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Archive for the ‘Economics’ Category

The hottest corporate finance topic in recent weeks has been “merger inversions”, in which American companies are acquired by or merge with non-US based corporations. The combined entity is then re-incorporated abroad in order to shield future earnings from high US corporate income taxes. Treasury Secretary Jack Lew and the President have called these transaction “economically unpatriotic”and have called on Congress to raise the drawbridge and only allow corporations to escape the IRS if foreign share ownership is more than 50% of the combined entity.

History of the US Corporate Tax

The first US corporate income tax was implemented from 1861-1872. The current iteration began with the federal excise tax on corporate income in 1909, which predated the ratification of the 16th Amendment in 1913 that gave Congress power to levy income taxes on individuals. The original tax rate was 1% of income for both individuals and corporations. As with any other tax, the rate paid only increased over time.

Today the U.S. has the highest nominal corporate income-tax rate in the developed world. While U.S. corporations face a combined federal-state statutory tax rate of 39.1%, our competitors in the Organization for Economic Cooperation and Development (OECD) face an average rate of 25%. France’s tax code—typical of most OECD countries—exempts 95% of foreign-source income from taxation, while the U.S. tax code fully taxes such income.

Corporate Tax Rates In the OECD

Despite the high nominal rates, the US tax code is littered with deductions and preferences that dramatically lower the effective tax rate paid by corporations, leading many Americans to consider the “crony capitalist system” essentially corrupt. Overseas income of American corporations is taxed only when it is repatriated to the US. This has led to the holding of as much as $2 in unrepatriated corporate profits and huge disincentives to ever bring it home. The following chart indicates that the effective tax rate is actually lower in the US than in most of the OECD.  

Effective Corporate Tax Rates in OECD, 2000-2005 average

As one can discern from the chart above, it’s not that the average amount of tax paid is too high, because corporations utilize deductions like depreciation and interest. It is the marginal tax rate that is the impediment to the US economy.

According to Laura Tyson, former chairwoman of President Clinton’s Council of Economic Advisers,

“America’s relatively high rate encourages U.S. companies to locate their investment, production, and employment in foreign countries, and discourages foreign companies from locating in the U.S., which means slower growth, fewer jobs, smaller productivity gains, and lower real wages.”

Why do we have a Corporate Tax?

Economists are broadly divided about whether corporate taxes are paid by capital or by workers. Superficially the corporate tax is on capital, but many economists believe that workers ultimately pay much of the tax in the form of lower wages. This results from lower capital investment due to a higher cost of capital, which reduces productivity and therefore wages, and because capital investment moves to other countries where corporate income taxes are lower. The Tax Policy Center pegs the portion of corporate taxes paid by workers as 20% of such taxes. 

What cannot be argued is how the current tax regime is affecting corporate behavior. Corporate taxes encourage the use of debt rather than equity financing because interest reduces taxes and paying dividends increase taxes. More debt increases business risk of failure and discourages new investment by increasing the cost of capital. 

Overall, corporate taxes generated in 2013 were $330 billion, about 10% of federal revenues from all sources. If there were no corporate tax, from where will the tax revenue be replaced? A recent National Bureau of Economic Research paper titled Simulating the Elimination of the US Corporate Income Tax shows the many positive effects of eliminating the tax entirely. Summarizing the findings, author Laurence Kotlikoff said

“They simulate corporate tax reform in a single good, five-region (U.S., Europe, Japan, China, India) model, featuring skilled and unskilled labor, detailed region-specific demographics and fiscal policies. Eliminating the model’s U.S. corporate income tax produces rapid and dramatic increases in the model’s level of U.S. investment, output, and real wages, making the tax cut self-financing to a significant extent. Somewhat smaller gains arise from revenue-neutral base broadening, specifically cutting the corporate tax rate to 9 percent and eliminating tax loop-holes.”

As this study shows, cutting the corporate tax rate would increase total corporate tax receipts. At first blush, this might seem to be a surprising result. It shouldn’t be. Corporations, run by people, respond like individuals to incentives. By taxing repatriated profits at 39%+, the federal government gets far fewer repatriated profits. If one examines tax receipts following tax cuts, it is clear that tax cuts yield higher federal tax receipts. In the last instance, the four years of the Bush Presidency after the 2003 reduction in tax rates saw a 44% increase in Federal tax revenues. With regard to corporate taxes, revenue increased following rate cuts in Canada in recent years. Some economists dispute the correlation as less than perfect due to many other factors including the business cycle of recession and expansion, but these results are mirrored across the OECD.

Diogenes Proposes…

It’s time for Congress to reform a tax system that mainly benefits other countries. Ideally, Congress would pass comprehensive tax reform for both business and individuals, but reforming today’s corporate tax alone is easier to do. The argument for reform is that it can be easily made to be revenue neutral or better, it improves “social equity”, and reform provides ongoing incentives for corporations to remain and invest in America. Theoretically, reform should receive broad bi-partisan support.

The US should lower the corporate income tax to 10% and eliminate the capital gains and dividends tax preferences for stocks and mutual funds for individuals. These gains have traditionally been taxed at lower rates (to the dismay of progressives) to mitigate the impact of “double taxation” since every dollar of corporate income is taxed before it is distributed to shareholders. Excluding non profit institutions, about 91% of stocks and mutual funds are held by those in the top 10% of household wealth, or foreigners, so this is a very progressive, well targeted tax.

Eliminating corporate taxation reduces the incentive to lobby for special tax breaks, reducing crony capitalism. Further, reducing the tax to about a quarter of what it was greatly reduces the incentive for corporations to spend money on non-productive tax sheltering activities.  

Lowering the corporate tax rate from the highest in the OECD world to the lowest would be an incredible draw to companies currently domiciled abroad. If a corporation can move its headquarters and tax base to the premier destination in the world where their operations are protected by the American rule of law, we would eliminate the inversion issue entirely. Instead of trying to intimidate American corporations into remaining here, let’s just make it more attractive to stay. Turn the problem into an opportunity for any multinational company to pay their (lower) taxes here.

Current Monetary Policy

American monetary policy is implemented by the independent, a-political (and unelected) Federal Reserve Bank. It’s actions control the money supply primarily by setting targets for the key federal funds rates.  The Fed also controls the money supply and interest rates through open market operations (buying and selling government bonds) and by setting reserve requirements for banks. Theoretically, these actions serve to influence output and inflation, although in reality, the velocity of money changes in response to variables related to risk and return, and often may not respond directly to Fed policy desires.

Long time Fed Chairman Alan Greenspan maintained an implicit inflation target of zero from 1987-2006, which he believed would yield maximum sustainable economic growth. Under his successor Ben Bernanke, the Federal Reserve Board in January 2012 set an explicit inflation target for the first time with a ”longer-run goals and policy strategy” statement.

“The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling–a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.”

Inflation targeting steers monetary policy to try to hit the target inflation rate. This approach has for years been the official policy of Britain, Canada, Australia, Sweden, New Zealand, Brazil, and South Korea, among others. The theory is that inflation-targeting policies tend to stabilize their inflation rates while keeping economic growth on an even keel.

Is Inflation Targeting the Right Approach?

The link between inflation rate targets, price stability and full employment is far from a settled issue because many other factors can affect economic growth, from natural disasters, energy policy, fiscal policy and wars. Increases in inflation as measured by the Consumer Price Index (CPI) are not necessarily coupled to any factor internal to a country’s economy and strictly or blindly adjusting interest rates would potentially be ineffectual and restrict economic growth.

Most economists today agree with the Fed that inflation is a necessary evil, and advocate for low, stable levels of inflation.  Deflation is often seen as a worse danger in a modern economy because it increases the real value of debt, may aggravate recessions and has potential to lead to a deflationary spiral. Yet research from the Fed’s own Minneapolis Reserve Bank shows that deflation does not automatically lead to depression and need not be a barrier to economic growth.

Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention. This view was challenged during the Great Depression. Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending.  This message was well received by officials who wanted to believe that government actions control the economy instead of the “animal spirits” of a jumble of factors.

For 50 years, monetarism has been the foremost alternative to Keynesian-ism as a means of understanding inflation. Monetarists think that inflation results from too much money chasing too few goods, rather than from interest rates, demand, and the slack or tightness of markets. The matter is far from settled, but the majority of leading economists today are post-Keynesian in thought and almost constantly advocate for active monetary stimulus to induce economic growth, despite the absence of evidence that such stimulus is effective. Even new Fed Chairwoman Janet Yellen recently admitted that the central bank doesn’t have a good model of inflation. (The Fed relies on the Phillips Curve, which charts a tendency for inflation to rise when unemployment is low and to fall when unemployment is high.)

The notion that nobody who expects prices to fall in the future would spend money today is nonsense. It ignores entirely the concept of time preference, and we can see that this is not the case every day in the market for computers or smart phones. These products get cheaper and better every year, yet demand for them is strong and people spend considerable amounts of money on them today. In other areas such as clothing, products are far less expensive today than they were a generation ago, in large part due to less expensive offshore labor, falling trade barriers and Wal-Mart.

Is there a Better Way?

The primary reason inflation is desirable in public policy is because it facilitates use of government debt to accommodate federal fiscal irresponsibility and permanently stimulates home ownership by inflating away the value of mortgages. Inflation is a form of sovereign default. Paying off bonds with currency after ten or twenty years that is worth half as much as it used to be is like defaulting on half of the debt. Government can steal value out of your pocket full of money without you even seeing anything happen.

For nearly 5,000 years, the majority of countries have used money denominated in or backed by metals such as gold or silver. As long as governments have been in power, they have sought to increase their ability to spend money in excess of their receipts. During the Roman Empire, the Emperor Nero debased his currency by reducing the percentage of silver in minted coins. Paper money was first introduced in Medieval times in Italy. Why does paper money have any value at all? In our economy, the basic answer is that it has value because the government accepts dollars, and only dollars, in payment of taxes.

The key problem with fiat money is that governments have the power to arbitrarily produce more of it, debasing it’s value. In the era of metal currency, there was neither inherent long term inflation or deflation. The United States, despite prior episodes of paper money failures (Continentals during and after the Revolutionary war, and Greenbacks during the Civil War), issued the predecessor of today’s paper currency in 1913, revalued it against gold in 1934, and suspended any convertibility into gold in 1971. Meanwhile, the value of the dollar in gold terms has fallen 92% since 1913. As the chart below shows, inflation of the US$ is the norm, and deflation is an unusual phenomenon. 2009 was the most recent year of deflation, and it was 54 years since deflation had occurred. In both 1955 and 2009, the US had positive GDP growth. 

source: US Bureau of Labor Statistics

So what are the alternatives to using paper money and the inflation that inevitably follows? In the internet age, there have been a series of attempts to create a medium of exchange that does not inflate and is not subject to government exchange controls and taxation. These attempts are based on securely exchanging information which is a process made possible by certain principles of cryptography. The first “cryptocurrency” to begin trading was Bitcoin in 2009 although numerous other cryptocurrencies have been created since then. Fundamentally, cryptocurrencies are specifications regarding the use of currency which seek to incorporate principles of cryptography to implement a distributed, decentralized and secure information economy.

Bitcoin appears to be a brilliant solution to the problems of fiat currencies and inflation. But it fails on a variety of other key measures, the most important of which is a relatively stable store of value. Bitcoin has been plagued with extreme value volatility. Further, the anonymous nature of its transactions enable it to be easily used for illicit and illegal activities such as drug trafficking. Because  government regulators are not involved in Bitcoin administration, it’s value can be erased by computer viruses or outright fraud. Mt. Gox, a key Bitcoin exchange, collapsed into bankruptcy in February taking $500 million of Bitcoin value with it.

In the history of man, no fiat currency has ever survived as long as the US dollar without the restructuring the American dollar is experiencing. Inflation, and monetary policy by the Fed is effectively defaulting our debt and devaluing our currency every year. This inflation is another form of stealth taxation which promotes and enables profligate federal spending.  Our central bank’s primary mandate is price “stability” (and full employment). One need not be an economics PhD to recognize that a monetary policy of taking 2% of its citizens money annually is simply wrong.

We Still Need Health Care Reform

The Obamacare fiasco is an almost perfect illustration of the difference in approach to government by the left and the right. Liberal pundits routinely depict conservatives as uncaring, but the fact is that both sides fundamentally agree on the need to provide all Americans with affordable health insurance. Indeed, government insurance exchanges and universal mandates originate from Republicans, but the ways to achieve goals are vastly different from right to left.

Conservatives would prefer to provide a catastrophic health care safety net for all while also lowering total medical expenses for all Americans. This would be accomplished by providing a regulatory framework and allowing the states and market forces to achieve their objectives. Examples would be to allow insurance to be sold across state lines with limited mandates as to coverage requirements and making health care insurance portable and permanent.

Progressives fundamentally believe the federal government should mandate coverage requirements for all that include routine health care, and that the program should employ a wealth transfer mechanism whereby care for the poor and chronically ill are subsidized by wealthy and healthy Americans. This vision is similar to the Social Security system, which originated as a safety net program and not as insurance. Like Obamacare, Social Security was supposed to be self funding via mandatory payroll taxes, and benefits would be available to all regardless of payments into the system. (Can we imagine a new introduction of Social Security in an era of distrust of government?)

The Affordable Care Act Needs to Be Replaced

Obamacare is on life support, and it is almost certain to fail. Once the fiasco of the healthcare.gov website is fixed, there will be a continuing cascade of problems to hit those newly enrolled in the system. Until now, anyone who appeared at an emergency room for catastrophic care was treated regardless of their ability to pay. Obamacare expands to the 45 million Americans previously without health insurance the right to seek care for routine health issues from the current provider network, while at the same time reimbursing those providers at a lesser rate than private insurance plans and individuals. Adding 15% more patients to provider workloads logically requires an expansion of service providers, but this has not been done. Waiting times for appointments will be rapidly extended for public patients, even as private patients secure shorter access. Many providers will begin to restrict or eventually refuse to accept public patients, much as has previously occurred with Medicaid patients.

As newly insured patients demand more routine and preventive care from the system, costs will escalate and require higher premiums from those not subsidized by government. Total costs for all health care will expand even as the program fails to be self funding. Americans now understand that the essence of the Affordable Care Act is that millions of people are being conscripted to buy overpriced policies they would never choose for themselves in order to spend on the poor and those who are medically uninsurable due to pre-existing conditions. In essence, this will be a wealth transfer mechanism from the middle class to the poor. It is not insurance in the classic sense. Obamacare does not only cover unforeseen events. It is meant to cover most, or all health care expenses. Since one can enter the system with small penalties at any time, why not avoid entry into the system until one has a need for services? In “real” insurance systems, one buys coverage for say fire insurance to cover the small probability of a catastrophic event. Under Obamacare, one buys fire insurance after the fire has devastated your home.

The Affordable Care Act provides people with access to health insurance rather than access to medical care. The health insurance and pharmaceutical companies are entirely complicit in this disaster. Seeing only riches in millions of new customers required by law to buy inflated coverage or pay a (voluntary/optional) tax, they ghost wrote long sections of the ACA, which all congressional Democrats voted for “so they could find out what’s in it”. Diogenes, for one, would like to see the insurance mandate commuted to catastrophic (requiring surgery or a hospital stay) medical care. Routine care could be “uninsured” for all. Making these routine expenses discretionary might well allow medical care providers to compete on service/quality and price, as do almost all services providers.

Now Could Be A Great Time for Reform Because of What We Have Learned

In our hyper partisan political climate, it is difficult to imagine thatAmerica’s health care problems can be remedied by legislative action. But the failure of the ACA provides just such an opportunity. After warning for years about the impending disaster of the ACA, conservatives finally have earned some credibility concerning how to restructure a health care safety net. Liberals who would like to salvage that goal without ending their political careers could finally reach across the aisle to find real solutions.

Obamacare will in time be seen as the high water mark of progressive government. The administration’s many foreign policy failures have meant little to most Americans who do not pay attention to world affairs. Obamacare is different in that it hits many directly in their wallets. We are now approaching another crossroads in the health care debate. Liberals will say that the solution is a single payor system run by government. Conservatives point out that embarking on a single-payer system would not expand access—though that slogan would be used—but would deny and limit care in order to control runaway spending.  After the disaster that was the roll out of healthcare.gov, who in their right mind would want to give our central planners even more power?

45 million previously uninsured Americans need to have access to health care that does not bankrupt them or the rest of us. As a society, we can afford to do this, and the moral imperative is that we must do so.  The federal government, having assumed the job of subsidizing these people, should do so honestly and openly. Instead of the 2000+ page Rube Goldberg system under the Affordable Care Act, we need a simpler framework that allows a multitude of alternative solutions at the state and local level. Expanding the role of a ridiculously inept government would be madness.

 

The US government has a corporate tax problem of epic proportions. On a statutory basis, America has the highest corporate tax rate on income in the developed world. Theoretically, 35% of the worldwide income of US based corporations is to be paid as federal income tax, after deducting for foreign taxes, other credits and preferences such as depreciation. State and local taxes can bring the theoretical tax rate to over 40% of income.

In a recent report commissioned by Senators Carl Levin (D-Mich.) and Tom Coburn (R.-Okla.), the GAO looked at taxes paid by profitable U.S. corporations with at least $10 million in assets. Even when foreign, state and local taxes were taken into account, the companies paid only 16.9% of their worldwide income in taxes in 2010. So how is it possible that almost 25% of all corporate profits are not being paid as taxes?

Unlike other countries that tax only corporate profits made within its borders, the US taxes worldwide corporate income but then allows companies to postpone the payment of income tax on profits that remain abroad. As a result, many large companies simply do not repatriate most of their profits or shift income to subsidiary entities abroad. The American worldwide income tax regime perversely encourages corporations not only not to bring their profits home. It also discourages them from investing those profits in the US, where the profits on future investments will be subject to continuing high tax rates. If those companies build new factories in foreign low tax countries, future profits will not be subject to taxes.

The solution to the lack of corporate profit collections is to revise the  US tax code to have a lower rate on regional profits. But nothing is easy in Congress today. Bipartisan efforts at tax reform are dead in the water for this term, with Senator Majority Leader Harry Reid stating that any reform he permits to come to the senate floor for a vote must include higher revenues in exchange for lower rates; a non starter for Republicans.

So what is the US government supposed to do to end a Mexican standoff with corporations that refuse to gratuitously pay taxes they can easily avoid? Diogenes believes that Congress should enact a one time only tax holiday in 2013 on corporate profits held abroad that are paid out as dividends in excess of 105% of those paid out in 2012. In other words, pay no corporate taxes on marginal increases in dividends paid out.

The profits repatriation dividend would:

  • stimulate the economy
  • increase the total amount of taxes paid
  • discourage corporations from moving more investments abroad

There is about $1.9 trillion held abroad as unrepatriated profits. The overwhelming bulk of those funds are held abroad to delay/defer the payment of US taxes rather than for operational needs. Let’s assume that $1.5 trillion would be returned to the US and paid out as dividends under the one time tax “holiday” being proposed. About 80% of American stocks are held individually by Americans or through mutual funds and retirement plans.  Not all taxpayers are in the highest brackets paying 39.6% federal taxes, but they own stocks so presumably most are above median income levels, so let’s assume a 25% federal rate. This one time event would/could generate $1.5 T  X  80% Individuals  X 25 % tax rate = $300 billion. And $1.2 trillion would be left over for Americans to save or spend. It’s a “free” stimulus!

We give most small businesses the option to file as LLCs or Subchapter S Corporations. These structures give liability limitation benefits to owners similar to those of larger corporations and still allow for a single level of taxation. Under the Diogenene proposal, we turn that policy inside out by offering the benefits of one level of taxation to companies that have already limited their liability.

In an ideal world, no tax regime should use one time gimmicks, but our tax code is dysfunctional. It does not raise taxes and it encourages our companies not to invest here. This proposal is not ideal, but it is better than other workable options right now. Perfection is the enemy of the good.

When you buy something at a local store, the merchant automatically tacks on state and local sales tax to the item’s purchase price. When items are purchased online taxes are not included in the total purchase price unless the vendor is located in the same state as the customer.  Let’s say you want to save some money and purchase an I-Pad Mini from E-Bay for example, because the listed price is $39 less than the $329 list price from Apple. If the vendor is from Georgia and you are in New York, you would not incur and sales tax. But if the vendor is in NY, you would be charged 8.875% , or $25.74 on this purchase.

Why aren’t internet sales taxed now?

States and localities fund their operations from a variety of other taxes and fees including property taxes, income taxes, gasoline taxes, corporate taxes, usage fees (tolls, parking, water, garbage), and federal grants to administer programs such as Medicare and Medicaid. 45 of America’s 50 states have some sort of retail sales tax. The highest state tax is California’s 7.5%, but local sales taxes can add as much as another 3% in many locales.

The US Congress is currently considering new legislation to tax online retail transactions that have until now been largely free of sales taxes. This is because in 1992 the Supreme Court in  Quill  Corp. Vs. North Dakota ruled that a business must have a physical presence in a state for that state to require it to collect sales taxes, in part because of the complexities of doing so.  It was the late pre internet age and the ruling referred to mail order retailers. The court explicitly stated that Congress can overrule the decision through legislation. Today, if an online retailer does not collect sales tax at the time of purchase, the consumer is supposed to pay the sales or “use” taxes on such purchases directly to the state when filing annual tax returns. This happens so rarely that Congress is now considering legislation to collect these “lost tax receipts”.

How much are we talking about?

Purchasing merchandise across state lines was historically limited to catalog buying and comprised only a small portion of retail sales. However, the growth of E-commerce has increased at more than twice the rate as bricks and mortar retail sales for 10 years, and now accounts for 5.5% of all retail sales. Internet sales are trending at a rate approaching $250 billion/year.

Local retailers and their many organizations have for several years supported efforts to tax online sales. They claim that online retailers have an unfair advantage when they do not charge consumers taxes. The congressional initiative known as the Marketplace Fairness Act (MFA) is the latest effort to tax internet sales. It will require all retailers with sales over $1 million/year to use “simplifying” software from the Streamlined Sales Tax Project (SSTP), which will be instantaneously able to sort through the thousands of taxing entities and calculate taxes for each locale in order to collect, report and remit local sales taxes for each one. If enacted, all internet sales other than from very small vendors will be taxed regardless of the location of the vendor. The MFA is estimated to generate from $11 billion to as much as $24 billion to state and local governments. Shown below is the relative impact upon consumers in the various states.

Why the MFA is not good legislation

Proponents claim that sales taxes are merely one of several methods to fund local and state governments. But sales taxes in most locales are a way that these governments mitigate property taxes. In terms of “fairness”, sales taxes are far more regressive than property taxes, which are disproportionally imposed upon our wealthier citizens.

An internet tax allocates sales from each retailer to each state and local entity. Yet it also creates the framework for a federal sales tax, or VAT. Lawmakers salivate at the prospects for a “new” revenue stream. Those seeking more limited government are strenuously opposed.

More troubling than the prospect of additional taxes is that an internet tax would be an egregious violation of federalism, in that states would be able to enforce their tax laws outside their borders. Online retailers would be remitting taxes to governments where they are unrepresented, and local citizens would be precluded from voting with their wallets by purchasing from vendors who do not charge those taxes.

A privacy concern related to internet taxes is that the SSTP software creates a vast new database which could be used to track any individual’s purchases. At some point, a security breach is a massive risk which could make this information available to unauthorized parties. Potential government usage of the data is more dangerous. Diogenes is entirely uncomfortable with this.

Internet retailers may not have to pay local taxes, but this  advantage is mostly mitigated by two factors. First, shipping charges are often about equal to sales taxes. Secondly, ordering online requires consumers to wait for their merchandise, and many shoppers require the instant gratification that local shops provide.

Diogenes believes that the case for taxing internet sales with the MFA is not at all persuasive. It is contrary to good public policy in that it taxes citizens without representation or benefit. It creates privacy concerns. It creates the framework for a new federal VAT.  Evening the playing field with local retailers is not a valid reason to take billions more in taxes from Americans.

Other solutions

Some believe that internet retailers should pay some sales taxes, albeit at lesser rates because of their better ecological footprint and diminished use of local services. After all, online sales don’t need more cops or streets paved or other costs which support local retail. Internet sales also allow for efficient warehousing and delivery which could reduce America’s carbon footprint.

There is an alternative solution to an internet sales tax than that proposed by the Marketplace Fairness Act. Diogenes believes that internet sales could and should be taxed at the rate in effect at the location of the vendor, in the same way that sales at local retailers are taxed. There would be no reports to file, data to be collected, violation of federalism or infrastructure created for other new taxes. A consequence of this solution would be that many smaller internet vendors might relocate to one of the five states that do not levy sales taxes. This “competition” between the states is a wonderful benefit for all citizens to make use of…or not.

Why Most Antipoverty Programs are Not Effective

In Part 1 Diogenes discussed in economic terms what it means to be poor in America and reviewed federal programs for those in need. After 50 years of effort and spending at a rate of about $600 billion/year, more Americans are poor than when the programs began. An old adage states that “insanity is repeating the same mistakes and expecting different results.” Here we will look at a policy alternative to current approaches.

The primary reason for the failure of governmental poverty programs is an “agency problem.” The antipoverty bureaucracy has itself often become an impediment to those who would try to climb out of poverty because of disincentives for working. We have agencies that try to insure that those receiving aid it use it for “correct” purposes (milk, not beer).  Such attempts always fail because nobody spends somebody else’s money as carefully as their own. And then there is the cost of the agency. For example, the food stamps program (SNAP) has program costs of about 12%.

Add in waste and poor management, and today America cumulatively spends more on poverty programs than it would cost to raise the income of every American above the poverty level. Even assuming NO income for the 46.2 million Americans in poverty, and multiplying by the $11,170 per capita that is the level below which per capita poverty is defined, would cost about $514 billion. The costs would be considerably less if we gave this aid on a household income basis.

The only enduring cure for poverty is increasing production of goods and services which result in greater demand for labor, because ultimately jobs are needed to pull people out of poverty no matter how good government antipoverty programs are. In other words, free markets are the ultimate antipoverty programs.

What We Should Do

Diogenes believes that America should implement a Guaranteed Minimum Income (GMI). Also known as a Negative Income Tax (NIT), a GMI would provide baseline support to which all would be entitled. Diogenes would define this as the federally defined household income poverty level of $23,050 for a family of four, plus $1. Adjustments up or down would be made for additional children and for each state’s cost of living.  The GMI would be implemented through the tax code utilizing IRS infrastructure.

The GMI is not a new idea. Milton Friedman advocated for a NIT in the early 1960s. Legislation was first proposed during the Nixon administration, and had support from both liberals and conservatives along with a long list of recipients of Nobel Prizes in Economics and other economists, but ultimately did not pass Congress.

Almost all other antipoverty programs should be phased out in order to pay for the GMI. The GMI would be far more efficient than welfare, food stamps, subsidized housing, unemployment benefits, and the 47 different federal job training programs. The GMI should be progressively phased out at a rate of 50% reduction of benefits per dollar of income, so as to incentivize Americans to find any sort of work at any wage.

The GMI would also necessitate a repeal of minimum wage laws, as all workers would already be guaranteed a base income just above the poverty level. Any work income would incrementally reduce government assistance even as the workers’ household income rose to median levels. Reducing the costs of unskilled labor would encourage business to hire more workers, providing crucial entry level jobs that are priced away with existing minimum wage laws.

At first blush, the move to a GMI might appear to be a radical shift away from the status quo. However, the GMI would be a dramatic expansion of perhaps the single most efficacious federal antipoverty program, the Earned Income Tax Credit (EITC). Congress first implemented the EITC in 1975 to offset the burden of social security taxes for the working poor, in order to provide greater incentive to work. When the EITC exceeds the amount of taxes owed, it results in a tax refund to those who claim and qualify for the credit. According to the IRS, the total cost of the EITC was $61 billion in 2011, and program costs were less than 1%. It helped move 6.6 million Americans, half of them children, out of poverty. In 2013, the maximum credit to a married couple filing jointly with three children is $6,044. The credit phases out as income increases to about the national median income level.

Why This Hasn’t Been Done Before

Diogenes proposes to dramatically expand the single best program we have and replace lots of programs that do not work. The incremental cost would be nothing because the change would redirect current antipoverty funding. And if the program succeeds, it’s cost would decline. So who would disagree? For starters, the entire federal antipoverty bureaucracy who would lose their jobs. Unlike the private sector, government is rarely reorganized when the results yield fewer jobs.

Historically, government antipoverty programs have seemed reluctant to give cash aid to the poor. For example, food stamps have value restricted to consumable products excluding alcohol, as if aid recipients didn’t know how to spend what funds they have. The moral legitimization of the welfare system requires that recipients use aid to support lifestyles that comport in some rough sense with the idea of a good life held by taxpayers who provide the funds. In the minds of many, it’s one thing to provide a safety net, and another to support those who just don’t want to work. The counter argument is that by keeping a GMI at a less than “comfortable” level for able bodied Americans, incentives to work would dramatically increase.

Others might argue that there are other problems with a GMI:

  • The incentive to work is reduced, however marginally, by providing any level of guaranteed income.
  • If government lowers the minimum guaranteed level below an absolute safety net, we don’t fulfill our societal imperative to provide for all who are unable, for whatever reason, to provide for themselves.
  • By having only a gradual phaseout of support as income grows, we invariably will pay (some) benefits to those above the poverty level.
  • Whatever the initial level of a GMI, politicians will continue to raise the amount until it eventually bankrupts us. Just look at Social Security, welfare and the Income Tax for examples.

The rebuttal to these arguments is that living at the no work GMI base level is pretty tough in America. No one would want that kind of life if they could reasonably easily augment it. Raising lower than median incomes to the median level (about $51,000 for a family of four), would be an excellent use of American resources. Because of income inequality, this measure is far below the mean income, and we are already spending at the cost of a GMI with far less effective programs. A limit to future spending largesse could be enshrined in the legislation by defining the base income to $1 over the poverty level and by pegging the phaseout of the GMI to an upper limit just below the median income.

A GMI would not be a perfect program, but the perfect is not to be found. It would be a significant improvement over current antipoverty programs and would not cost taxpayers a dime. Isn’t that something virtually everyone wants?

What does it mean to be poor in America?

There are many ways of defining poverty. For most of recorded history, man’s basic needs were food, clothing and shelter. In recent generations, we have included access to clean water, sanitation, health care and education. Poverty can also mean a relative lack of material goods or money, so that in every “free society” (where inequality in income to some extent reflects inequality in ability and effort)  some portion of the population will be considered poor.

We can also define poverty in overtly economic terms. The federal poverty threshold is $11,722 in annual income for an individual, and $23,497 for a family of four, which is about 44% of mean income for an individual and 30% of the mean for a family of four. The economic definition of poverty has changed over time, but real wage growth in the 1960s caused the poverty rate to fall from about 20% in the 1950s to around 15% of our citizens today.

A hundred years ago, having enough food to eat meant that you weren’t poor in most places. In most wealthy countries, death by starvation is already very rare. Poor Americans today are not likely to be starving, though malnutrition remains a scourge. Many live in households that have a refrigerator, a washing machine, a high definition TV with cable , an XBox and a cellular phone. In fact, the electronic gadgets used by our poor are not substantially different than those employed by the wealthiest Americans. Overall, the quantities and qualities of what ordinary Americans consume are closer to that of rich Americans than they were in decades past despite growing income disparities between the wealthy and the poor.

The inflation-adjusted hourly wage hasn’t changed much in 50 years. Still, it is unlikely that an average American, even one living in poverty, would trade his wages and benefits in 2013—along with access to the most affordable food, appliances, clothing and cars in history, plus today’s cornucopia of modern electronic goods—for the same real wages but with much lower benefits in the 1950s or 1970s, along with those era’s higher prices, more limited selection, and inferior products.

Is it better to be poor here than elsewhere?

Poverty tends to be defined in the relative sense. The poorest 5-10% of a population would probably be considered poor in any society, but to the extent that “fairness” in a society is defined as less disparity between rich and poor, a higher percent of US citizens would be considered poor than in most other developed countries. The OECD, a rich-country club, provides comparative figures for a poverty line of 40% of median household income after tax and transfer. On that basis America’s rate is 11%, well above the OECD average of 6%.

Another way to define poverty is in an absolute sense rather than a relative one. The World Bank estimates that “extreme absolute poverty” is living on somewhere between $1-2/day/person depending on where one lives. Few Americans are this unfortunate, but something like 20% of the world’s population are subject to these conditions, so most poor Americans could be considered “not poor” in most of the world.

Are federal anti-poverty programs working?

Federal programs to reduce poverty in America trace their origins to FDR and the New Deal in the 1930s, though what most Americans would identify as specific anti-poverty programs were begun in 1964 with LBJ’s Economic Opportunity Act which came to be known as the “war on poverty”. Today, there are more than 120 different federal anti-poverty programs. The major ones are Medicaid, unemployment insurance, food stamps and welfare, ans our government spends about as much on these programs as it does on defense. And yet, almost 50 years later, and despite about $13 trillion dollars spent, the rate of poverty and the total number of Americans living in poverty has not been significantly reduced.

“…the federal government spent more than $591 billion in 2009 on means-tested or anti-poverty programs, and will undoubtedly spend even more this year. That amounts to $14,849 for every poor man, woman and child in America. Given that the poverty line is just $10,830 (in 2009), we could have mailed every poor person in America a check big enough to lift them out of poverty – and still saved money.”  M.D.Tanner, NY Times, 9/16/2010

In general, the liberal left’s approach to social policy is to shield people from the American economy, while conservatives’ approach must be to enable them to enjoy its benefits—to enable people to move up rather than to make them more secure in poverty. Some call for a wholesale rethinking of antipoverty programs.

“The bottom 20% in America are not stuck because their welfare support is insufficient. It is because these cultural institutions are not helping them lead the lives they deserve. Volumes of research have shown that Great Society welfare policies—such as public housing and aid to families with dependent children—fueled family dissolution, community fragmentation, generational joblessness and government dependency. Many … welfare and redistribution policies are encouraging a return to these conditions.” Arthur Brooks, WSJ, 10/8/12

Some might argue that one of the causes of persistently large numbers of Americans living in poverty is that economic mobility constantly moves some of our citizens out of poverty even as others descend into poverty from the middle class. This notion of being able to move from rags to riches in a generation is a fundamental plank of the American Dream. Unfortunately, Americans’ perceptions about their likelihood of changing position in the income distribution may be exaggerated. Those within the three middle quintiles (the middle class) will, statistically, experience some economic mobility. But according to a study by the Pew Economic Mobility Project, 43 percent of children whose parents were born in the bottom quintile remained at the bottom when they became adults. In contrast, 40 percent of children born to parents at the top quintile were also at the top as adults. The study compared inter-generational mobility rates between 1984 to 1994 and 1994 to 2004. In addition, contrary to public perceptions, social mobility in the US is less than in Europe.

What to do?

As a nation, it is dangerous to our social fabric to have created a semi-permanent underclass living in poverty. Spending more on poverty programs does not appear realistic now, especially in fiscally austere times. We need to make sure the programs we do have create incentives to replace handouts with wages, even as we strive to close the opportunity gap through better education for all. The best solutions are complex and to be found through a mix of policies including education reforms and revamping the tax code.

Most Americans, regardless of their political leanings, desire a strong safety net for all citizens. Americans living in poverty do not have comfortable or easy lives, and taking advantage of available programs is incredibly time consuming, even as it is dispiriting. Permanent solutions are to be found not in more funding or more programs, but from economic growth that fuels demand for more employees at higher real wages.

What is the Fed?

The Federal Reserve Bank System is a unique hybrid public-private bank network whose 12 district members are owned by local banks and regulated by a 7-person Board of Governors, each of whom are appointed for one 14-year term by the White House. It was created in 1913 and amended in 1935 primarily to use monetary policy to deal with cyclical bank panics. Congress established three key objectives for monetary policy in the Federal Reserve Act:

  • maximum employment
  • price stability
  • moderate long-term interest rates

The private banks give input to the government officials about their economic situation and these government officials use this input in Federal Reserve Board policy decisions.

How does the Fed employ monetary policy?

Monetary policy should ideally be used in conjunction with fiscal policy as a means to achieve desired national economic objectives. In America monetary and fiscal policies mostly are independent of each other. Congress and our President have led America to the brink of a “fiscal cliff”, and no comprehensive fiscal policy reform seems likely in the near term. This state of affairs has thrust the Federal Reserve Board, and its Chairman Ben Bernanke, to the forefront as the savior/enabler of today’s American macro economic policy.

The primary tools of the Federal Reserve Board are:

  • to set bank reserve requirements
  • to set the discount rate for interest paid by the Fed on bank reserves
  • to conduct Open Market Operations that seek to influence the Fed Funds rate (that is paid by banks to each other for short term borrowings) via open purchases and sales of US Treasury and federal agency securities

Minutes of the regular meetings of the Fed’s Open Market Committee (FOMC) are widely published by the media in order to inform business and banking leaders about probable Fed actions. The Fed has said it doesn’t expect to touch short-term rates until it sees the unemployment rate fall to 6.5% or lower, as long as inflation forecasts remain near its 2% target. That would mean, according to the Fed’s economic projections, that it would keep short-term rates near zero into 2015.

” In case there was any doubt about its resolve, the Fed statement also issued a new implicit annual inflation target: 2.5%. The official target is still 2%. But the Open Market Committee stated that it will keep interest rates near zero, and by implication keep buying bonds, as long as the jobless rate stays above 6.5% and inflation stays no more than a half-percentage point above the Committee’s 2-percent longer-run goal…That is a 2.5% inflation target by any other name, and it’s striking to see a central bank in the post-Paul Volcker era say overtly that it wants more inflation.”  WSJ, 12/12/12 “The Fed’s Contradiction”

Many economists think we have to inflate our way out of the debt crisis. Inflation remains quiescent, but central banks that ask for more inflation likely get it. The Fed is now buying about 70% of new long-term Treasury debt, and when you add “QE3” debt purchases, it appears to be well on its way to monetizing not only the deficit, but also a large chunk of the accumulated federal debt.

Why do the Fed’s policies matter?

Fed policy continues to punish thrift and reward irresponsible debtors. A 2.5% inflation rate and interest rates on deposits near zero compounded diminishes the real value of saving by 1/2 over only 28 years even absent any income or taxes. This is a tax on our middle class. Benefits for those receiving government benefits will be indexed to a CPI. The rich can make investments in hedge funds, private equity and other vehicles that can earn better than inflation adjusted returns after taxes. It is those who have long worked and saved who will pay these penalties.

By keeping interest rates ultra low, central banks including the Federal Reserve may have likely created a ticking time-bomb for investors in the bond market. The risk is that the many retail (middle class) investors who sought safety in bonds don’t fully understand the losses they will face if there is a sustained economic recovery and yields start to rise.

The Fed’s near-zero interest rate policy will continue to disguise the real cost of government borrowing. One reason the Obama Administration can keep running trillion-dollar deficits is because it can borrow the money at bargain rates courtesy of the Fed. Each 1% increase in rates on a $16 trillion federal debt is $160 billion per year, and those increases must begin sooner or later.

For the past four years the Fed has maintained expansionary and unconventional policies and we are told there is still no end in sight. Mr. Bernanke famously failed to predict the 2008 monetary crisis, and then was slow to react (although he did so effectively). Now we are supposed to believe he will know when to pull the ripcord on growing his balance sheet. The Fed and Mr. Bernanke may well be geniuses and get it all just right this time, but Diogenes is not optimistic that this will happen.

Hostess Brands, makers of Twinkies, Wonder Bread and many other relatively “junkie” foods, filed Chapter 7 bankruptcy liquidation papers recently. The company had revenues of nearly $3 billion, and was bought and sold by private equity funds twice in the last 10 years. After loading the company up with debt, Hostess twice filed for Chapter 11 bankruptcy in order to restructure. Six different management teams in the last eight years, each presumably more highly compensated than its predecessor, failed to change the company’s product offerings to respond to the market’s demand for healthier products.

The liquidation was triggered by a nationwide strike by the 5,600 employees who were members of the Bakery, Confectionery, Tobacco Workers and Grain Millers Union (BCTWG). 92% of that union’s employees rejected a new collective-bargaining proposal in September. The company’s offer included an 8% wage cut in the first year, a 17% increase in employee health-care costs and changes to workers’ pension plans that could have reduced payouts. Hostess long had said it couldn’t survive without cutting labor costs, even as it enraged workers by increasing top executives’ pay by 60% earlier this year. In a move reminiscent of Russian Roulette, the bakers union workers essentially pulled the trigger for all of the company’s workers…and lost.

Teamsters, which with 6800 employee members was the company’s largest union, narrowly voted to accept the company’s proposed deal. Teamster President Jimmy Hoffa said his team “switched gears” from trying to preserve all 18,000 Hostess jobs, a prospect he viewed as “off the table,” and instead was trying to drum up buyers for “bits and pieces” of the business.  Average pay for union workers was $16 an hour for the bakers and $20 an hour for the Teamsters. Frank Hurt, President of the BCTWG, called the company’s proposed 8% wage cuts “draconian” even as his members received 100% wage cuts from loss of their jobs. For this inspired leadership, he is paid about $250,000/year.

Hostess Chief Executive Gregory Rayburn had a different vision of how the bankruptcy auction process would play out. “Nobody wants to have anything to do with these old plants or these unions or these contracts,” Mr. Rayburn said. The company had hunted for buyers for the last several years as it tried to avoid a second trip into bankruptcy, but no buyer came forward. Potential buyers have made clear that their interest partly is because a liquidated Hostess would be free of its collective-bargaining agreements. A buyer might yet pick up a few of Hostess’s plants. Alternatively, the union(s) can now buy the assets in bankruptcy and reconstitute the company as a workers paradise without management sucking out all the benefits.

At the time of this bankruptcy, Hostess, with dozens of plants, had 372 collective bargaining pacts, 80 health and benefits plans, 40 pension plans and $100 million in retiree health benefits. The company had asked the unions to take the pay cuts and increase in benefits costs in exchange for a 25% share in the company and an interest-bearing $100 million note.

It appears that the bakers were operating with relative efficiency, and it is possible that some of the 33 plants producing the Hostess products will be purchased and their workers reemployed. The Teamsters, who were on average better compensated, had tied logistics into knots for years with negotiated work rules. As an example, Twinkies and Wonder Bread that were produced in the same facility and destined for the same customer had to be delivered by separate trucks, and put into warehouse or store shelves by different union workers.

18,000 workers are a large group of people. Unfortunately for these workers, they are strategically unimportant to the US economy. Hostess plants were scattered around the country and the shutdowns will not inordinately affect any one state or section of the country. With average annual wages of less than $40,000/worker these were jobs held by relatively unskilled laborers. Unlike autoworkers who are cogs in a complicated supply chain, other industrial workers do not heavily depend upon the Hostess products output. Most of the forgone Hostess products will be quickly and easily substituted with the output of Hostess’s many competitors.

What is the lesson to be learned here? Is this a case of unionism run amok? Was it a case of internecine union warfare with the bakers tired of getting a worse deal than the Teamsters? Were the workers justified in finally pulling the plug on a company whose management(s) repeatedly failed them? Or was it but another example of “creative destruction“? Diogenes suspects it is all of the above. It remains a tragedy in human terms. Many, if not most of those workers will likely face an extended period of unemployment. If and when they do find new jobs, that work will likely pay less and offer fewer benefits. The union operation was a success. Unfortunately, the patient died.

The mismatch between federal government revenues (taxes) and spending has resulted in $1 trillion+ deficits for the last four years. Left unaddressed, the US could become another Greece in the next 10 or 12 years; unable to sustain existing benefits and services for its citizens. Democrats favor balancing the equation by increasing taxes while Republicans have opposed most tax increases and demand spending reductions. This has led to an impasse and multiple calls for reform of the US Tax Code, which has become 73,000+ pages long and has not seen major revisions since 1986. The Simpson Bowles Commission and other would be reformers advocate a simplified structure with 3 tax brackets and a great reduction in deductions.

In order to see where such changes would need to come from, Diogenes examined the major deductions and credits taken by US taxpayers to discover which are the most unfair, or unjust. Below is a chart showing the magnitude of each of these “tax expenditures”.

Employer Paid Health Insurance

The largest single deduction, that taken for employer provided insurance plans, should be the first deduction to be eliminated. The amounts companies (or government) spend on these plans should become ordinary income for everyone. All Americans should be given a deduction of up to about $10,000 for direct health insurance spending. While this would cost revenue, there is no public policy benefit to forcing the 30% of Americans who are self employed or self insured to pay for their health insurance with after tax dollars.

Municipal Bond Interest & State and Local Income Taxes

Not shown on the chart are an estimated $120 billion in interest payments on about $3 trillion in municipal bonds, which are generally not subject to federal taxes. Many wealthy citizens avoid tax on substantial portions of their income with these deductions. The Alternative Minimum Tax (AMT) was originally enacted to force these few to pay their “fair share”, but because of the “Fiscal Cliff“, the number of Americans subject to the AMT absent Congressional action before January will rise from about 4 million to over 25 million.

This deduction should also be eliminated. There is simply no justification to reduce federal revenues to provide support for the local and state projects that these bonds finance. Similarly, the $54 billion in deductions for state and local income taxes should not be deductible from federal taxes. Why do all taxpayers have to subsidize the profligate states (California, Illinois, Massachusetts)? We could broaden the tax base and lower marginal tax rates. The real effect of this deduction is subsidize the high-tax-rate states at the expense of all other taxpayers. People deserve the governments they get. Those who don’t like the policies in Illinois and don’t live there don’t deserve to be forced to pay for a part of the results.

Mortgage Interest Deduction

“Subsidizing housing finance is especially problematic, as home building clearly over expanded in the early 2000s and needed to contract. If public policy subsidized a good into excess supply, further subsidies aren’t the cure. The Fed has merely delayed adjustment in the housing and financial sectors by continuing to direct credit to them.” (Gerald O’Driscoll, WSJ 8/31)

The mortgage interest deduction is also socially unjust, as it disadvantages minorities and the poor. Only 43% of minorities and 65% of whites are able to take advantage of it. Furthermore, it has failed to achieve it’s public policy purchase of increasing home ownership. The rate of home ownership in the US trails many other countries which provide no tax advantages to home owners. By subsidizing housing finance, the US government has also absorbed about $160 billion in losses at Fannie Mae and Freddie Mac (so far).

Deduction of Charitable Contributions

Americans have a long history of being among the most charitable people on Earth. But why does government need to support this generosity with over $50 billion in tax deductions? Wouldn’t we still give? And if I am an atheist, why do I need to taxably support contributions to your church?

How Do We Decide Which Deduction and Credits To Eliminate?

We have just identified over $325 billion in tax deductions that should be immediately eliminated in the tax code. However, one can only imagine the howls of protest from lobbying groups whose determined efforts have resulted in these distortions to an equitable tax code.

The AMT and various code reform attempts including Simpson Bowles suggested that deductions be phased out as income increases. However, this again results in continuing complexity within the tax code. A reform proposed last week by Republican Presidential candidate Mitt Romney is to enact tax simplification by limiting any taxpayer’s total deductions to an amount that would result in revenue neutrality after enactment of across the board rate cuts. He has suggested that the number would be between $17,000 and $50,000. The genius of this proposal is that it would protect the deductions of the middle class. It would limit benefits to high income earners even as it cuts their rates to spur investment activities.

The approach is also appealing because it would make more income subject to taxation—which boosts revenue—while reducing opposition from taxpayers who want to preserve specific deductions. One benefit for politicians is that capping deductions wouldn’t produce the same intense opposition they would get if they tried to eliminate just a few specific deductions. And Congress could continue to sell their fiscal favors to special interests secure in the knowledge that they wouldn’t be hurting the country (much).