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Archive for the ‘Economics’ Category

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,Americahas 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 profitableU.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, theUStaxes 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 theUS, 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 theUStax 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 USgovernment 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 theUS 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).

What is the Fiscal Cliff and Why is it Important?

“Fiscal Cliff” is a term coined by Federal Reserve Chairman Ben Bernanke to describe the confluence of tax hikes and spending cuts set to begin in January 2013.  The non-partisan Congressional Budget Office (CBO) has projected that as a result of these changes in fiscal policy, over $600 billion will be taken out of the US economy in 2013, of which approximately 60% are tax increases and 40% expenditure reductions.  Over a third of all the changes are tax increases that arise from repeal of the 2001 “Bush Tax Cuts” and an increase (from about 4 million to over 30 million) in the number of taxpayers subject to the Alternative Minimum Tax (AMT), which phases out tax deductions and regular code benefits as income increases. Unlike regular tax rates, AMT rates are not regularly adjusted for inflation. The chart below shows the relative impact of the expiring provisions and changes.

Source: CBO

Other key parts of the pending policy changes are the expiration of Payroll Tax cut, the end of extended federal unemployment benefits, and the first of the across the board “sequestrations” which limit all federal expenditures, including defense, without respect to the relative importance of programs. Taken together, if Congress does not act to prevent these changes, the US economy will have about 5% lower total GDP next year as compared to a continuation of current policies. The expected growth in 2013 in GDP without the pending changes is 1.7% according to the CBO. Unabated, the policy changes would push the US economy into a significant recession with as much as a 3% contraction in 1Q’13 and would be accompanied by a large increase in unemployment.

How Did we Get Here?

The US economy has run record budget deficits of over $1 trillion for each of the past 4 years. As in Europe, constantly rising deficits threaten to eventually overwhelm any government’s ability to repay their debts and are not sustainable. Congress has been unable to forge a bipartisan consensus for achieving stability. Taxes and the role of government lie at the heart of the debate. Generally speaking, Republicans favor spending cuts as a primary means to achieve deficit reduction. Most have publicly pledged to oppose all tax hikes, suggesting that growth through tax cuts will increase revenue. Democrats typically believe tax increases should be part of any bargain to reduce long-term entitlement spending, and have generally supported greater reductions in defense spending.

The Fiscal Cliff is in many ways the culmination of a series of increasingly contentious fiscal showdowns between the two parties over the last few years. A fight to raise the debt ceiling in August 2011 (so the government could continue to pay its bills) resulted in the Budget Control Act (BCA). The BCA required a bipartisan “supercommittee” to identify $1.2 trillion in targeted budget savings over ten years by November 2011 or trigger automatic spending cuts for both defense and non-defense spending in fiscal 2013, a result so onerous to both sides that it was believed to incent agreement. The supercommittee was unable to reach a consensus. The balance of the policy changes in the Fiscal Cliff essentially occurred as an accident of timing, unplanned and unintended, a result of lack of agreement and disagreements.

What’s Going to Happen Now?

The US economy is in the middle of a political game of “chicken”. Almost no one expects any significant attempt to deal with the Fiscal Cliff before the November general election. This uncertainty is widely expected to shave 0.5% from GDP growth in the second half of 2012, as successful businesses postpone capital purchases and hiring additional employees until after some clarity appears.

If action to alter the policy changes does take place, most think it will occur during the Lame Duck session of Congress to begin in late November. Many alternatives could occur as Congress addresses each of the fiscal changes individually. The theory is that by delaying some of the near-term contraction in favor of longer-run deficit reduction, we could get the best of both worlds: no recession in the near term and no debt crisis in the long-term.

It is likely that the largest single change, the Bush era tax cuts, will be allowed to expire. Democrats were reluctant to extend them in 2010, and aren’t anxious to do so again, as they achieve the party’s goal of raising taxes on those who pay taxes rather than broadening the tax base. Republicans perversely want the Bush cuts to expire so that any changes to rates enacted after January can later be claimed to be tax cuts from a higher rate.

The Lame Duck session will probably extend the “temporary” Payroll Tax Cuts,  and an AMT “patch” will likely be passed to keep millions of middle income taxpayers from being subjected to the AMT’s higher rates. The fate of the balance of the Fiscal Cliff policy changes are subject to the general election results. If Mr. Romney wins the presidential race, the Lame Duck session will likely pass legislation to postpone most or all of the changes for about six months to allow the new administration to deal with the issues. If Mr. Obama is re-elected, it is likely that most of the changes will be allowed to take effect. A mild recession will almost certainly ensue, but many believe that taking this tough medicine could set the stage for a more enduring recovery.

How Do We Fix the Problem?

The worst possible outcome from the Fiscal Cliff would be if Congress merely postpones all the 2013 policy changes. The trouble with kicking the can down the road is that you eventually encounter it again. Allowing current law to take effect (walking off the cliff) might pressure legislators enough to enact a comprehensive plan to replace much of the policy changes with a combination of tax reform, entitlement reform, and spending reductions which could phase in gradually and thoughtfully to put the debt on a clear downward path. (see On Leadership). Lower tax rates coupled with the phaseout of the many special interest deductions and credits could unleash GDP growth that would allow the US to grow its way out of deficits and reduce persistently high unemployment.

Harvard College was established in 1636. For the next 200 years Harvard, six other members of what became the Ivy League and a few religious schools were the only colleges in America. Attendance at these schools was almost exclusively a rich man’s privilege. The first government funded public universities were established after passage of the Morrill Land-Grant Colleges Act of 1862, which aimed to make higher education more easily accessible to the citizenry of the country. Unlike the Ivy League schools, which provided a broad liberal arts and religious education, the land grant schools redefined higher education to have more practical applications. They were designed to be agricultural and industrial colleges.

Roughly 80% of American college students now attend public colleges and universities. These schools have a long tradition of  being essentially free and open to all. Despite that tradition, today public school students, or their families, typically pay about $10,000/year in fees, and room and board are not included. Many private schools now cost more than $40,000/year.  College costs increased 439% over the 25 year period from 1982-2007, compared to inflation of 106%, and outpacing even healthcare cost increases of 251%.

The reasons for the rise in higher education costs are many, but the primary one is the lack of productivity growth. Unlike the industrial and agriculture sectors, higher education is essentially unchanged from its 19th century conception. It is labor intensive and not subject to the demands for ever increasing efficiencies which after inflation have reduced the costs of manufactured and distributed goods such as electronics, clothing and food.

Higher education cost increases have been largely made feasible by government Pell Grants and the federal takeover of education lending. These now allow any citizen not convicted of major crimes to obtain funding without any assessment as to ability to repay this debt, much as no documentation loans fueled the sub-prime credit crisis, so essentially, we already have a higher education entitlement.The Department of Education spends about $30 billion/year for various higher education programs, grants and aid, and has now largely pushed private lenders out of the $1 trillion student loan market.

Even with this public support, 82% of college students now take out college loans to pay for a higher education that is far from perfect (see my post Grading Higher Education). If having more of our population attain a college education is the best way for America to increase our collective wealth and economic vitality, why do we saddle our young adult college students with debts that are the modern equivalent of indentured servitude, or an excess mortgage? Public universities should revert to their traditional function of providing good practical educations at very low cost.

The established model of education is under pressure given its accelerating costs, its reliance on public funding and institutional resistance to recognize new education-delivery techniques through technological advancements. At the same time, making education more accessible would be a giant step towards addressing income inequality and social inequity, because education level attainment is the best long term predictor of economic success. So how do we pay for low fee public education for more of our young adults?

Merely imposing more cost containment features will not be sufficient to significantly lower the costs of higher education. We need to reinvent what a college degree means in this century. Americans will need to adapt to new social and economic realities. Online classes have already become part of an extended curriculum for many students. In an iTunes version of public education, relevant learning experiences will originate from the large building down the street, from a music studio in Lincoln Center or a lecture hall at Oxford. Critical thinking skills will still need to be developed by working in close interaction with educators who can correct papers and offer individual advice, but online lectures for most courses will permanently reduce the demand for bricks and mortar. Likewise, expensive library systems in a digital age are essentially unnecessary. Relatively new online ventures such as Coursera and Udacity already have over a million students taking free college classes from well known professors including many from elite schools.

In order to provide the incentives for public schools to control their costs, funding should be capitated for each student and paid directly to the schools much as we fund public primary and secondary schools. Taking only the existing expenditures on higher education at the federal level, this would equate to about $1500/student. State and local funding of public schools added another $85 billion, or $4300/student. Numbers vary every year, but public spending on higher education from all levels of government on the 20 million or so students is roughly $5800/student/year. So we aren’t talking about a lot more in costs; it’s a rethinking of how to spend that money in a vastly more efficient way.

If we are to re-imagine higher education as a low cost publicly funded “privilege” and entitlement as much as a primary and secondary education, we should then question why we should also continue to fund private higher education? Private universities should should be granted the standard student capitation rate much as charter schools are funded, or vouchers are provided for private schools in some districts. Beyond that, let private schools fund their own students.

If you get accepted at Harvard, then it should be up to Harvard to provide grants or loans that make it possible for you to attend. After graduation, you would owe Harvard or its bank, not a federal agency. Such debts could be discharged in bankruptcy, so real credit decisions would need to be made by loan officers, perhaps making it harder to fund art history majors, but easier to provide funds for engineering students. If Harvard declines to provide adequate funding, then you don’t go there. There would be some bright but poor (or middle-class) students who can’t go to Harvard. Instead they’ll have to go to UCLA or Rutgers. Why is this a tragedy? It might even end up as an improvement as state universities find themselves able to enroll more of the very best students, and private universities redesign their cost structures to adjust to a different funding model.