Wednesday, October 26, 2011

Republican Tax Proposals – Some Quick Observations

The Republicans contending to be the candidate of their party for President have put tax reform on the national agenda. The plans proffered by Herman Cain and Rick Perry have garnered the most attention.

Both these plans are bold in conception and bereft of detail. For most people, they are not really worth serious study, since they are unlikely ever to become law. Here, though, are some quick observations.

Neither plan addresses transition issues. In other words, can you get there from here? For example, many people have considered, with much encouragement, tax issues when saving for retirement. However, if the government decides not to tax dividends or capital gains, then Roth IRAs no longer make much sense and traditional IRAs would be much less attractive. I do not think Perry or Cain has been clear what the tax treatment would be for distributions from traditional IRAs and 401(k)s under their plans.

Also, the plans seem to hit moderate income people fairly hard, while giving a tax cut for the wealthy. For example, as some commenters have noted, the Cain's 9-9-9 plan consists of a 9 percent tax on wages and salaries, a 9 percent national sales tax, and the equivalent of a 9 percent value added tax. Those who devote a greater percentage of their economic income for consumption get hit harder than those who have room to save and those whose income include a significant amount of capital gains and dividends. Perry's optional 20 percent flat tax confers no benefit on those whose average tax rate is less, even though their marginal rate may be higher. Those in the highest income brackets might find it to their advantage, even after forsaking some deductions.

Neither plan is simple. There is deliberately created confusion here. A flat tax is not necessarily simple. Having different marginal rates is not what makes the current tax code complicated. Determining such things as the character, timing, source, and amount of income, as well as the eligibility for and valuation of deductions and credits are what make taxes complicated.

The Democrats would have an easy time picking apart the Cain and Perry plans, if either were the nominee.   Republicans would yell "class warfare," but I think Democrats would successfully counter that those who propose lowering taxes on the rich and raising them on moderate income workers are the ones engaging in class warfare.

Mitt Romney is apparently being more circumspect. He is making proposals that, while not likely to be enacted in their entirety and about which there can be strong disagreement, are nevertheless less ambitious and probably harder to ridicule.

Another thing that deserves mentioning is that many of those who lean Republican, including those who write the Wall Street Journal editorials, like to praise President Reagan and the Tax Reform Act of 1986. I agree that the Tax Reform Act of 1986 was a major accomplishment. But those on the right who praise this major piece of legislation forget that it eliminated the preference for long-term capital gains and taxed these gains at a maximum rate of 28 percent. I remember Charles McLure, who was the politically appointed Treasury Deputy Assistant Secretary for Tax Analysis from 1983 to 1985 and headed up much of the work that culminated in the Tax Reform Act, saying in speeches that income should be taxed the same whatever its character. Among other things, this would eliminate tax strategies aimed at recharacterizing income and losses because of tax treatment. In other words, the Treasury's position was that, borrowing from Gertrude Stein, income is income is income. Of course, the lack of preferential tax treatment for long-term capital gains was a provision which did not endure.

The case for broadening the base and lowering the rates has merit. I am all for sensible tax reform. We currently use the tax code for too many policy objectives in addition to raising revenue, though I believe that the tax code should be progressive and not have a flat rate. But why make this a priority now, when the unemployment rate is at 9.1 percent? After all, as the history since the enactment of the Tax Reform Act of 1986 demonstrates, the Congress will always be making changes to the Code and undoing even good ideas.

As for the Cain and Perry plans, they are not thought through. Again, borrowing from Gertrude Stein, "there is no there there." 

Tuesday, October 25, 2011

The Misery Index and GDP Growth – Then and Now

There is plenty of reason to be despondent about the economy.  Unemployment remains stubbornly high at 9.1 percent, the real estate market continues to be distressed, and a Eurozone crisis threatens to spill over into the U.S.

But it is not as if the U.S. has not suffered through bad economic times before.  Yes, there was the Depression in the 30s, but the latter half of the 1970s and early 1980s were also pretty bad.  For some reason, this seems to have been erased from our collective memory.
Some charts might help jog the memories of those who were old enough then to be cognizant of the situation and remind others of what their parents experienced during the earlier period.

The first chart starting in 1965 is the monthly unemployment rate.  As can be seen, we did reach current levels and higher in the early 80s.

The second chart is the inflation rate (monthly CPIs compared to a year ago).

Inflation was a real problem in the late 1970s and early 1980s.  It is currently creeping up, but it is nowhere near the level it was back then.
This brings us to the “misery index,” which is the sum of the unemployment rate and the inflation rate.  This is an index attributed to Arthur Okun as a quick way of summarizing how bad economic conditions are, though limiting it to these two statistics and giving them equal weight seems more due to convenience than the result of any thorough analysis.

Because of the stagflation in the late 70s and early 80s, the misery index was then much higher than it is now.
Finally, here is one more graph – the annualized growth rate of quarterly real GDP.

GDP growth went further into negative territory in 2008 than it did in 1980.  Note that there was a “double dip” in the 1980s, as the Fed squeezed the inflation out of the economy.
All this is not to minimize the severity of the current situation, but the earlier rough times should not be forgotten.  We should also recall the significant economic policy changes that took place in the 1970s.  For example, among other developments, the last meaningful link of the dollar to gold was broken when President Nixon closed the gold window to foreign countries, the Bretton Woods system of fixed exchange rates ended, and there was a failed experiment with wage and price controls.  Finally, we went through a recession essentially engineered by the Fed, which finally ended the high inflation and paved the way for better economic times. 

Friday, October 21, 2011

Realpolitik and Economic Policy

In thinking about the debate about the correct government policy to follow in an economic environment characterized by high unemployment, large budget deficits, slow growth, and economic and financial problems in the Eurozone which, if not adequately addressed by European officials, could aggravate problems in the U.S., the school of international relations known as “Realpolitik” came to mind. As a way of conducting international relations based on a country’s national interests, Realpolitik can be viewed as cynical, but an important point is that, in order to conduct a foreign policy based on its tenets, one must correctly understand what the national interest is.

I wonder if those who are currently advocating shrinking government and, even in some cases, reducing taxes, correctly understand where their interest lie. After all, a reduction in joblessness and a return of economic growth as quickly as possible will benefit everyone, including the rich and businesses.

There are some who believe that any attempt to increase economic growth through budget stimulus is doomed to failure, because of the hangover the economy will suffer when the stimulus comes to an end. According to this view, there seems nothing the government can do but to shrink and let the private market solve the problem. The trouble with this view is that it may be a very long wait before the economy resumes adequate growth to reduce unemployment, and the wait may prove to be politically intolerable.

Also, those who hold this view need to address why the deficit spending accompanying World War II., which resulted in a public debt in excess of GDP, put an end to the Depression once and for all, and the debt as a percentage of GDP fell markedly in the years after the war. In other words, sustained stimulus can work.

Perhaps those who oppose further stimulus know this but either believe that a sustained federal effort is not politically possible or fear that a multi-year spending program not the result of a war would be difficult to end. If that is what they believe, then there could be a healthy debate about the issue and what the government should do. The prerequisite is that thoughtful conservatives admit that this is what they think.

For liberals, the stimulus enacted under the Obama Administration demonstrates that to get out of the current slump there needs to be larger effort of longer duration with less reliance on tax cuts. The conservative view, which may be correct, is that this is not politically possible, though the political difficulty may in fact be due to conservatives. They may also be right that federal spending may be difficult to stop, though infrastructure projects do have obvious termination points.

Conservatives, though, may need to reassess their contingency plans if the economy worsens or the current slump shows no sign of ending. It may not be in their interest, correctly understood, nor in the national interest for the government to be seen standing idly by while the economy struggles.

The Success of Occupy Wall Street

It is not surprising that those on the right first tried to dismiss the Occupy Wall Street (“OWS”) movement with ridicule, which some cable news outlets, including CNN (here or here) joining in. To an extent, ridicule was inevitable since this is a protest movement with grievances but no proffered solutions.

The OWS lasting power and engendering of similar demonstrations in cities across the U.S. and in Europe has effectively silenced the ridicule. Now the attempt by some GOP politicians is to characterize the OWS as a “dangerous mob.” That’s not flying too well either.

While the lasting power of OWS throughout the winter may be in doubt, it has already been successful in one respect. For all its incoherence, OWS has focused national attention on unemployment and the increasing wealth and income disparities in the U.S. It was not that long ago that most of the attention was on the debt and budget deficits of the federal government. This is an important, and welcome, change. And for those whose chief concerns are the debt and deficit, they should realize that economic growth and a reduction in joblessness would help pave the way to address those issues. In fact, many, if not most, economists think that further stimulus measures (even if you do not want to call it that) are the necessary accompaniment to longer term efforts to reduce the deficit.

The G-20 Communiqué

International communiqués usually make for extremely boring reading. In this regard, they compete with Financial Accounting Standard Board statements, though the latter actually make sense if you take the time to study them, and they can be quite important. International communiqués, though, often make less sense the more one pores over them, and, while sometimes they are signaling something important, at other times, they seem to be produced even if there is nothing new to say, because that is what is expected.

The acronym laden “Communiqué of Finance Ministers and Central Bank Governors of the G-20:  Paris, France, 14-15 October 2011” is a case in point.  On the first page of this document there is the following sentence: “Advanced economies, taking into account different national circumstances, will adopt policies to build confidence and support growth, and implement clear, credible and specific measures to achieve fiscal consolidation.”  The more one thinks about this sentence, the more it becomes clear that the finance ministers and central bank governors did not agree to anything here, except that each country would do what it thinks best. The communiqué goes on to say:  “Those with large current account surpluses will also implement policies to shift to growth based more on domestic demand. Those with large current account deficits will implement policies to increase national savings…”  I suppose it is left as an exercise to the reader to divine what these policies are.

With respect to emerging market countries, the communiqué starts off with this informative declaration: “Emerging market economies will adjust macroeconomic policies, where needed, to maintain growth momentum in the face of downside risks, contain inflationary pressures and endeavor to enhance resilience in the face of volatile capital flows…”  Perhaps someone thinks this means that a significant agreement has been reached.

To be fair, in some badly written prose, there are some more specific statements later on in the document mostly reaffirming what the G-20 has said in the past.  As for the U.S., the agreement by the Fed and the Treasury on regulatory matters may not mean much unless the various bank regulators, the CFTC, and the SEC agree.

What is dismaying is that this mushy, poorly drafted document must have consumed many hours of staff time in all the countries of the G-20 as staffers participated in numerous meetings and conference calls to negotiate this document, which hardly anyone reads but whose absence would have been noted. Its vagueness about economic policy, though, does serve to signal that there is no real agreement in the G-20 about what the appropriate policies should be.  That is probably not what the drafters intended.