As is the case with so much within the Beltway these days, reaction to the expiration is predictably partisan.  Unfortunately, discussion is as partial in its facts as it is in its perspectives.

Presidential-Candidate Obama advocated restoring the maximum capital-gains tax to 20% from Bush’s 15%, and he held firm, simply not answering a barrage of repeated questions from Charlie Gibson about why anyone would raise a rate when the lower level has yielded higher revenue in the last few years.  This viewer was left with the impression that Obama wanted to soak the rich, and was more interested in revenge than in revenue.  Otherwise, he could have dispatched of Gibson’s returns in at least two different ways: (1)  “Ah, but Charlie, you’re acting as if the only variable was the change in tax rates.  What if it’s the bull market of recent times that’s responsible for revenue increases?” and (2) “Charlie, you know as well as I do that a goodly amount of all this rise in revenue is because people are selling stocks early, before the rates increase in 2011.  In other words, the revenue is just getting bunched, not increased in the long run.”

Some of the confusion can be cleaned up by more careful use of vocabulary.  Instead of talking about “taxes”, we should talk about “tax rates” and “tax revenues”.  Tax rates and tax revenues don’t necessarily move in the same direction.  An increase in rates, for example, is likely to decrease the tax base by changing incentives and, with them, choices.  The question is how sensitive or “elastic” the base is.  In some cases, at least hypothetically, the base will contract so much that the increase in rates will actually decrease revenues.  This possibility is at the heart of “supply-side economics”.  It’s particularly interesting in the case of capital-gains taxes.

The rationale for taxing dividends at a lower rate than most earned income is that dividends have already been taxed at the corporate level.  “Even though it’s still a double tax on profits,” adherents to this approach would argue, “at least we’ve reduced the total.”  The problem is that they’ve also increased equity concerns.  With the Bush cuts, someone “clipping coupons” worth $300,000 would pay much less in income taxes than someone working hard to make the equivalent salary.

Some of this disparity will be eliminated by Obama’s plans to extend Medicare taxes to “unearned income”.  Doing so, however, raises another equity concern:  Weren’t Medicare taxes set up in the context of tying health insurance to employment and therefore forcing people to save for medical expenses when they were too old to work?  Now what?  Populist redistribution?  People are so happy being angry at that legal fiction, a corporate entity, that taxing only flow-through income, with corporate taxes of zero, is unthinkable – or, at least, undoable.  Few, therefore, are talking about this possible “reform”.

Nor are many talking about the effect of inflation on capital gains.  When stocks have been held for a long time, a lot of the increase in their “paper value” is due to the cumulative effect of inflation.  Surely capital gains should be indexed for inflation?

In response to increases in tax rates, politicians from states like New York are calling for the brackets to be indexed not just by inflation but also by differential costs.  “An income that would make one rich in rural Alabama doesn’t cut it in New York City,” they properly note.  But shouldn’t they run the same analysis on minimum wages?  And wouldn’t making real cost distinctions unduly complicate the already detail-ridden tax code?  How many different cost zones would there be in the state of New York alone?

The Wall Street Journal adds its complaints that the deductibility of state taxes on federal tax forms already subsidizes state excesses.  It neglects to mention that more and more of us run afoul of alternative-minimum taxes (AMT), where these deductions are added back into the taxable base.  So much for state and local subsidies.

Art Laffer is considered to have invented “supply-side economics”, with a little graph on a paper napkin.  He didn’t – invent it, that is: the napkin part of the story is true.  He just popularized the concept of elasticity, with a focus on taxes. Laffer is certainly correct that the rich are clever at avoiding taxes – legally with the help of lawyers, illegally with chicanery of the sort practiced by Sen. John Kerry in endeavoring to shelter his yacht from state taxes by docking it in Rhode Island rather than his home state of “Taxachusetts”.

There should be little doubt that the change in capital-gains and dividend taxes will make stock markets less attractive than it used to be relative to bonds and t-bills, and, within stock markets, the dividend-paying stocks relatively less attractive than zero-dividend growth stocks. What we really need is studies on how private decisions based on reducing taxes affect the overall economy as well as the stock market.  Efficiency must suffer.  The question is “How much?”

In his “The Soak-the-Rich Catch-22” opinion piece in August 2’s Wall Street Journal, Laffer continues to run with his signature theme “Higher Taxes, Lower Revenue”.  Over and over again, he compares tax rates on “the top 1% of income earners” with tax revenues over different periods, showing that they’re negatively correlated.  Never does he tell his readers what “income earners” means.  Is it just wage income?  Or does it also include interest and dividends earned on wage income saved decades ago?  How about gains from the sale of real estate?

Laffer delights in demonstrating that the percentage of tax revenues paid by the top 1% have risen as their tax rates have fallen, he fails ever to tell us whether or not the percentage of their income in GDP has also gone up.  If the top 1% earns a much higher fraction of total US income now than before the Bush 43 cuts, this factor must be incorporated into any tax analysis, whether the argument is based on efficiency or equity grounds.

And that brings us to yet another issue.   When discussing taxes and the actual and proper distribution of their burden, shouldn’t we also discuss government spending and the actual and proper distribution of benefits – both on the three levels of federal, state and local?  There’s plenty of work to be done, and it should all be bipartisan and factual.

Taxes should not be based on envy and politics, but on economics and data.  The time for rationality is now.  We have some tough questions to ask, and we must answer them with facts rather than emotional convictions.

President Obama is expected to announce today a $3.8 trillion budget with a $1.2 trillion deficit for FY2011.  Here’s the context within which he will reveal his plan.  For decades now, the federal debt acquired through years and years of deficit spending has been the “elephant in the room” – the huge presence nobody talks about but everyone knows is there.  In last week’s State of the Union address, however, debt joined unemployment as the two most urgent issues facing America as Obama enters his second year as our President.

Last year, the White House and Congress went “Keynesian” in a big way as the real-estate bubble popped and started to pull Wall Street and Main Street down with it.  In crisis mode, they quickly passed stimulus bills designed to unfreeze credit and prevent the rate of unemployment from reaching double-digit percentages through a combination of renewed lending and “shovel ready” government spending to increase overall demand.

Last fiscal year, our federal deficit reached a record $1.4 trillion, and it’s projected to total $1.7 trillion this fiscal year, the first quarter of which has already seen spending exceed revenue by $389 billion, a 17% increase over the same period a year before. But as we enter February, unemployment resists declining below 10%, and debt as normally configured has reached almost $12,300,000,000  – or roughly $40,000 for every man, woman and child in America.

On January 12, the Obama Administration announced that its Council of Economic Advisers determined that the $787 billion stimulus program “saved” or “created” between 1.5 and 2 million jobs during 2009. Using the upper bound, that’s $393,500 per job. The “what if” ‘s of history cannot be proved, they can only be stated.  But even if we accept the upper bound as a true of the extra unemployment we’d have suffered if the Administration’s policies had not been implemented, it’s hard to conclude that our money has been well spent.  At best, each job has cost us $393,500, while none is regarded as permanent and the average compensation for comparable work is surely less than $75,000 on an annual basis.

<em>Pace</em> John Maynard Keynes and his new followers, it looks as if new government spending programs and the concomitant deficits are hurting, not helping recovery. Consumers, savers, and businesspeople alike worry about which taxes are going to increase and by how much to avoid continued debt explosion.  We also worry about what’s going to happen to interest rates and their effect on private borrowing expenses and the carrying costs of the national debt.

How, then, should we analyze the debt and its effect on the economy?

First of all, it’s ridiculous and misleading to compare today’s $12 trillion with, say,1950’s  $357 billion because of the cumulative effect of inflation over the last 60 years.   And we should also correct for growth in the economy.  After all, whether a $200,000 private mortgage is extravagant and foolhardy or modest and frugal depends upon the income of the borrower.  The following graph basically makes both of these corrections.

As is the case with most statistics, the tone of the story depends on its starting point.  Begin in 1945 if you want to relax, in 1980 if you’re okay with having your blood pressure soar.

Either way, two other adjustments are also appropriate. We should rework the numbers for automatic stabilizers, and we should separate government spending into consumption and investment categories, just as we do for private spending.

The Beltway doesn’t have to change anything to get some Keynesian stimulus spending going.  As unemployment increases, welfare payments will rise and tax revenues will fall, increasing or creating deficits.  If there’s any validity to Keynesian Economics, these quick developments are appropriate, and fair assessment of deficits should reconfigure the sums with these formulaic changes in mind.  We should find out, in other words, what the difference between spending and taxing would be at a level of employment considered “full”.

Our evaluation of debt should also depend in part on whether it’s being acquired through consumption or investment spending. We should be less concerned about deficit spending that finances investments than we are about deficits fueled by transfer payments properly categorized as consumption. Just as the probity of taking on a $200,000 mortgage depends on income (and its security), so is it sometimes okay and even good to take on some debt when acquiring an asset like a home, but not so good to finance a shopping bender in the Mall of America or a new car (which loses half its value right off the lot).

Unfortunately,“investment” is a malleable term that politicians will use to their advantage and not to ours.  Is the War in Iraq an investment in our future (which includes national security, itself dependent on reliable supplies of oil)?  Is Obama’s likely proposal of a huge increase in spending on education an investment in our youth, the individuals whose payroll taxes will be funding our Social Security checks?  Or, absent reform, is it more like income redistribution and consumption?

The issue of Social Security demands more scrutiny.  It also requires grit.  While insight is gained, the comfort our graph of debt/GDP can provide if we start with the Truman years is trashed.  The US could reduce national debt as a fraction of national income after World War II fairly easily because budgets weren’t encumbered by entitlement programs as they are today.  The value of these programs is not in question.  The problem is their cost, both in dollars and in flexibility and control. Baby-boomer demographics were not in play during the  1940s.

The unfounded future liabilities in entitlement programs like Social Security and Medicare dwarf all other deficit and debt concerns.  Neither has a nest egg adequate to the soaring payouts the formulas predict as baby boomers become eligible for benefits and are expected to live longer than their parents and be supported by taxes on a smaller work force. Last year alone, the combined debt of these two programs rose $5 trillion
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The fiscal health of our federal government is also worse than today’s debt figures would indicate because they fail to include off-budget items like subsidizing Fanny May and Freddie Mac.  Last week, the Congressional Budget Office reduced its guesstimate of another decade of their financial support by a whopping $20 billion. Yea!  But that leaves $79 billion still expected to be expended and begs the question of why these important players in the real-estate bubble remain “outsiders” even though any pretense that they’re run for a profit should long have been abandoned.  Time will tell, but the move to increase their loss limits does not auger well for us taxpayers.  It’s a cheap trick for the government to take quick credit for the positive effects of subsidizing mortgages through Fan and Fred, their cousin Ginnie Mae and uncle FHA, while failing to account for all the default risks accumulating as loss ceilings rise.

And then there are all the times the federal government improves its budget by fobbing off responsibility for funding certain programs to the states.  Medicare mandates are one example of this cost shifting.  In assessing government debt issues, we should be looking at all three levels of government – national, state and local, with an eye not only to their totals but to whose debt is really whose.  Should federal mandates really be paid by the states?  For what government spending should the counties, cities and towns be responsible?

Another matter involves the cost of servicing all this debt.  Like entitlement programs, interest payments are a huge part of overall government spending – indeed, its fourth largest category.

To whom are all these interest payments made? In times past, almost all debt holders were Americans, so we could call these payments mere “transfers” among our citizens.  Increasingly, however, our debt goes overseas, where China, Japan and the UK are currently our largest debtors.  Their holding our debt helps finance our trade imbalances and keeps our interest rates lower than they might otherwise be, but it also makes us vulnerable to outside change and exchange-rate issues.

It’s a good thing that we are now talking about the Elephant of Debt in the room.  The focus for reform, however, should not be debt but rather the growth in government spending, expected to reach 35% of GDP this year.  That’s the real, and even larger elephant whose presence we’ve been ignoring.

In the case of pulling an economy out of recession, it can be argued, although not with complete confidence these days, that additional government spending can actually increase private production.   In the case of full employment, however, all government spending takes the place of private spending.  If it’s funded by debt, interest rates may rise and “crowd out” private investment.  If it’s funded by taxes, the consequent declines in consumer demand and company profits will also cause private investment to decrease.

The key issue then becomes whether diverting resources to government use improves the public weal or not.  The consequences of whether the spending is financed by today’s taxes or by tomorrow’s taxes, for all their importance, remain secondary.  An important difference would involve whether voters respond more strongly to tax or debt increases and through their response can impose adequate spending restraint on politicians approving the programs.

How do we change the current trajectory of the ratio of government spending to GDP?  Given all the worthy entitlements and the difficulty of defining and controlling “waste”, the most attractive option is to grow the economy.  Investment in equipment, technology and people is key.  The question, then, is whether and to what degree the government, rather than the  private sector, should undertake these investments.  We already know that predictability in tax and regulatory legislation is a necessary first step.