep growing with eventual default becoming increasingly likely. Germany and a few other Euro countries that are still relatively healthy don’t exactly want to have their fates hinged upon the total aggregate health of the EuroZone. Germany is a bit like the doctor who has been brought in to a hospital to treat patients (e.g. Italy, Spain, Greece and France) that have a highly contagious and potentially lethal disease– probably would rather avoid going on staff at that hospital!  

On the other hand, Germany as well as many of the other European countries economies rely heavily on trade with other less healthy EU members. Worsening financial debt situation of these countries reduces trade opportunities and thus hurts the Germans as well. So expect the German “doctor” to make many more visits to the hospital dispensing more medicine (ECB loans) in the future while keeping a safe distance from the patients at the same time.

The European situation is very instructive and is the classic economic and financial “Catch 22”. Countries such as Greece, Spain and Italy and soon France need to rid themselves of high levels of debt in order to avoid a financial “death spiral” (i.e whereby interest rates on debt keep rising, because bondholders see an increasing risk of default, this higher interest cost must be funded by more debt which in turn increases rates further until there is eventual default–which is catastrophic for everyone in that country and not exactly good for everyone else).  However, in order to actually REDUCE debt, these countries must end deficit spending and even start running surpluses through a combination of tax increases and cuts in spending. But in doing so, the short run economic impacts can be very negative which in turn will reduce tax revenues and make the task that much harder to accomplish. Further, these “austerity” measures are highly unpopular with the rank and file workers who will see their future and current promised pension benefits cut significantly as a result. However, there is no other way to get back to fiscal solvency and “default” on the nation’s debt will mean far more drastic cuts in all government pensions and services, hardly an option that EuroZone countries want to consider.

Given the painful and unpopular consequences of “austerity” (and particularly the more severe form of “austerity” that is actually needed), it is not surprising that we see constant attempts of the EU thru more borrowing (and Euro printing) to “solve” the European debt crisis. The most recent meetings did little as far as ensuring actual austerity targets are met, while expanding the ability for more ECB loans to be made to troubled countries and banks. The markets greeted this with considerable glee for several days, but the financial optimism has quickly faded. Expect another European market “crisis” to emerge later this summer with another stop-gap “solution” in effect involving more Euro printing designed to postpone the inevitable further.   

Meanwhile, the US with its $15.7 trillion total debt burden which is now more than 100% of GDP ironically remains the “safe haven” for world wide investors. This of course is a mirage.  What makes us different from European countries is that (1) the dollar is still viewed as “valuable” and “safe” by the world and in relative terms much more so than the Euro (2) we control a printing press that allows us to print as many dollars as we want to and (3) for the time being at least the perceived safe investment are US treasuries despite their incredibly low yields. However, we need only look to Europe for our lesson in recent history to see what happens once debt levels become unsustainable and what the likely future is for the US under our current fiscal/monetary path.

Most importantly, we need to avoid repeating the mistakes that have already been made in Europe. The biggest of all throughout most of the EU zone was the promise of very generous pensions and medical benefits that couldn’t possibly be funded. (However, states like California and Illinois are still repeating this mistake in the US). In addition, inefficient tax policy discouraged investment and economic activity in many of these countries resulting in declining tax revenues as it choked economic growth.  Finally, there was little recognition of the fundamental law of public finance: when times are good, pay down the debt and put some money away for the rainy days. Instead, the integration of the EU countries under one common currency in the early part of the last decade allowed for low-interest borrowing which was pursued by banks, countries and consumers with reckless abandon.

The bottom line for the US: Let’s not repeat Europe’s mistakes and instead bring our fiscal and monetary house in order before it is too late.

The big news of the past month has been the trifecta of (1) The worsening European debt crisis and economies (2) US slowdown in job and GDP growth to a crawl and (3) the increasing realization of the upcoming “Fiscal Cliff”. The stock markets have not greeted this news well with the S&P 500 down more than 10% since its peak in April, though it has recovered some of late. Interestingly, the Fed is expected by some to begin a QE-3 (i.e.quantitative easing , likely involving additional money printing) but I wonder what positive effects it can possibly achieve even in the short run. (And as we know in the long run this is just further poisoning the value of the US dollar). Today, ironically enough, treasury bills and bonds are viewed by the world as the “safe haven” . This has led to extremely inflated treasury prices relative to even recent history. Yields are at all time record lows. So it is a little hard to see how more massive, money printing will do much good even in the near term.

The interesting political and economic question is what will Congress do regarding the “fiscal cliff” and more importantly, what should it do. It is my contention that NOBODY in Congress wants EITHER the tax increases or the specific spending cuts (even Republican deficit hawks don’t like the large amount of cuts to Defense) due to go into effect at the end of this year. While some observers fear a stalemate in which Congress takes no action and both the tax increases and automatic spending cuts occur, a more likely outcome is a last-minute Congressional delay in these policies so the 2012 status quo is extended to 2013. Both Rs and Ds can “save face” by claiming that they were unable to meet their party’s objectives (e.g. D’s repealing the Bush tax cuts on the “wealthiest few”, R’s targeting budget cuts so that Defense is not hit nearly as hard) because of the intransigence and lack of bipartisanship of the other party. However, both will make predictable announcements about plans to work on more serious long-term changes and reform NEXT YEAR. (just like the Cubs are likely to win it all NEXT YEAR).

OK so what should Congress do?

First, Congress needs recognize that one part of the “fiscal cliff”, the automatic spending cuts, will have only a relatively small, short-term impact on the economy, not the Armageddon that some have predicted. We are spending at a $3.6 trillion annual rate (vs our $2.7 trillion rate in 2007) . Is cutting this spending by a mere $100 billion really going to take the starch out of a $15 trillion economy? Clearly, the answer to this is NO, despite some of the political rhetoric you are already hearing. Sadly, the US Government is a bit like the alcoholic who admits he has a problem,  agrees to attend at least one AA meeting (i.e. our budget deal of last summer) and then, when someone points out that those meetings can be unpleasant, decides that maybe he’d rather not go.  These “automatic” cuts (about $1.3 trillion over the next 10 years) only get us about 10-20% of the way towards the ultimate cuts we will need in future spending, but if Congress can’t even abide by its own agreement to start this process, is there any chance we can actually tackle this problem? I believe we should NOT postpone these cuts.

Second, the other part of the fiscal cliff is five times more significant and includes $500 billion in new taxes, or expiration of tax cuts. $120 billion of the increase is from the social security payroll tax cuts which was to be a temporary “one year” (hah!) cut in taxes to help revive the economy. As expected, its political popularity (every worker benefits) has resulted in its extension thru 2012 and almost certainly 2013 as well. The largest part of the tax increase is the $300 billion from the expiration of the Bush-era tax cuts . This seems to be the most misunderstood part of the tax changes. Many including some in Congress seem to think that these were entirely to the benefit of the wealthy few, but in fact involve cuts in ALL the income tax brackets with the largest % cuts occurring in the lowest brackets (the bottom marginal tax rate of 15 percent was cut to 10 percent and the amount of income not subject to tax at all was increased significantly). In other words, there will be widespread pain associated with these tax increases. Given the relatively large short-term impact on the economy, and the fact that this Congress is NOT going to pass any meaningful reform this year, Congress should extend the current tax code thru 2013.

Unfortunately, the discussion of the fiscal cliff is a distraction or a sideshow. It is just another excuse to postpone the hard decisions off until well in the future. Instead, Congress needs to pass  a comprehensive,  three-pronged strategy that includes:

(1) Major Tax Reform– Blog readers will know that I prefer the “Fair Tax”, but even changing our code to a few marginal income tax rates with NO deductions is vastly preferable to what we have now. The most important part of this would be to make the tax code more efficient so it raises more revenues without hurting the economy. (See “Should 5 Percent Appear to Small …” Post in March)

(2) Targeted cuts in Federal Domestic Spending— This should include greater privatization and user fees for some services as well as elimination of some non-core government functions. —  (see my “Defusing the Debt Bomb….” Post in January) 

(3) Long run entitlement reform of Social Security and Medicare.–This is the most important area of all and one that I promise to post about soon. The explosion of these costs in the next 10 years could ruin our economy for a long time.

Congress needs to start working on this NOW, as opposed to postponing this still further into the future. This is probably just dreaming on my part, but hey that’s what blogging is all about! Otherwise, I guess “I’m really down.”

One of the most troublesome economic policy questions in the US today is how to create new jobs and rid ourselves of high unemployment. There is little question that unemployment today (and “disemployment” –which counts all those discouraged workers who have left the work force ) is a major problem in the US. It has many negative implications for the economy, for an individual’s self-worth and esteem and by most estimates a huge toll on personal health. So an obvious question is how to get the economy fully employed (or nearly so) at least at the levels that the US became accustomed to prior to the 2008-09 recession.

Unfortunately, the normal Neo-Keynesian response these days to spur job growth is to provide economic stimulus in one of three general forms:

(1) programs tailored to spur jobs in specific sectors by subsidizing activities that are usually NOT economic (e.g. renewable production tax credits, cash for clunkers etc.)

(2) federal government deficit spending at record high levels supporting more federal government jobs, related private sector jobs, as well as increasing/extending payments such as unemployment insurance and food stamps and a temporary cut in the payroll tax, all of which help support consumer spending  and

(3) monetary policy designed to accommodate major deficits and ultra low-interest rates so that consumers save on borrowing for major purchases such as homes.

I will acknowledge that some of this activity has been necessary and certainly humane and by most measures accounts for most of the short-term– albeit limited– growth in the economy and jobs since 2009. However, the degree and extent to which we have artificially stimulated the economy is really quite frightening. This “stimulation” coupled with a number of other factors (our HUGE levels of consumer and federal debt, massive money printing and highly inflated stock and bond prices and even home prices) means we are probably headed for a major fall of the US dollar and US inflation (eventually) and a steep recession or even depression in the US and around the world with devastating  job implications. This is an important topic for a future blog: Whether we can still avoid the inevitable serious recession or at least ameliorate the degree of recession?

However, with respect to jobs the real question is how can we improve LONG TERM job prospects in the US rather than a short-term quick fix as we have seen with stimulus.

First, I think it is appropriate to diagnose what has happened to US employment over the past several decades to better understand what needs to be done to create new jobs in the US in the future. Over most of the past 40 years, the US has been the envy of the world in both economic growth and job creation. Between 1970 and 2007 , US jobs have grown from 79 million to 146 million or at an average 1.7% compounded growth rate. This growth rate significantly exceeds the US working age population growth rate of about 1.3% per year during the same period. With only a few exceptions, the US growth rate in jobs far outstrips most of the developed countries around the world which have generally seen much slower growth rates during this same period. (Australia and Canada are the major exceptions but in both cases, the growth in working age population far outstripped the US).

Of considerable note  is that there were only 3 times prior to 2008 that absolute jobs in the US actually fell year to year. In 1975 , 1982, and 1991 there were losses of about 1 million jobs from the previous years and in 2002, a loss of 0.4 million jobs. So even during past recessions (including the fairly deep recessions of 1974-75 and 1981-82), not nearly as many as jobs were lost as in our current recession where we shed 7 million jobs between 2007 and 2010. Even more importantly, job losses in past recessions were quickly made up in just one year (with the exception of 1991 when it took two years), but sadly we still haven’t made up the 7 million job loss more than four years after the recession began.

So whats wrong now? Or better yet, what did we do correctly in the past? Looking at the data more closely, the rate of growth in jobs has varied over the forty-year period. The best period by far was the 1982-1990 period when 19 MM jobs (or 2.4MM jobs/year) were created , a compound annual growth rate of 2.23% which was almost double the 1.17% per annum growth in the working age population during that period. 1992-2000 was second best with a creation of 18 MM jobs (or 2.3 MM jobs/year) a growth rate of 1.8% per year which still outstripped the 1.23% growth rate in working age population. Both the 1971-81 and 2002-2007 periods created about 2 MM jobs/year, but only slightly outstripped the annual growth rate in the working age population in both periods.

In looking at these periods, it is clear that many factors were involved in economic and job growth, but several long-term structural factors seem to be most associated with job growth:

1. Deregulation of industries–In the case of the 1980s, airlines, banking, telecommunications, trucking, railroads and natural gas supply were all deregulated to varying degrees. New electric generation was deregulated. In virtually all of these cases, prices declined and output went up resulting in significantly more jobs. Also, lower prices for these services resulted in greater disposable income which in turn was spent on more goods and hence further job growth. In the 1990s, the effects of the 1980s deregulation continued, and electric utility deregulation and telecomm deregulation was expanded.
2. Free trade agreements–some of this began in the 1980s but major progress was made during the Clinton administration with the passage of NAFTA (North American Free Trade Agreement)  in the mid 1990s. This allowed US products to freely compete in Canada and Mexico and on balance produced many more net exports and jobs for the US.
3. Lower Marginal Tax Rates on Business and Individuals–During the early 1980s, the top income tax rate was lowered from 60 to 50% and then ultimately to 28% by the late 1980s. There is little question that the top rate of the 1970s (which was commonly paid by many small businesses) squelched new business formation and investment and hence job creation. The top rate was raised back to 40% during the Clinton years and is probably one of the reasons that the rate of job formation was slower during the Clinton years than the Reagan years. The Bush-era tax cuts helped spur some job growth during 2002-07 BUT the change in the top income tax rates was relatively small and phased in slowly (40 to 35 percent over 4 years) despite all the hoopla to the contrary. A bigger change was the reduction in dividend and capital gains tax rates which had the effect of increasing equity and capital investment– an important component of the growth in jobs.
4. Major Technology/ Productivity Advancements—These have clearly been enhanced by #1, #2 and #3 and have occurred throughout our history. However, there is little question that the period from the 1980s and 1990s saw a computer and internet revolution which substantially lowered the cost of doing business, improved productivity, lowered prices and hence fueled more demand and jobs. There have been technology advancements for centuries, but by any measure the advancements in the 1980s and 1990s were pretty extraordinary.
5. Significant Increases in Two-Income Families–during the late 1970s thru the late 1990s, the number of two earner families grew significantly. (As one indicator of this, labor participation rates among women in the US grew from 45% in 1974 to 60% by 1999). This meant that even more disposable income was available for discretionary spending by families which helped fuel the economy and jobs further.
6. Relatively Low or Declining Inflation– The corollary to this is a “conservative” monetary policy. Clearly, this was not the case in the 1970s and as inflation soared, employment growth soured. But in the 1980s and 1990s, inflation was tamed in large measure because the Fed refused to grow the money supply beyond what was needed for economic growth. During 2002-2007, the fed became much more accommodative and held interest rates down too long which contributed mightily to the housing bubble (and eventual bust).

So what does this tell us going forward?  

First and foremost, the current hyperstimulative path we are on with $1 trillion+ deficits and massive money printing will NOT create or even preserve jobs in the long run, but in fact will do just the opposite when the piper must eventually be paid. It is more than understandable that many in the government want to do something to keep people employed and our economy growing in the short-term, but unfortunately this is only inflating an already inflated economy more. More importantly, history tells us that real improvements in the economy are needed NOT artificial stimulus. At this point, we need to start paying off our debts , turn off the money printing presses and let sanity prevail.

Second, we need to continue to find opportunities to deregulate (rather than regulate) and take advantage of the power of the competitive markets to lower costs and increase net demand and jobs in the US. Health care and education are two prime examples where there is a strong need for competition and deregulation but other examples exist as well. In addition to deregulation, a lighter hand in federal, state and local government regulation (e.g. environmental, permitting, and overlapping federal/state/local regulation) also is important.  

Third, we should continue to resist the cries for protectionism in trade and continue expanding free trade agreements in the future.

Fourth, we need to reform our tax code so that it is much simpler (preferably the Fair Tax that I posted about earlier) eliminates tax subsidies and tax breaks and at the very least lowers marginal rates on small businesses. The efficiency gains from such a major reform (absent ANY net tax revenue cuts) will help fuel long-term economic and job growth.

Fifth, in order to help spur technological progress and the next set of breakthroughs and to make sure American labor competes successfully in the international markets, we need to change our education system in the US so that it uses more competition among schools (and teachers) to improve the basic education every child should get.  (More on this in a later post)

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I’m afraid that the a major recession is probably unavoidable in the next several years for many of the reasons I have discussed above and in previous posts. Nonetheless, I still believe that we can take action to ameliorate the extent of this downturn and at the very least, such reforms can make the US a better place to live and work for our children and our children’s children. Maybe then the Silhouettes lyrics won’t be prophetic after all: “Tell me that I’m lying ’bout a job…That I never could find.”

Little did the Guess Who realize some 40 years ago that they were prophetic regarding sugar.  In fact, they were much more so, than Nancy Sinatra, who enjoyed “Sugar Town”, Sammy Davis Jr. who extolled the “Candy Man”, or the Four Seasons who found their “Candy Girl”.  

There is now overwhelming scientific evidence that sugar isn’t just empty calories but is an actual toxin to the body. The unfortunate reality of US public policy and for most of the US public is that we haven’t caught up to these facts about the dangers of sugar consumption (and particularly excessive sugar consumption).

So what is the evidence? First and foremost, everyone knows that eating too much sugar is a major contributor to obesity. In fact, the historic evidence suggest strongly that it is the PRIMARY cause. In the last 30 years, we have lowered the fat in our diets from 40 to 30% of calories, but have replaced it (and more) with sugar (i.e. either fructose or sucrose, their impact is the same) . This directly correlates with our average weight  increasing  an astonishing 25 lbs! In fact, since the early 1900s when we got all of our sugar (15 gm a day) from fruit, our sugar consumption has steadily increased to 20 gm by WWII, 37 gm by 1977, 55 gm by ’94 to todays level of about 70 gm per day.  It is the one constant in our diets where we have seen large per-capita increases. Meanwhile, our share of “good” foods such as complex carbohydrates and fiber has gone down. (Average fiber consumption is only 15 gm per day down significantly over the last few decades and way down from an estimated 100-300 gm per day during early man’s existence. This is a fact that never ceases to amaze me.)

What is even more damning for sugar is that it  is actually “toxic” to the body. Though lengthy and a bit preachy at times, I recommend to all the 90 minute video of a lecture by Dr. Lustig called “Sugar The Bitter Truth” which is easily found on YouTube. Dr. Lustig very convincingly links sugar to many other problems that go beyond obesity such as diabetes, gout, hypertension, high glycerine/HDL ratios (which he notes is the best predictor of heart disease not just LDL), high amounts of LDL,  among many other problems. He does this in the biochemistry part of the talk which though a bit complicated does make you realize that the body takes in complex carbohydrates and fiber with only positive effects. However, fructose or sucrose cause eight very negative things to happen to the body.  ( I wasn’t exactly pleased that these same negative effects occur with alcohol consumption as he shows in his lecture, but after all it is a fermented sugar. ) Separate research (see 60 Minutes Story on Sugar) has also strongly tied sugar consumption to a number of cancers as well.

In addition, sugar has an “addictive’ quality to it, which rivals cocaine! (See 60 Minutes story). This makes it particularly insidious in that it is very hard to eat it in moderation. This is also no surprise to parents of small children or to adults who have sat down with a box of chocolate chip cookies after a rough day and tried to eat just one. 

What should we do? As individuals cutting out all soft drinks, fruit drinks, and even fruit juices is clearly a ‘must’ as well as most desserts or snacks. (In my case, it means not even having them available in my house. ). It is particularly important to limit those juice boxes for infants and young children and replace them milk, water or with real fruit.  (Note that though real fruit has fructose it comes with nature’s “antidote”- fiber- as Dr. Lustig explains. In fact, it takes about 6 oranges to equal a 12 oz orange juice. And I can’t remember the last time I ate 6 oranges!) Even just one of these sugared drinks gives you all the sugar your body can handle. Similarly, alcohol consumption should be limited (but you already knew that :) ). However, you also should watch out for added sugars in refined products you eat which can quickly add up. (As examples, almost all bread, tortillas and breakfast cereals have added sugars. But some, such as Cheerios, Shredded Wheat, fresh-baked sour dough and french breads , and corn tortillas have NO added sugar).

At the public policy level, I believe we should also “tax” sugar consumption. This is not just because sugar is empty calories, but because it is a toxin just like ethanol. And we after all, regulate alcohol and cigarettes and tax them heavily. Why not sugar too? I find the evidence (including the above noted videos) as pretty compelling regarding these toxic effects, much more so than other activities that we have banned or heavily regulated such as air pollution which I am also all too familiar with on the science side.

I think the rationale for taxing sugar is compelling. First, taxing sugar will help reduce consumption, which is a positive given its documented  very negative health consequences. Second, revenues from taxing sugar can be used to help pay for our increasing Medicaid and Medicare costs in the future as rates of diabetes, heart disease and other long-term illnesses likely continue to increase at least for some time. Third, and perhaps most importantly, the tax on sugar can be part of the messaging of the “war on sugar”, which would need to accompany it and hopefully greatly reduce its consumption over time.

The size of the tax is a little more difficult to determine. My simple math suggests there are approximately 8 trillion grams of sugar consumed in the US. each year (320 MM x 70 gm per day x 365 days per year) and a mere 3 cents a gram would yield about $240 billion per year.  Three cents a gram would add about $1 to the cost of a 12 oz. sugared soda or fruit drink which would be enough to start affecting consumption significantly. Such a tax would need to be phased in gradually so not to be too much of a shock to consumers or the economy at least initially.

Normally, I am a seldom an advocate for selective government taxes for public policy purposes (i.e. to penalize or subsidize one industry vs. another), but in this case, there is a clear “market failure” (as economists like to call it). We have a product “sugar” which is clearly bad for us but difficult to eat in moderation and even arguably addictive. We have huge long-term health problems that sugar is already helping to cause, which we all pay for whether we personally end up with these problems or not, thru insurance or thru Medicare and Medicaid. This simply cries out for a strong economic disincentive at least to no longer to consume as much sugar.

Sorry folks, but it’s No Sugar Tonight!

It is hard for me to work on completing my taxes without thinking of George Harrison’s “Taxman” from 1966. And of course doing my taxes has reminded me of one of my favorite topics: tax reform.

And  in my mind, tax reform is not rhetorical tinkering with the current code which seems to be what we are generally hearing from the political candidates and the Administration. Instead, tax reform should be a complete wholesale destruction of the current ridiculously complicated and inefficient tax code and replacement with a simple and efficient system instead. Perhaps the countless thousands of pages of tax laws and regulations could be printed out and a giant bonfire produced which would provide us all with some sorely needed closure!

The best way to approach tax reform is to start with first principles. What are we trying to accomplish with a tax system? I would argue that there are three main objectives:

(1) A tax system should be designed that raises revenue in the most efficient and cost-effective manner possible–in other words, the system needs to be simple such that paying taxes is automatic and a simple  procedure in stark contrast to the rather painful and costly process that exists today for most taxpayers. It needs to make compliance virtually universal rather than the current system where non-compliance (in many cases unintentional) is increasingly the norm.

 (2) A tax system should be fair— This means that everyone pays taxes (except those below the poverty line) AND wealthier people pay MORE taxes than less wealthy people.  How much more is a legitimate topic of debate of course.  BUT the current convoluted system where some middle class citizens pay ZERO federal income taxes  and some of the wealthy pay a lower percentage of their income as taxes than other middle class citizens is “unfair” by virtually anyone’s standards.

(3) A tax system should not appreciably harm the economy or distort it in any way–In other words, taxes shouldn’t subsidize certain industries, activities, or interest groups while penalize others. This creates an economy which is less efficient and grows more slowly. Unfortunately, our tax system is replete with such subsidies for real estate, homes, special types of energy production, renewable energy, agriculture, charities, non-profits and borrowers in general. At the same time, it penalizes the most important group to our economy: savers and investors.

The current system fails on all three of these principles. We have a startlingly high rate of non-compliance (mostly unintentional) estimated at 40% of the public by the IRS. Tax evasion amounts to some 16% of taxes due. Not even included in this figure is that we are not taxing some $1 trillion per year from the “criminal economy”. Our tax code has contributed mightily to the housing bubble and the massive overbuilding and speculation that occurred during the last decade. Our tax code has also contributed to the consumer debt problems that plague our country to this day.

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My favorite tax reform proposal to rectify these serious problems is something called the Fair Tax. See FairTax.org. The proposal represents a simple and effective way of raising tax revenues and having a system which is fair and positive for the economy.  To quote the website: “The FairTax is a comprehensive proposal that replaces ALL federal income and payroll based taxes with an integrated approach including a progressive national retail sales tax” … and
” a prebate to ensure no American pays federal taxes on spending up to the poverty level”. Of particular note:

•  Simplicity– The FairTax is a 23% national retail sales tax on all goods and services plus a prebate to cover consumption up to the poverty level. This  eliminates ALL federal personal income, corporate income, gift, estate, capital gains, dividends, alternative minimum, Social Security, Medicare and self employment taxes. It is very simple and straightforward to collect and eliminates the incredibly complicated federal tax system we have in place today.
• Efficiency—Compliance with the FairTax would be far better than under the current tax system due to its simplicity and its collection at the point of sale. (Something most states already do). In fact, even the $1 trillion criminal economy would be taxed as they would consume goods and services with their ill-gotten gains. The costs of personal and corporate tax accountants, tax lawyers, HR Block, TurboTax and the IRS would disappear entirely and filling out your tax forms would no longer be necessary.
• Great for the Economy and Jobs–By eliminating the large amount of unproductive activity associated the current tax code, resources are freed up to produce more goods and services more efficiently across the economy. In addition, the elimination of subsidies and penalties in the current tax code, will eliminate overconsumption which is also inefficient, and encourage savings and investment which are badly needed in our debt laden economy.  Net retail price increases in the first year of the tax should be relatively small because the 23% tax on prices will be mostly offset by the elimination in corporate and other business taxes (which are estimated by economists to account for about 20%+ of  retail prices today). The US will become the mecca for foreign investment and US companies will no longer produce as much offshore given the elimination of these embedded taxes on exports. This will mean many more jobs in the US and better paying jobs as well.
• Fair and Progressive—The system provides a prebate in the form of monthly check equal to the sales taxes paid on consumption at the poverty level for each family. This means that  the first approximately $30000 of spending is completely tax-free and the effective tax rate for those that spend at or below the poverty level is zero. In addition, all used goods (e.g. cars, appliances, furniture, homes etc.) are completely tax exempt. This means that necessities to live are NOT taxed while discretionary items are taxed. Also, those who are frugal and save more, get taxed less. This is very different from the system today where the working poor pay significantly more federal taxes (when payroll taxes are included) than under the FairTax.  Studies also demonstrate that spending on goods and services are generally proportional to income (e.g. someone earning twice as much usually spends twice as much) . Thus, the tax is progressive ( a higher effective rate is paid for those who earn and spend more).

In sum, the FairTax would broaden the tax base, aid the economy, create more US jobs and help us out of our budget and debt crisis. In addition, it can be easily modified to make it even more progressive by increasing the prebate and overall tax rate to account for the lost revenues, if that it is ultimately what US taxpayers want.

The only and perhaps insurmountable problem with the FairTax is POLITICAL. The benefits of the proposal is to the US population and economy collectively. However,  the benefits of the current tax system are to a multitude of special interests ranging from higher education, wind manufacturers, oil and gas drillers, public employee unions, the medical industry, real estate brokers as well as lawyers and accountants that thrive on the current hopelessly complex system. Any attempt to change the current system, let alone completely eviscerate it will be met with strong resistance. And of course those who are not serious about really cutting federal spending ( unfortunately many in Congress) will hate the proposal since it will force the government to be truly accountable about how much it needs in taxes.

But it doesn’t hurt to try. It’s a good idea whose time has come. It’s about time we changed a federal tax system that was born in the early 20th century.

More on other tax reform ideas in later blogs.

While I had intended to write about tax reform and tax policy this week, the Fed’s action (and signals) last week reminded me of a more immediate discussion topic: our massively expanding money supply. I have alluded to this on both my previous postings, but felt it important to tackle this one now in light of the Feds actions and statements this past week.

First, let’s start with some basics. Generally speaking, U.S. money supply is defined as the amount of $$$ in circulation. However, there are multiple definitions of money supply though one commonly used by economists is the “monetary base”. This refers to the amount of currency in circulation plus the deposits held by banks at the federal reserve. (For more discussion of this definition, I would refer you to an excellent blog from www.aftershockeconomy.com/blog/What-do-we-mean-by-money-supply. I also highly recommend the book and analysis done by these authors, though I caution you that you may lose some sleep after reading their book!!! )

There is a strong correlation between the rate of growth in the money supply and the long-term rate of inflation. Notably, inflation lags money supply growth by a couple of  years and even longer when the economy is weak (e.g. today). However, eventually the growth in money supply results in inflation, and the higher the  growth rate in money, the higher the rate of inflation. The “After Shock” authors cite work by Ben Bernanke and others that found this correlation, but in order to prove it to myself, I downloaded the Fed data back to 1959 and took a look at the trends. Sure enough, an increase in money supply growth showed up as higher inflation a few years down the road, while a lower rate of growth in money supply growth typically helped reduce the inflation rate. Of course, Milton Friedman won a nobel prize for his work on monetary policy and his theories about the association between money supply growth and inflation.

We have had a “relatively” stable monetary policy historically with  “monetary base” growth averaging 6.3% per annum between 1959 and 2008, with most years growth falling between 2 and 8 percent. The exceptions have been when the Fed has pursued a very expansionary policy (e.g growing the money supply by 9-10 percent during the mid to late 1970s which occurred a few years prior to the double-digit inflation of 1979-1981) or has actually pursued a restrictive monetary policy often to curb inflation (e.g. zero growth during 2000-01 to curb inflationary pressures during the “irrational exuberance” period of the late 1990s). However, the largest exception of all is during 1929-1933 when the Fed REDUCED the money supply by one-third. This enormous restrictive action helped cause an enormous DEFLATION spiral which in turn fueled the Great Depression.

If you have made it this far, you may be asking why is this important TODAY? First, history and economic studies have proven the common sense notion that inflation is simply too many dollars in the US economy being used to buy a set of goods and services. The more dollars available in the system, the higher the prices (in $ terms) of those same goods and services. Second, and most importantly, after decades of monetary policy during which the average growth in the monetary base between 1959 and 2008 has been 6% per year(and almost always between 2 and 8 percent per year), we  have  MORE THAN TRIPLED the monetary base in only a bit more than the last 3 years. (e.g from $0.8 Trillion in late 2008 to $2.6 Trillion today). It is NOT an exaggeration to say we are in completely uncharted territory and no one knows what the ultimate outcome will be over the next few years as all this money eventually fully circulates thru the US economy. However, it is good bet that we will eventually see much higher inflation, quite possibly double-digit inflation, very high interest rates and a much weaker US dollar. This combined with a U.S. economy which is still heavily saddled with consumer debt , a housing market that is still inflated (relative to long-term history), and a still rapidly increasing US federal debt burden will almost certainly be enough to push us into a serious recession, which will probably make 2008-2009 look pretty good in comparison.

The recent Fed announcement indicates that it intends to hold interest rates to near zero levels thru 2014 and comes primarily as a reaction to the continuation of relatively slow growth that we have had of late. (NOTE: historically, US recoveries generally have very robust GDP growth rates of 5-6% or even more for a couple of years , but this recovery has been barely above the 2-2.5% growth needed to reduce unemployment levels.) The implication is that in order to keep rates to these very low levels, the Fed will almost certainly have to expand the money supply even more. This likely means a QE-3 (ie. the third “quantitative easing” program) in which the Fed will buy back US treasury bonds by printing enormous amounts of additional money. In my view at least, this will only exacerbate our problems in the long run.

Why is the Fed doing this? The Fed and a number of economists view that the US economy and the European economy are very weak and needs to be stimulated through near zero interest rates so more loans will be made, housing values will go up again and there will be greater capital investment to help  the US economy grow more rapidly. The Fed also views that it can reverse its monetary course if inflation begins to heat up.

The problem with this theory is that stimulation doesn’t work too well  (and certainly hasn’t for the past three and a half years) when consumers are laden with record amounts of debt already and home prices are still at very high levels relative to long run historic norms.  (Over the past 100 years, home values have roughly kept pace with inflation/personal income growth except during two periods, the Great depression when they dropped by some 30 percent in real terms , due to the deflationary policies of the Fed and during the first seven years of the past decade when they roughly DOUBLED in real terms). Second, reversing our monetary course (selling more US debt and retiring the money supply)  wont be at all easy politically (as it will in itself result in much higher interest rates) and probably wont be done unless we have a rapidly growing economy which now appears highly unlikely. So whatever reversal the Fed does ultimately pursue will almost certainly be too little too late.

What should the Fed do? Allow interest rates to rise moderately by turning off the monetary spigot and gradually beginning reversing its ultra-expansionary policies of the past 3 years NOW. This obviously isn’t going to happen because it will mean slower growth or even zero growth for a while and the Fed is watching today’s stubbornly high unemployment levels as well as inflation. 

Thoughts?

I promise to move onto less depressing topics next week!

Based on the feedback from my first blog post, it would appear that most agree that we have a very serious debt and economic problem on our hands with our exploding federal debt. In contrast to the current political rhetoric, dealing with this problem will require both substantial cuts in ALL types of spending AND increases in tax revenues. I will have more about increases in tax revenues in a future blog (though increasing tax revenues in the US should and can be  mostly be accomplished through tax reform rather than just raising personal marginal tax rates).

This post will address cutting federal spending which at the end of fiscal year 2011 (9/30/2011) totalled some $3.6 trillion- an incredible $0.9 trillion above FY 2007 levels.

Understanding what and how to cut the current federal budget requires understanding more about the nature of our expenditures. Accordingly, I have divided our $3.6 Trillion FY 2011 budget into four categories:

• 1. “Benefit” programs($1.85 trillion or 51% of total) – includes Social Security($0.8 trillion), Medicare/Medicaid($0.8 trillion), Unemployment and VA Benefits ($0.25 trillion).
• 2. Defense–($0.95 trillion or 26% of total)–includes Defense dept ($0.74 trillion) , Iraq/Afghanistan Wars ($0.16 Trillion) and Homeland Security ($0.05 trillion)
• 3. Domestic programs (Non-Core/Subsidy) ($0.50 trillion or 14% of the total)–includes Agriculture ($0.15 trillion), Transportation ($0.08 trillion), Energy ($0.05 trillion), HUD($0.06 trillion),Tax Expend.($0.12), Labor/Small Bus./Commerce/Other ($0.09 trillion)
• 4. Federal programs (Core)($0.32 Trillion or 9%) includes HHS, State and Intl. Prog., Justice, Interior , EPA, Treasury, Education, and NASA.

The last two categories bear some explanation. Category 3 includes programs and federal spending which are generally for goods and services that could be produced by the private sector. This ranges from everything to subsidizing crop production, Amtrak, energy production, housing or small businesses. Thus, category 3 in business parlance is a “non-core” part of the federal government’s charter. It is not essential to running the country and largely serves to subsidize various commercial activities or various interest groups.

Category 4 Federal Programs (Core) includes agencies/departments that  generally produce “public” goods which the government needs to provide. This ranges from Health and Human Services, international relations, managing federal lands, environmental protection, public school education and managing the treasury.

Please note that for simplicity these categories are intended to be rough approximations. There are some agencies or departments within Categories 3 and 4 that could be moved between categories or for which some of its activities are “core” and others are not. For example, I would argue that public school education could in fact be significantly privatized (though a voucher system or other means) though this would still end up being a significant (albeit smaller) budget item so I left this in the core.

I have assumed that we must cut the total budget by an average of $1.0 trillion per year over the next ten years achieving this level of cuts in the next 3-5 years. This coupled with tax revenue increases through tax reform and some tax increases should get us to a balanced budget by mid-decade. Note, $1 trillion per year is a much greater number than has been discussed in last year’s aborted budget debates (i.e. about $1-4 trillion over 10 Years). However, with a current $1.4 trillion deficit and the near certainty that interest payments will be increasing significantly, this amount of cuts are essential to bring the US debt problem under control.

Given the size of these cuts, and the nature of our current spending, we need to get MOST of these cuts from the first two areas — Categories 1 and 2. (i.e. Benefit Programs such as Social Security, Medicare, Medicaid and National Defense) since they account for more than 3/4 of our current budget. However, it is also important to make sizeable cuts in Categories 3 and 4, because social security, medicare and Medicaid are growing rapidly due to inflation and greater numbers of retirees, so it will be even harder to cut these expenditures below current levels.

As an initial starting point at least, I would recommend that the following cuts which would equal $1 trillion in total:

(1) Reduce Category 2 (Total Defense) from $0.95 to $0.65 trillion or by $0.3 Trillion Per Year. This is a little more than a pro-rata share of the cuts that will be needed across the budget, and should largely come from phase down or elimination of Afghanistan war spending ($0.16 trillion) and some significant down sizing of Americas troop strength home and abroad as well as cutbacks in some weapon systems.

(2) Reduce Category 3 (Domestic Non-Core Spending) from $0.5 to $0.2 Trillion or by $0.3 Trillion Per Year. This can largely be accomplished by taking aim at the most egregious and largest subsidy producers (i.e.Agriculture, Transportation and Energy) and by eliminating the tax expenditures (i.e. subsidies under Treasury) entirely (as part of  Tax reform) of $0.12 trillion per year.

 (3) Reduce Category 4 (Federal Core) Spending from $0.32 trillion to $0.22 trillion or by $0.1 Trillion per Year. A key part will be reforming our Education spending (injecting more competition into the public school system) so that the dollars generated at the state and local level from property taxes can be mostly used to fund education. In addition, we should be focusing on cuts in aid to foreign countries  which aren’t good friends of the US (e.g Pakistan).

(4) Reduce Category 1 (Benefit) Spending from $1.85 to $1.55 Trillion or by $0.3 Trillion Per Year . This may be the toughest to do, because it will require some substantial changes in Social Security and Medicare in particular and as noted before, these programs are growing rapidly as the ranks of retirees grow. (This will be a topic of future blog posts.) On Social Security at least, the answer would appear to be some combination of (1) raising the retirement age to 70 phased in over this decade (2) reducing the annual inflation adjustment by 1 or 2 percent (3) phasing out benefits (or taxing benefits) to a greater extent for middle to upper income seniors. Also, we probably will see some declines in unemployment benefits as the ranks of the unemployed (hopefully) continues to fall.

While these changes will be difficult, they certainly are doable in my opinion. Note that our total budget in FY 2007 was $2.7 Trillion or $0.9 trillion below today’s levels, so I refuse to believe that we can’t get $1 trillion in cuts in the next few years. 

However, these cuts will be very unpopular with many American citizens. In fact, when you combine these cuts with the tax revenue increases needed through broad tax reform and some tax increases, it is fair to say that almost everyone will be unhappy to some degree. More details and specifics in future blogs. Thoughts?