Bastiat's Bastions

The new White House spokesman, Jay Carney, tells reporters in this video that the White House’s goals for the stimulus package have been met.  If that is the case, then the White House’s goal must have been to bankrupt the federal government, to leave many states in fiscal crisis, and to wreck the dollar, while leaving record numbers of Americans out of work and out of a home, facing their own private bankruptcies.  We have heard claims of “Mission Accomplished” from a previous White House, a claim that turned out to be premature to say the least.  Now this White House is claiming that trillions of dollars of stimulus and bailouts have worked?  Does the White House really expect the American public to believe them?

-MC

Economists recognize a limit on government spending due to the sources for the spending for those dollars to be spent.  Economists call this limitation the “government budget constraint.”  We recognize that there is a tax to be paid one way or the other, different ways of raising the funds implies different taxes.  Some of these are up front taxes, where we know we are being taxed, while others are hidden taxes that we pay, nonetheless.

Indulge me to some simple math.  Let’s use “G” for Government Spending, ”T” for Taxes, and “D” for Deficit.  The Deficit, D, is, of course, just G-T, so D = G-T.  That part is obvious:  the part of government spending that exceeds the taxes raised to pay for that spending is the deficit (government debt on the other hand, is the deficit accumulated over the years minus the few surpluses we have had).

So, the excess of government spending over above the taxes to pay for that spending is the deficit.  A hallmark of Keynesian economics has been the idea that deficits are ok, that they are even a good thing during recessionary periods.  This approval of deficit spending by the federal government removed the moral constraint to not run deficits that had been in play for years.

Borrowing to pay deficits and taxes on capital and labor

The next question is “how do we pay for this deficit?” Well, of course, we borrow the money–we choose to increase our debt by borrowing from anyone who thinks that we are credit worthy, better risks than others at the interest rate we are paying.   We simply put IOUs (or treasury bills) up for sale. Some of the creditors or buyers of these IOUs are our own citizens, and some are not.

If we only sell our IOUs only to our own citizens, we soon have to lower the price of our IOUs in order to sell more, as there will be a point where the our citizens will start to have to take their funds from investment projects in which they are willing to invest and keep those funds in treasuries, or government IOUs.  While I will not go into the explanation in this post, interest rates and the prices of IOUs go in opposite directions, but here is a sufficient explanation from About.com.

As we drop our price to sell more, our interest expense increases.   So, as we increase the size of our debt with deficits year after year, we also drive up interest expenses for most of the debt we owe, as much of it is in short-term securities.  Since interest payments amount to part of our G, government spending, the deficit goes up at an even faster rate.

Of course, we sell our IOUs not only to our own citizens, but to all those around the world.   By selling them to those outside our borders we are able to raise more funds at the same interest rate as compared to only selling them domestically.  Still, as our debt creeps upward, we have a larger proportion of our spending going to pay the interest on this debt.  Since so much of our current debt obligations are in short-term obligations, new debt from additional deficit spending raises our interest expense on most of our debt.   As more borrowing to finance new deficits begin to push interest rates up as the default risk on these funds increases (just like a lender runs a higher risk of not getting his funds back from someone who owes ten times what they make in a year compared to someone who is now debt free, but once had a mortgage), and so, lenders must get higher rates to take the risk of making the loan.

Interest rates start to edge upward as it becomes more difficult to sell our IOUs.  Higher interest rates mean fewer business investments in machinery, equipment, factories, etc. will be worth making and less of these tools will be available for workers to use.  Less capital per worker means lower productivity for workers and less pay, as workers are ultimately paid because they are productive.  If the worker does not produce as much, the worker cannot be paid as much.

So, increased borrowing is a tax on workers and owners alike, as lower wages for workers and less capital held by owners harms both of these producer groups.  This tax is hidden from immediate view, as it is not obvious that excessive government spending is immediately coming out of their pockets.  The tag line for our blog, “what is seen and what is unseen” becomes important here, as people usually perceive taxes that they get a bill for as a tax, but they don’t see deficits as taxing them.  As Louisiana Sen. Russell Long was noted for saying, voters really mean “Don’t tax me and don’t tax thee, tax the man behind the tree.”  We are the men behind the tree.  Or, when it comes to taxation, as Walt Kelly’s Pogo said “We have met the enemy and he is us.”

Printing money to pay the deficit and the inflation tax

Now one of the tricks that governments have used in the past is to have its central bank (our Federal Reserve) become one of the creditors and buy up these IOUs.  In an earlier day, we would simply have some institution print or coin money.  Increases in the supply of money in an economy usually or eventually results in raising prices, in inflation.  If the increased money supply causes people to reduce their acceptance of the money involve as they expect the money to have a declining value,

The unstable Weimar Republic, the post-WWI German government, did exactly that, resulting in inflation rates that boggle the mind, reaching a rate of 100% every 2 days.  In other words, prices were doubling every two days for a while.

Another way of thinking about that is that a person’s savings in money fell in half every two days.  There is an often-repeated story of someone choosing between a huge prize and a penny payment that doubled every day for a month (30 days—we won’t get greedy here).  Imagine getting a million dollars in 30 days or the penny payment doubling every 30 days.  Here is a little article on that choice.   The doubling penny ends up being $5,368,709.12 in just 30 days.

Now imagine the reverse, where you start off with cash holdings of $5,368,709.12, and you face inflation of 100% every two days.  In only 60 days the buying power of your cash holdings is reduced to a single penny.  In those short 60 days, the government’s inflation policy, turning its debt into money, has taxed away over $5 million of your savings.  “My father was a lawyer,” says Walter Levy, a German-born oil consultant in New York, “and he had taken out an insurance policy in 1903, and every month he had made the payments faithfully. It was a 20-year policy, and when it came due, he cashed it in and bought a single loaf of bread.” (From the PBS series, Commanding Heights )

While everyone may try to rid their portfolios of money assets, it cannot be done for the whole economy, and so, wealth held in dollar assets falls, making us all poorer, but also making the inflation tax even higher.   As people try to protect their portfolios by buying real assets (not money or dollar denominated IOUs), we end up in a game of “who gets stuck with the worthless money.”  We spend that money at a faster and faster rate.  For instance, the German hyperinflation mentioned above led to retailers raising their prices several times a day.  Workers and their spouses soon started demanding to get paid several times a day so that the same marks were going around the economy at faster and faster rates.  A very old and well known relationship in economics is that the price level (think CPI) times the output of real goods and services produced (think real GDP) equals the Money in the system times the speed at which money circulates (something called Velocity).  Or, put another way, the growth rate in the Money Supply times the growth in Velocity divided by the growth in the economy is the growth in prices better known as inflation.  Either more money or faster circulating money will drive up prices if we don’t increase our output.

We see store owners and farmers raising prices and seldom think that it is really the government and the central bank behind these price increases, making inflation amount to an invisible tax eroding away at the cash savings we worked years to build up.

I should point out that economists recognition of a government budget constraint, that we are taxed one way or the other for all of our spending is noted in the acronym “TANSTAAFL,” standing for “There Ain’t No Such Thing as a Free Lunch,” coined by Robert Heinlein in his science fiction book, “The Moon is a Harsh Mistress.” Still earlier, David Ricardo noted the equivalence of taxing and borrowing in his 1820 “Essay on the Funding System.”

Why Do Deficits Matter?

If we are taxed one way or the other as has been shown, why do deficits matter, why should we care about deficits and running up big national debts?

Well, just as Ricardo noted the monetary equivalence between borrowing and taxing to pay for some large government expense, such as a war (Ricardo’s example), Ricardo also suggested ways that these were not the same, noting that people often fail to perceive the full costs of government spending when it is financed by borrowing, noting what has been called by one of my professors, James Buchanan, “Fiscal Illusion.”  The problem is that the taxpayer-voter seldom notices the perpetual interest payment the government must make as the same as the immediate tax increase to avoid a deficit.

Another way of putting this is that not all taxes are seen as such.  People seldom connect the inflation that they face because of government services that they receive while refusing to pay higher taxes.   People also do not notice that they have less equipment and tools at work and fewer sellers in each industry because investments were not made at some earlier time because interest rates were too high.

Taxes out of their own pockets are seen and kept to a minimum, while government benefits they get are seen and kept to a maximum.  On the other hand, stealth taxes on capital and on money holdings are not seen as payments for their government benefits or the reductions in taxes for which they themselves are liable.

So, voters ask for lower taxes and higher benefits, more spending, and their representatives oblige.  The cost of government is perceived as being very low.  When we do not see the full cost of something, we usually ask for more, just as the consumer who does not pay for the environmental costs of the products they consumer want more to be produced.

Deficits matter because they misrepresent the true costs of decisions to voters.  Voters who benefit from the spending vote for it, as it is clear that they benefit.  Voters who pay the inflation tax or the capital tax (higher interest rates) do not perceive their liabilities and do not try to block passage.  The most popular legislation, then, raises deficits.  Fiscal Illusion that plagues us, especially when we employ deficit financing of government spending, makes continued deficits more likely, as voters, more than Twist, find it easy to ask for “More, please.”

-MC

The Houma Courier ran a story yesterday with the headline, “Is a tuition hike a tax increase?”  

That is a question I will take.  The answer is a resounding NO!

In the article, Rep. Dee Richard, as a sitting member of the Louisiana House Ways and Means Committee, the committee charged with reviewing taxes in the state, stated that “it’s a tax increase, because it’s a cost being passed onto a consumer though a government directive.” (quote is from the article, not a direct quote from Richard).  Richard should note that according to his definition, almost any regulation would then be a tax.  Also, though rare, there can be taxes where costs are not passed on to consumers.

Taxes are coerced payments, payments that do not involve a direct quid quo pro, a direct exchange.  Whether you as an individual pay your taxes or not, the services you get from government do not change.  You pay your property taxes and the city can light the streets you drive along.  If you (just you) fail to pay your taxes, the street lights still go on.  Whether you drive through the streets at night or not, you still owe those property taxes.  The tax bill does not depend on your use of the service and your service does not depend on you paying your taxes.

On the other hand, user fees are what governments charge as a price for a good or service that the government can sell.  Water and sewerage bills are examples of user fees, as are rates paid for campground sites and park visitation at state and national parks.  Tuition paid to colleges is another example.  If you want to enjoy the park by camping there, you can expect to pay for that privilege.  If you wish to go to a state community college or a state university, you pay for that privilege.  Certainly, when Tulane and Centenary raise their tuitions, these increases are not deemed taxes.  Should you choose not to go to college, you do not have to pay tuition.

Do I like tuition hikes?  With 2 of my children at a state-run university, I am not thrilled with the prospect of having to pay more.  However, my children and I both think that their education is important enough to pay something for it.  While the state as a whole may benefit from having more college-educated citizens, my children certainly expect to benefit from their studies.

By calling something a “tax,” certain opponents of the tuition increases distort the language for their political ends, hoping to taint the tuition increases with despised term, tax. Words are meant to communicate ideas that are shared and understood both by those using the words and those they mean to affect.  Tuition is a payment for something received, part of a voluntary exchange.  There is nothing voluntary about taxes.

-MC

This and all posts on this site are the ideas and opinions of the writers and not necessarily the position of Nicholls State University.

Ben Bernanke, the Chairman of the Board of Governors of Federal Reserve, states in this article that the   

“…stock market rally that began last summer was fueled by the Fed’s efforts which improved U.S. economic activity.”

The question is why has the stock market gone up in response to Fed monetary policies of increasing the money supply.  It might be that there has been increased “real activity,” increases in production that have encouraged stock market demand.   On the other hand, another very real possibility is that because of increases in the money supply base, through the Federal Reserve’s promised buying of over a half trillion dollars of U.S. Treasury Bills, that inflation is expected to increase. 

One thing that investors and others do to protect their wealth against inflation is to buy stocks because stocks tend to go up with the price level because businesses can raise the prices of their goods.   Gold is another hedge against inflation, and gold prices have shot up through the roof in response to Fed credit-easing policies.

While recent news of a substantial one-month decline in the unemployment rate from 9.4 to 9.0, but there were small gains in employment over that time, only 36,000 jobs added.  The answer to that puzzle is that the number of people who did not look for work in that time period went way up, suggesting that people had become too discouraged to continue to look for work. 

There seems to be too little of an increase in real activity, in actual production, to increase employment.  The Fed’s monetary policies seem to be having little effect, except on inflationary expectations.

-MC

What was that again, about our hypocrisy?  Recently (10/8/10), I posted an article “Drugs, Money and American Hypocrisy.”  Here are a few updates, some news articles about the currency dispute with China and what we in the US are doing about our own currency. 

First is this article from Reuters on how some Federal Reserve officials are advocating inflation to affect the dollar’s exchange rates.  

Next is this article from Bloomberg on how the expectations of the Federal Reserve expansion of the money supply to increase inflation is already affecting our exchange rates with other currencies. 

With this devaluation of the dollar relative other major currencies as reported here by the Financial Times, there is the possibility that other countries will retaliate with their own devaluations (see this article from Reuters).   With no major currencies holding their value, one would expect gold to get bid up even higher. 

The US continues its fight with China, claiming that the Chinese are manipulating their currency, but ignore that man behind the curtain who seems to be pulling levers and turning knobs, just watch the Chinese currency.  Even if the Chinese are pushing their prices down, why should we in the US really complain?  This just gives us lower prices, particularly at Wal-Mart, helping the poor and the unemployed. 

At least for now, the Obama administration is taking the higher road, and has backed off of labeling the Chinese as currency manipulators.  They seem to be waiting at least until after the midterm elections in the US and after the meeting by the leaders of the “Group of 20″ in Seoul, S. Korea on 11/11/10. 

Update on this update–this just in–(10/25/2010), from Reuters and on the CNBC website: I just read hear that Germany is now accusing the US of currency manipulation, the same claim the US is about to make against China.   

Perhaps our own leaders would do well to follow that New Testament advice, to ”Judge not, lest ye be judged.”

–MC

Now, I am not an America basher.  But, from time to time, we can be a bit hypocritical.  For instance, at the same time that we complain to Mexico about the drug traffic through their country, Californians are considering the decriminalization of marijuana.  The Mexican government has surely noticed (see article here)

But worse, is the hypocrisy of our elected officials in the U.S. House of Representatives, along with the Secretary of Treasury, Timothy Geithner, Senator Olympia Snowe (ME-R), and others for condemning China’s currency policies, in what they claim to be manipulation of the currency value, while the U.S. seems to be devaluing the dollar in the same fashion.  Mark Perry, Professor of Economics, University of Michigan-Flint, and a visiting scholar at the American Enterprise Institute in Washington, D.C., cleverly highlights the hypocrisy of the China currency bashers in this blogpost by editing or marking up an article on China currency manipulation, replacing China and its renminbi (yuan) with the U.S. and the dollar.

Of course, even if China is manipulating the renminbi in order to make Chinese goods less expensive for Americans, low prices happen to be one of the best anti-poverty programs we could have, making each dollar a poor person has go further in the marketplace.  If the Chinese wish to send us their goods at very low prices, subsidizing the American consumer, especially the poorest consumers, should we tell them no?  It is just as if the Chinese were writing all of us a check each month, that is, if they are truly manipulating their currency.

Protectionist policies, such as those endorsed in the recent House of Representatives vote that sacrifice the wellbeing of the poor at the expense of well-healed special interests that especially harm the poor.  Moreover, such trade policy action is likely to bring about countermeasures by China which could lead to a deepening of the recession, the same way that the Smoot-Hawley Tariff of 1930 led the country into the Great Depression (see Wikipedia on this).

We should also be mindful that we depend on the Chinese to keep lending us to fund our huge deficits.  Should the Chinese retaliate against our self-harming protectionist moves by just slowing down in their purchases of our treasury bills at auction, our interest rates could jump dramatically, and our debt will climb at an even greater pace than it is climbing now.

–MC

Vice President Joe Biden has recently been touting the amazing performance of stimulus package in bringing us back from the brink of economic disaster (CBS News). In speaking at The Brookings Institution, Biden said “But the fact that the recovery act is multifaceted doesn’t reflect a lack of design, it is the design.” The spending and tax relief stimulus package that the White House left up to Congress to design, what we got was something that resembled a platypus, that is often said to be designed by a committee.

In a working paper (just written, and not yet published; cited here with permission of the authors) Andrew Young and Russell Sobel of the University of West Virginia explain why concentrating more of the stimulus spending in areas where it would have a bigger effect on unemployment, such as areas with high unemployment rates and where incomes are low (which would be areas where people re-spend more of each dollar of income, creating a larger ripple effect in their area). These researchers found that these economic factors associated with more efficient stimulus spending, were either unrelated to the location of the stimulus spending or the statistical relationship was of the “wrong sign.” This means that in the cases where the researchers could detect a relationship between these local economic factors and the location of stimulus spending, the spending was in the places where it would have a lower effect on economic activity, rather than where it would have a greater impact.

A good example of the inefficiency of stimulus spending is found in Los Angeles. The International Business Times and the LA Times note that the stimulus spending has been particularly disappointing in that city, where $111 million the city received in stimulus money created or saved fewer than 55 jobs, amounting to more than $2 million per job created or saved. If the nearly $800 billion stimulus program were to have an average efficiency in creating jobs equal to LA’s, that would mean a grand total of 400,000 jobs created or saved, 2% of our nation’s 19.4 million unemployed. Obviously, a more efficient way to help people would have been to give money directly to people. Isn’t that what tax cuts are about?

Instead of having a single designer with a single major objective, the stimulus package was designed by politicians with their own objectives, objectives to reduce unemployment—their own unemployment. Young and Sobel find that political factors were much important in determining where stimulus money got spent than the economic factors. This is like Congress voting to spend $1 billion on helping victims of a fire disaster in Colorado and finding that most of that money was spent in Oklahoma.

What should be unsurprising is that Young and Sobel found that the best predictor of where the stimulus grant spending occurred was the past geographical pattern of government grants. The same political power that determined previous grant spending, such as homeland security grants, persisted and affected stimulus spending in the same fashion.

Young and Sobel’s results reflect what Bob Tollison and Gokhan Karahan found in our 2006 Public Choice paper on Homeland Security spending—that Congress does not spend money in the areas to meet the problem it is supposed to be addressing, but rather, money is spent in a way to gain approval, and payoffs are made to certain politician’s districts or states to gain politicians’ approvals, just like we saw last year with the healthcare bill.

So, the political design of the stimulus bill, spending on pork-barrel projects favored by key politicians to help guarantee their re-election efforts, with money being thrown at their districts, the way a Mardi Gras crew throws things along a parade route, does little to get people into meaningful work. Rather, the public purse is once again used for the re-election efforts of the powerful politicians.

-MC

One of my students raised an interesting point when we discussed international trade and comparative advantage.  It seemed that all he had heard was that the U.S. no longer made much  anymore.  Now his point was more that we consume beyond what we produce, borrowing too much to pay for the trade deficit.  Still, many have the view that since manufacturing employment in the U.S. continues to decline (it peaked in 1979), that the U.S. is no longer making much stuff to sell.  Of course, part of what has been going on is that the U.S. has been increasing its services production.  Below is a link to a CBS news video along with links to a few articles on what has been going on with our production and trade in both manufacturing and in services.

First, is the rather misleading video of the CBS report by John Blackstone that aired 2/16/2010 on manufacturing in the U.S.  Note that the declines mentioned are measured in jobs rather than in output.

Now here is an article by Dan Ikenson of the Cato Institute that appeared in National Review Online in August, 2009 where he busts the myth that “We don’t [make things] any more — at least, not like we used to.” 

Along the same lines is a little longer is another article by Ikenson, “Thriving in a Global Economy: The Truth about U.S. Manufacturing and Trade,”  from 2007.

In an email (via a list I am on) from Ikenson I got Feb. 17^th, Ikenson writes:

The manufacturing jobs number (which, by the way, peaked in 1979 and has been on the same downward-sloping trajectory since then) masquerades as a barometer for the health of manufacturing, which has been setting all kinds of records with respect to output, value-added, revenues, profits, return-on-investment year after year (with the exception of the recent recession, which affected all sectors of the economy similarly). 

American manufacturing remains the world’s most prolific manufacturing sector accounting for 20-24 percent of global value-added; China accounts for about half that.  People ask: How can that be when most shelves in retail stores are loaded with products made in China, and ”Made in USA” labels are nowhere to be found?  Part of the explanation is that products labeled made in China are only 35-50%, on average, Chinese value-added.  (Apple iPods, which each register in our trade stats as a $150 import from China, contains about $4 of Chinese value-added–that’s only 3%!)  “Made in China” often means “snapped together in China” from components made in Japan, Taiwan, Singapore, Korea, and the United States.  Another part of the explanation for the dearth of “Made in USA” products on retail shelves is that U.S. manufacturing doesn’t make a lot of products sold on retail shelves.  Pharmaceuticals, chemicals, sophisticated componentry, airplane parts, and technical textiles aren’t sold through retailers, and those are some of the high-value products made in America.

Michael McKee writes this article at Bloomberg.com (Bloomberg News) from November, 2009, also busting the myth of U.S. manufacturing declines.

Finally, take a look at this February 17, 2010 op-ed article from the New York Times by W. Michael Cox , director of the Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business.  Cox writes here on the huge and growing size of U.S. production and exports of services.  I should point out that Dr. Cox is the former chief economist of the Dallas Federal Reserve, and even though I never had a class with Dr. Cox (he arrived my second year of graduate school), I still learned a good bit from him in our twice-a-week seminars at Virginia Tech.

 -MC

(A note to my students looking to get comment points–you will need to show that you looked at the video and have read the articles linked and cited above, or have done other reading on the subject–and link to your sources.)

What got my attention this week was something I heard this past Sunday on Fareed Zakaria’s Global Public Square (GPS) program on CNN.  Zakaria states point blank, that the Bush tax cuts are the single largest part of the deficit.

Notice that Mr. Zakaria thinks he has Greenspan and Paulson in a “gotcha moment,” claiming that they fail to live up to the ”courage of their convictions”  by not supporting immediate repeal of the Bush Tax Cuts.  The problem is that Zakaria is a poor listener.  We face two problems, the recession, which is short term and acute, and the deficit which is long term and chronic.  Notice that Paulson says that the deficit is a long-term problem.  Zakaria is missing a vital point in this discussion.  Reducing deficits, either by raising taxes or cutting spending, during downturns are widely thought to exacerbate recessions.  Paulson and Greenspan both suggest that now, because of our current recession, is not the time to be raising taxes, but they never rule out raising them at some time in the future.

Zakaria later points listeners to a Feb. 4, 2010 article in Time by Jeffrey Sachs, a leading economist at Columbia University, whose work on something called the “natural resource curse” has captured my recent research attention.

The current budget deficit runs about 10% of our national GDP (US  tax receipts are currently at 15% of GDP while spending is at 25%).  Sachs writes in his article that closing up the Bush tax cuts on the rich would only amount to .4% of GDP, which means that the Bush tax cuts account for only 4% of the deficit.  Sachs states: “even with rollbacks of tax cuts for the rich, the fiscal gap will remain enormous.  The Bush cuts in rates hardly account for the biggest part of the current deficit, as Zakaria claims.  Zakaria is not only a poor listener, he is also a poor reader.

Take a look at this picture of Federal Spending and Receipts in millions of dollars:

Here are those same figures but as percentages of GDP:

I should point out that there were actually two Bush Tax Cuts, one enacted in  2001 after 9/11 and the other in 2003.

Note that tax revenues rose faster after the 2nd Bush tax cuts than they did in the Clinton era, with the tax revenue growth coming to an end in 2007 at the beginning of the recession.

More importantly, notice that starting in 2001, public spending as a percent of GDP started to grow again after shrinking, as it had over the Clinton era.  While we should avoid post hoc thinking, we should also note that while the  tax cuts may have led to revenue declines, there were also large increases in government spending that started at the beginning of the Bush era.  The Bush spending programs included a generous pharmaceuticals program for the elderly, an increase in Homeland Security spending, an expensive war in Iraq in 2003 and allowing Republicans in Congress to spend heavily in their districts to increase their reelection chances.

It is the growth of entitlement spending that is at the heart of our future deficit problem, and in the very near future, growth in entitlement spending, from Social Security to Medicaid to Medicare, will be the drivers in our deficits.  Driving these spending figures are an aging population and rising health care prices.  One of the biggest reasons for the rising health care prices is that we have an aging population, boosting the demand for health care goods and services.  Increasing entitlements, through the health care bills that have gotten approval in the House and the Senate are destined to push projected deficits even higher.

A more realistic, as well as more pessimistic, view of the growing defict is reported in this ABC article.  The article reports the findings of the Peterson-Pew Commission on Budget Reform.  One of the commission’s publications is the testimony of Alice Rivlin.  Rivlin, an economist who was appointed by Johnson, Carter and Clinton to various government posts, recently testified before the Senate Budget Committee.  In her testimony, she states “In the next decade and beyond, federal spending, driven by the impact of an aging population and rising health care costs on Medicare, Medicaid, and Social Security, will rise substantially faster than the whole economy can grow–faster than the GDP.  Revenues, at any likely set of tax rates, will grow only slightly faster than the GDP.  The gap between spending and revenues will keep widening.” Obviously, repealing the Bush Tax Cuts, as Zakaria suggests, will do little if “revenues, at any likely set of tax rates,” will grow more slowly than the promised spending from Medicare, Medicaid, and Social Security.

Recently, my daughter and her roommate drove from Natchitoches, LA to Monroe, LA and followed her roommate’s global positioning device.   The car’s GPS routed them through Shreveport, doubling the usual time through Winnfield and Ruston.

As bad as the advice my daughter and her roommate got from the auto GPS, it did get her to her destination.  Zakaria’s suggestion that repealing the Bush tax cuts, or allowing them to expire, would put us much closer to erasing the deficit is just seriously misleading.   Zakaria’s GPS does not even set us on the right path.  Perhaps if Zakaria would listen more carefully and read the articles he suggests to his listeners, he might be worth listening to.

And this just in, President Obama has created a bi-partisan commission to come up with ways to deal with the deficit crisis.  From what I understand, the commission’s proposals would come before Congress to be voted on, yes or no, without amendments.  Unlike Zakaria’s suggestion of dealing with the Bush Tax Cuts (which should be on the commission’s table), President Obama has put us on course to effectively dealing with the long-term deficit problem, looking at both the spending and the revenue side of the deficit problem.

-MC

Once again, the idea of introducing a Value-Added Tax (VAT, better termed the “Stealth Tax”) to curb our mushrooming deficits is being discussed. This time, in a Feb. 4, 2010 article in Time magazine, Columbia University economist Jeffrey Sachs suggests the use of a new tax in America, the VAT, stating “Both sides could agree, for example, on a value-added tax (VAT) – a sort of national sales tax – combined with closing loopholes and reducing some marginal tax rates, including the corporate tax rate….”

Suggesting that we use a VAT instead of a straight-up sales tax to finance anything in this country, even a reduction in the corporate income tax, signifies either a lack of understanding of basic public finance or a willingness for the federal government to increase taxes on American buyers in ways unperceived by most voters.  While a VAT would be more visible than running deficits, which is another form of unperceived taxation, a regular sales tax would be far more visible by tax payers and works better in other respects, as well.

Sachs is right that a national VAT is sort of a national sales tax. With the VAT, instead of charging a flat rate on every dollar of retail sales, that same rate is collected from producers on the difference between the cost of the goods that they sell and their sales revenues, that is, on the value that they add to goods at each stage of production, from raw materials producer to manufacturer to wholesaler to retailer. Take the case of a loaf of bread that sells for a dollar. In the process of making the bread, a wheat farmer sells wheat to a mill which sells flour to a bakery which sells bread to a store which sells it to the final customer. The wheat that went into the flour that went into a loaf of bread sold for a quarter, while that much flour sold for a half dollar while the baker sold the bread to the retailer for 75 cents. Each producer adds a quarter at each of the four stages of production. If each producer is charged a 10 percent VAT, each of the four pays a tax of 2 1/2 cents, which adds 10 cents to the cost of the bread. The price of the bread ends up going up by 10 cents, the same amount as it would if there were just a national sales tax of 10 percent. Who ends up paying for this tax? It is the same person who ends up paying the sales tax, mostly the consumer.

This does not mean that there is no difference between these sales taxes and the VAT. Since most areas of the country already have some sort of sales tax, a national sales tax would cost little extra to collect. With a VAT, we would have to add a huge bureaucracy of accountants to check the cost of goods sold and the sales at each stage of production. This is a very costly tax to collect. With a sales tax, however, we could, in most states, piggyback collection and enforcement efforts on state and local government efforts.

Another difference is that the burden of a sales tax on the poor can be eased by putting exemptions on certain classes of goods, such as groceries, utilities or medicine, because the poor spend a larger portion of their income on these items than wealthier citizens. With a VAT, producer groups can be excluded, not consumer groups. Instead of easing the burden on certain consumers by exempting certain items such as groceries and medications from the sales tax, the VAT can only exempt certain producers.  This not only makes it difficult for the tax to be eased on the poor, but also makes it more likely that many producer groups will be lobbying in Washington to get their group excluded from the tax. Special interests do not lobby as much for exemptions from sales taxes because it is harder for consumer groups to organize than it is for producer groups. For Sachs, who rightly complains of the influence of special interests in Washington, to give special interests a greater incentive to lobby in Washington means that he does not understand the political incentives posed by certain forms of taxation.

A national VAT differs from a national sales tax in another important way. With a sales tax we see what we pay in these taxes at the cash register. The consumer never sees the bill for a Value-Added Tax, though the consumer ends up paying for the tax since it is mostly passed forward to the buyer. The lack of visibility of the VAT has prompted some critics of this tax, including me, to call it the Stealth Tax, because it hits the taxpayer/voter before she ever sees it coming. If there is a tax increase to pay for some new spending program, the tax increase is passed on as a price increase, and the buyer tends to blame the seller instead of the government.  But when the taxpayer/voter sees the bill for big government, she starts to question whether the spending is necessary. But when we don’t perceive the costs, we seldom question the value of the spending program.

The problem of the lack of visibility of a tax was first pointed out in 1903 by the Italian economist, Amilcare Puviani (as we see in this Richard Wagner paper), and then popularized among English-speaking economists by one of my professors, Jim Buchanan, a problem that has been called “fiscal illusion.” As voters, we are more likely to ask for new spending programs if we never notice how much it costs.   Importantly, Buchanan and others have noted that tax cuts and deficits fail to “starve the spending beast” of government, as many conservatives have proposed to deal with government spending, and instead reduce the visibility of the cost of spending to voters. Voters, then, become more supportive of almost every new spending program that comes along.  If the problem we are tackling with the VAT is the deficit, a very visible national sales tax makes a better weapon against the deficit than the stealthy VAT.

Sachs is quick to remind us that the VAT is widely used in Europe. This is true. And the Europeans have tackled the regressivity of the VAT buy introducing many spending programs to help the poor.  If we are facing a deficit problem, it would seem that additional programs to help alleviate tax regressivity unnecessarily add to the deficit by increasing spending on uncontrollable entitlements.

We should also note that the Europeans arrived at their VAT by their own peculiar history. Their VAT evolved from their former business tax, a tax on gross receipts at each stage of production. In our bread example, a 10 percent tax would collect 2 1/2 cents from the farmer, a little more than a nickel from the miller, about 8 cents from the baker and about eleven cents from the retailer, adding up to more than 21 cents. The Europeans quickly found that businesses could avoid the tax by combining the various stages of production into one business which would lower their taxes considerably, giving vertically integrated firms an advantage over those there are not.  It should also be pointed out that the Europeans already had a system in place to tax at each stage of business sales rather than a retail sales tax bureaurocracy.

So, if we are to go down the road of a new national tax on spending, we should note that a true national sales tax is superior to a VAT at every step, from being more visible and more of a deterrent to federal spending sprees, to being better suited to being shaped to help protect the poor from tax regressivity, to being less prone to being shaped to the liking of special interests, to being cheaper to administer.

-MC

(Note: I have written more than once about the Value-added tax, or VAT, and have repeated some of my own words from past articles, especially see “Vat for financing health care proposals still a bad idea.”)