Progressive Income Taxation and Socialism

My post dealing with the charge that letting tax cuts for high income taxpayers expire, Taxes, Bailouts and Socialism, has generated all sorts of comments. Over at Economists's View, comments range from those that analyze the economic validity of progressive taxation to those that explore why support for revoking tax cuts for high income taxpayers has been tagged as socialism. The former group of comments address the impact of progressive taxation on the preservation of the purchasing power of all taxpayers, and how taxing the wealthy during a recession can steer their dollars into investments, and how stimulation of demand, which is what puts the brakes on a recession, requires wealth transfer. The latter group of comments focus on what the critics of letting the tax cuts expire truly fear. Perhaps it is more government involvement in their life, perhaps it is discussion of the issues that need attention, perhaps it is a fear that lower income citizens will acquire more political power. Other comments note that during the past eight years there has been a huge redistribution of wealth, from the lower income end to the higher, and that government taxation and spending includes benefits transferred to corporations. Still other comments wonder if churches that advocate social welfare are "socialist." As I write, the comments continue. It's very much worth wandering over there and checking them out, though a few are more worthy of being skimmed because they wander into tangential issues that don't bear directly on the issue.

Over at A Taxing Matter, Linda Beale has taken a look at the question, in Progressive Taxation--Socialism? or Just Standard USA Tax Policy?. She does a good job refuting the claim that progressive taxation constitutes socialism, and makes some additional points that I didn't set forth. Take a look.

One of the regular readers of MauledAgain wrote with these comments:

Regarding your blog post on the topic of socialism, it is not merely increasing taxes on the so-called wealthy that is denounced as socialism; it has always been part of Obama's platform to increase tax on the wealthy, but you'll find the media references to "socialism" with respect to Obama has only picked up a great deal lately. It is raising taxes on the wealthy and then redistributing those dollars to people who do not pay any income tax whatsoever (and in amounts in excess of employment taxes they pay) - a tenet of the Obama proposal that has only recently begun to get attention, and Obama's admitting that his goal is to "spread the wealth," that strikes many as socialist. This is plainly stated in the article that you link to at the beginning of your blog post. I don't think your post gave the cries of socialism a fair shake, as you mostly defeat an argument they are not making (you state "revoking income tax cuts for the wealthy isn't socialism" - I don't think many disagree with that, by itself). Additionally, there is likely a heightened sensitivity to socialism currently, following the bail-out and fed purchase of bank stock - each of which has been ridiculed as socialist by many on the right.

It is a basic tenet of socialism to spread wealth around, and the circumstances surrounding Obama's tax cut/raise and his comments do seem to cross an admittedly arbitrary line into real socialism (as opposed to the imaginary socialism, the pejorative term used to describe Demoratic safety net policies that have been around for 70 years). Rather than saying we need to fund government, and what is a fair way to spread the cost around (e.g., Clinton raised taxes predominately on the wealthy in 1993, but on everyone), the new policy is to increase taxes on some in order to write checks to others. You may find the policy pleasing, necessary and/or fair, but it is a new policy in this country that I don't recall any major party candidate advocating, and goes far beyond merely raising taxes on the rich to pay for a war.

Obama has also stated that he didn't care whether increasing capital gains tax would DECREASE government revenue (it is not important whether the premise is true, it's Obama's state of mind that is relevant), because according to him, increasing the tax is a matter of fairness. This comment was also shocking to many, implying that he would deliberately increase the deficit in order to cause certain people to have less money. It is these circumstances which have caused many to claim him to be a socialist.

I responded to his comments as follows:

Perhaps we interpret Obama's statement differently. I did not read it as revoking the tax cut on the wealthy in order to give cash to the poor and middle class. I read it as revoking the tax cut on the wealthy so that the government did not need to rack up deficits to provide the health care, school lunches, head-start education programs, and other benefits that indeed give opportunity to people who otherwise would be stuck in poverty.

This nation has been doing that for decades. It's socialism, perhaps not as far along the spectrum as Sweden's version, but it's socialism. When the administration refused to raise taxes to finance the war, it ended up cutting benefits to those in need. Obama seeks to fix that problem. That problem is exacerbated by the impact of cutting taxes on the wealthy, who didn't trickle much down to the poor other than short-term smoke and mirrors and longer-term financial distress. The poor and lower middle class will suffer far more from the present and continuing recession (depression, perhaps) than will the wealthy.

My reader in turn offered this rebuttal:

A few responses though:

1. Bush cut benefits to those in need? He doubled the size of government yet he managed to cut benefits? I remember all kinds of hollering in the Gingrich years about cuts in spending (which were really increases that were not as large as some liked) but I don't recall hearing that Bush has cut anything. Has he really?

2. This is a side issue, but tax cuts for the rich can be justified on moral/fairness grounds - if I believe tax rates are too high for those making between $200,000 and $500,000, then I'll support cutting their tax rates. Whether wealth "trickles down," or whether or not it helps the economy, is beside the point. The point of raising taxes is to pay for government, not rectify life's injustices or turn on or off the economy.

3. we may interpret Obama's comments differently, but my point is not to argue what Obama meant, but what Republicans who are crying "socialism" mean. They don't mean that raising taxes on the wealthy is, by itself, socialism. They mean that raising taxes on one group, while writing checks to another group who doesn't pay tax, all in the interest of spreading the wealth, sounds like socialism.

4. your response to #3 may be we already have socialism to some degree. True. This raises it a notch. But government ownership of banks, the bailout and the explicit policy of wealth redistribution (taxing some to write checks to others) crosses the line from an acceptable level of socialism (the safety net that's been in effect forever) to, for lack of a better phrase, "real" socialism.

And I, of course, tried to clarify my position:

The Bush spending doubled because of interest on the debt, the Iraq war, the war in Afghanistan, whereas states have struggled under mandates (federal imposition of obligations without federal funding). Taxes pay for government, and government needs to maintain a stable and productive society, which it cannot do if the poor get poorer, the rich get richer, and the gap widens. I'm no fan of the bailout -- read my posts -- but that was bipartisan socialism, and McCain voted for it, so it seems it's ok to take from the poor and middle class and redistribute wealth that way. Or at least to create conditions "conducive to business" that benefit the wealthy. Real socialism occurs when the government owns everything. We're not there yet.

And I should add, that's not where we will be. Surely letting tax rates return to where they were, and to where they should have returned when war erupted, is not going to trigger government ownership of everything. The government didn't own everything when income tax rates were more than double what they would be if the tax cuts for high income taxpayers are permitted to expire.

What I think underlies these charges of socialism is fear. It's fear, not of millionaires paying another fifty or a hundred thousand dollars in taxes, not of government taking over ownership of all assets, but of change. For quite some time, the economic and tax arrangement have favored the wealthy. They created this arrangement by persuading the middle class and even the poor that life would be better if income taxes were cut, particularly income taxes on capital gains and dividends. Yet when all was said and done and the policies advanced by the tax cutters played out, the nation ended up in what may be the worst economic catastrophe it has faced. While wages barely kept pace with inflation, and in some instances fell, while jobs were outsourced, while the quality of products and services suffered, while health care became less affordable and less available, while resources allocated to education continued to be insufficient, the percentage of wealth owned by the wealthy increased. Because the sales pitch worked in the past, they expected it to work again, but to their surprise, the track record of the don't-tax-but-spend crowd has turned out to be no better than, and in most respects worse than, the track record of the tax-and-spend crowd. With that taking the wind out of their economic policy sails, they turned their focus on a broader question, using terminology designed to spread their fear throughout the electorate.

The answer to Joe the Plumber's question was honest. It might not be something with which people agree, but at least it's not the misleading promise that cutting taxes will make everyone economically secure. And underneath this trumpeting of the "socialism" warning cry is an unarticulated lack of faith in America, a notion that somehow citizens will sit back and do nothing if attempts to fix the economic mess turn too sharply to what genuinely is socialism rather than returning the country to the path which uses economic policy to promote fairness, affordable health care, improvement in children's education, and the other characteristics of high quality of life that were promised but not delivered by the merchants of tax cuts for high income taxpayers. I don't see the appeal in continuing to do what has been done, when what has been done is what brought us to where we are.

Taxes, Bailouts and Socialism

When a candidate's tax plan is described as socialist during a presidential campaign, it should turn public attention to the tax policy question of why taxes exist. When Senator Barack Obama replied to the question asked by "Joe the Plumber" about his tax plan by noting that "I think when you spread the wealth around, it's good for everybody," he opened the floodgates of accusations that his tax proposals would amount to socialism. The accusations come from the Republican candidates, from journalists, from bloggers, and from commentators.

Determining whether the accusations make sense require two analyses. One is identifying what Obama's tax plan does. The other is identifying socialism.

Obama's tax plan is to increase taxes for individuals with incomes exceeding $250,000. Most Americans do not fall into that category, and 95 percent are unaffected by this particular proposal. Americans in that category are paying taxes at lower rates than they were paying a decade ago. The theory was that reducing rates on the rich would generate benefits not only for the rich, but also for everyone else. This "trickle down" theory turned out to be a failed experiment. All that trickled down was the economic pain inflicted on America by the casino capitalist gamblers. Technically, Obama proposes revocation of tax cuts for the wealthy. They had their chance. It failed, other than to make the wealthy wealthier, the middle class smaller, and the gap between the haves and have-nots wider. Obama incorporated that thinking into the portion of his reply that doesn't get as much attention: ""It's not that I want to punish your success. I want to make sure that everybody who is behind you, that they've got a chance for success, too. My attitude is that if the economy's good for folks from the bottom up, it's gonna be good for everybody."

The tag of "socialism" is an easy piece of red meat (pun intended) for those who want to stir up fears not unlike those afflicting the nation during the "red menace" days. The irony is that just as Communism (with the capital "C") wasn't really communism (with the lower-case "C"), so, too, imposing higher income taxes on the wealthy isn't socialism. Revoking undeserved and economy-damaging tax cuts for the wealthy isn't socialism. If anything, it reflects the fact that the wealth is built on the backs of those who produce it, not those who grab it, manage it, mismanage it, or gamble with it when it belongs to others.

Will Obama's tax plan redistribute wealth? Hardly. The additional revenue generated by the revocation of tax cuts for the wealthy very well may end up paying the interest on the national debt that was incurred because taxes were cut and kept too low during wartime. One could consider those tax cuts to have been a loan to the wealthy, and the events of the past month have demonstrated what they did with it.

But perhaps there's some wealth redistribution involved. One reasonably can argue that the revenue raised by revoking the tax cuts for the wealthy will be used to fund government programs that help only the poor or only the middle class or only the poor and middle class. Does that make it socialism? More important, does that make it bad policy?

Senator Mel Martinez thinks so. He thinks that revoking the tax cuts for the wealthy is equivalent to adopting the economic policies of Cuba. He also called the revocation "communism -- not Americanism." Wow. I suppose the Obama tax plan means that all land will be owned by the federal government? The analysis from Martinez is about as enlightening as the conclusions about Joe the Plumber's tax situation to which people jumped, as I pointed out in Taxing Joe the Plumber.

Colin Powell has suggested that "Taxes are always a redistribution of money. Most of the taxes that are redistributed go back to those who pay them -- in roads and airports and hospitals and schools. And taxes are necessary for the common good, and there's nothing wrong with examining what our tax structure is or who should be paying more, who should be paying less. For us to say that makes you a socialist, I think, is an unfortunate characterization that isn't accurate." Hooray for Colin Powell. I might disagree that taxes ALWAYS are a redistribution, because to the extent that they pay for services being rendered to the paying taxpayer, they do not transfer wealth. They simply represent an exchange of cash for services or property. But that articulation technicality aside, there are, and have been for decades, valid arguments for imposing higher taxes on those on whom America has bestowed better opportunities and greater fortune. Undoing the mistaken tax cuts, and fixing the problems caused by trying to fight a war without raising taxes, isn't socialism. It's an attempt to undo the problems caused by welfare for the wealthy.

Other commentators have pointed out that if someone wants to find socialism in government policies, one need look no further than the $700 billion bailout of the financial services industry. When Governor Sarah Palin was asked about the bailout, she characterized it as "measures that had to be taken by Congress to shore up not only the housing market but the credit markets -- also to make sure that that's not frozen -- so that our small businesses have opportunities to borrow. And that was the purpose, of course, and that part of the bailout and the shoring of the banks." Again, articulation issues aside, why is a rescue of middle-class taxpayers any less a "measure that has to be taken by Congress" to shore up individuals' financial status? The difference, it seems to me, is that she and those of like mind think it's acceptable to shore up institutions and the wealthy but not to help the poor and the middle class.

Senator John McCain tried to distinguish the bailout from a tax increase on the wealthy by saying, "That's the reason why we have governments, to help those who need help, who can't help themselves, and in a time of crisis, to step in and do what's necessary to preserve the lives and futures of innocent people. It wasn't Main Street America that caused this; it was Washington and Wall Street." Whoa. A total ban on wealth redistribution would mean tens of millions of people in need would not get assistance, and in many instances would die. Social Security is wealth redistribution. So, too, is Medicare. So, too, are food stamps. So, too, is the program that provides breakfasts and lunches to school children who would otherwise go unfed. So, too, are all sorts of other programs. If these programs are socialism, and if support for these programs make someone a socialist, then here's some news: by that definition, America has been a socialist nation for decades, and most of its Presidents and legislators have been socialists. So what would it mean to purge "socialism" from public policy? What then would life in America be?

Another D-word and Taxation

In Children, Toys, Greed, Profits, Gambling, and Lessons from History , I noted that some experts have warned us that if the world's economic problems are not solved quickly, the world will enter a "dangerously deep recession." I then wondered if we tightened up that phrase, would we get Depression?

Well, the experts assure us that there is little chance of a depression. But, instead, they are beginning to express concern about another d-word. According to The Dark Side of Lower Prices, the concern is deflation. What is deflation? It's the opposite of inflation. Instead of increasing every month and every year, prices drop. Look around. Stock prices are dropping. The price of oil has returned to levels not seen for a while. The price of gasoline is now under $3 per gallon. Housing prices have been trending downward for at least a year.

Because inflation causes so many worries, particularly among individuals on fixed incomes and organizations on fixed endowments, it is tempting to think that deflation would be good news. But it isn't. Economists explain that when prices drop because demand falls, producers must cope with production costs that exceed revenues. Their reaction usually is a reduction of production, together with the dismissal of part of their work force. In turn, demand for goods continues to drop, and prices continue to fall.

Economists suggest that it is very difficult to reverse deflation. To many of them, it is "scarier than a recession." Though most of them don't think deflation will occur, the odds that at least one economist puts on it happening are now six times what they were a month ago. Deflation, it seems, can cause, hasten, or worsen a depression, though it doesn't necessarily have that effect.

Conditions for deflation are present, we are told. So it could happen, even if the chances aren't high. It's not comforting to be told that declining prices are not a reason to hope that the economy recovers quickly, but rather a reason to begin worrying about deflation.

Curious, I looked again at the tax code to see if my initial thought was correct. It was. A variety of numbers in the tax law are adjusted for inflation. Technically, they are increased to reflect upward changes in the consumer price or other index. What's missing, I thought, was a downward adjustment for deflation. My thought was correct. If deflation sets in, the tax law will not respond as it does when prices rise, unless Congress steps in and amends the law. We've been living with inflation for so long that no one considered writing the inflation adjustment language in a manner that responds to both deflation and inflation.

It took Congress decades to insert inflation adjustments into the tax law. If deflation comes upon us, will it take Congress several more decades to make adjustments in the tax law for deflation? From the economists' perspective, we had best hope that the question remains theoretical. For if it becomes real, we're in even deeper trouble than the deep mess in which we currently are. And that, folks, is a depressing thought.

Taxing Joe the Plumber

When I discuss the portion of the presidential candidate's debate over taxes with people who are not tax experts, they tell me they are bewildered and have little faith in what is being said. When I discuss the matter with tax experts, I generally find the reaction to be one of concession to the inadequacy of a debate as a platform for educating citizens about proposed tax changes.

The difficulty, of course, is that one cannot discuss proposed tax changes with people unless those people understand what it is that would be changed. The average American citizen does not understand the nuances of federal taxation that both major presidential candidates seek to change. Information is generalized, assertions are misleading, rhetoric trumps technical analysis, and people remain confused. It is even more difficult to put policy considerations into the spotlight if they are resting on a foundation of half-truths, mis-information, and rhetorical jabs.

In trying to make their point, both candidates argued about the impact of their tax plans on a fellow named Joe Wurzelbacher. He's a plumber who had a conversation with Senator Obama in Ohio during a campaign stop, and who has now become known as Joe the Plumber. Joe told Obama that he was planning to buy the plumbing business for which he has worked, but was concerned that his income taxes would increase under Obama's tax plan. So Senator McCain brought up this encounter during the debate and asserted that Joe's taxes would increase under the plan.

Here's the problem. No one knows the facts. Is Joe the Plumber looking to buy a business that generates taxable income of $250,000? Gross profits of $250,000? Revenues of $250,000? One need only google "Joe the Plumber" and "taxes" or "Joe the Plumber" and "250000" to find all sorts of web sites raising questions, and making factual assertions about Joe Wurzelbacher's plumbing enterprise. Some commentators are trying to analyze the income of the business based on the assertion that there are only two plumbers working for it, using assumptions with respect to hourly charges, hours worked, expenses, and similar issues. So for all we know, this particular Joe will have a taxable income of less than $250,000. Or perhaps his taxable income exceeds $250,000. We don't know.

What we also don't know is the impact of other proposed tax changes on Joe's hypothetical income tax liability were he to acquire the plumbing business. What is the impact of McCain's proposed elimination of the employer deduction for health care coverage or for the inclusion of health care coverage in gross income, coupled with a credit?

When the two candidates then engaged on this question during the debate, the analysis became totally clouded. McCain claimed that Obama would put Joe in a higher tax bracket, which would cause him not to be able to employ people. McCain then added "which Joe was trying to realize the American dream." Did McCain intend to describe employing people as the American dream? Later he clarified the American dream as that of "owning their own business." McCain continued to claim that fifty percent of small business income taxes are paid by small businesses. Excuse me. Does that mean that the other fifty percent of small business taxes, whatever in the world that might mean, are paid by businesses that are not small
businesses? If they're paid by businesses that are not small businesses, why would they be small business taxes?

Because we don't know the taxable income generated by the business Joe the Plumber is considering buying, we don't know by how much, if any, its taxes would increase under the Obama plan or under the McCain plan. Would those taxes increase by an amount equal to what Joe would pay an employee? We have no idea, and I doubt McCain has any idea. What we heard were sound bites that would earn more credit in an English literature class than in a tax course.

Obama responded by trying to demonstrate what he called the major difference in tax policy between himself and McCain. He noted that the issue wasn't whether taxes should be cut, but for whom the tax cuts should be enacted. As he phrased it, hopefully most listeners could understand the basic issue in the tax discussion. Who should get a tax cut? Obama proceeded to describe McCain's plan as one that would provide tax breaks to large corporations, specifically noting that Exxon Mobil and other oil companies would get a $4 billion tax cut. Is that so? No one has shared the computations by which that estimate has been determined, though there is no question that McCain's proposal would reduce corporate taxes. Of course, it would reduce taxes for corporations other than oil companies, but I suppose it serves Obama's debate purposes to turn the spotlight onto corporations that strike negative chords in most Americans. Would noting that taxes would be reduced for Wal-Mart have the same effect? Several commentators note that McCain's proposals would reduce taxes for General Motors, supposedly a good idea because it would help preserve jobs with that company, but the problem is that General Motors isn't paying taxes because it's not making money.

Obama then repeated his claim that the 95 percent of Americans who "make" less than $250,000 a year would see a tax cut. What does "make" mean? Earn? As in salary? Have as taxable income? As in any type of income? Note that he did not mention whether those who make $250,000 or more would see no tax change, or a tax increase. He then noted that independent studies had concluded his plan provided three times as much tax relief to middle-class families as did McCain's plan. But what is middle class? Does someone earning or making or getting $250,000 of taxable income from a business get classified as middle class? Perhaps, if compared to the folks hauling in tens of millions of dollars a year in income. Perhaps not, if compared with people earning $50,000 or $100,000 a year. Taxes, of course, ought not be set at three rates, one for top, one for middle and one for bottom. They ought to be set on a sliding scale so that even if the tax on someone with $300,000 of taxable income is increased, it is increased at proportionately less than the increase for someone with $1,000,000, or $3,000,000, or $10,000,000 of taxable income. Of course, trying to explain this in a short debate, without access to visuals, is extremely difficult. Were I debating, I'd insist on access to Powerpoint.

Obama then made an interesting observation. He noted that tax breaks are more important to those who are trying to get to the point where they were making more money rather than lowering taxes for those who had already achieved that goal. To do this, he said, " requires us to make some important choices." He did not specify those choices, but to someone understanding tax policy issues, they are fairly clear. At what income levels should each tax bracket be imposed, and for what percentage. Obama also noted, again, a correction to assertions being made about small businesses and the impact of his proposals by explaining that "98 percent of small businesses make less than $250,000." From what I've seen over the years, that seems to be a reasonable conclusion.

McCain then claimed that Obama wants to "take Joe's money, give it to Sen. Obama, and let him spread the wealth around" but that he wants "Joe the plumber to spread that wealth around." It is most helpful that McCain made this point. If Joe's business generates $260,000 in income, what Obama plans to do increases Joe's taxes by a few hundred dollars. To use Obama's articulation of the question, is that a choice America wants to make? It depends on whether one thinks the taxes paid under current law by someone generating $260,000 in income are too much, too little, or just right. The complementary question is whether business would spread the wealth around. The presumption that the additional cash flow generated by tax breaks to a business end up as salaries and not as contributions to the purchase of luxury items manufactured abroad has not been proven, and events of the past several years puts this "trickle down" theory to a genuine practical test that questions its validity.

McCain asked, "Why would you want to increase anybody's taxes right now …Why would you want to do that, anyone, anyone in America, when we have such a tough time?" Obama answered that there are people who are not having a tough time and who "can afford to pay a little more in taxes." Of course, that's not the fundamental policy question. That question is whether they ought to pay more taxes, and the answer should explain why they should pay more taxes. McCain then tried to reject that response by asserting "We're talking about Joe the plumber" but his question was "why would you want to increase anybody's taxes right now." Someone paying close attention would see what's wrong with the reference to Joe the plumber in that context. Obama rejoined that the reason was to generate funding for tax cuts to give to Joe the plumber when he was still trying to get to the point where he could make $250,000.

Obama then shared a general tax policy observation that often gets overlooked: "So, look, nobody likes taxes. I would prefer that none of us had to pay taxes, including myself. But ultimately, we've got to pay for the core investments that make this economy strong and somebody's got to do it." McCain's response trivialized the policy question: "Nobody likes taxes. Let's not raise anybody's taxes. OK?" Here's the problem. If we don't raise taxes, we face either crippling deficits that threaten the nation's security and survival, or we cut spending, including Social Security, Medicare, and national defense, and perhaps even interest on the national debt, which also threatens the nation's security and survival.

What neither candidate said is that taxes need to be increased to undo the damage caused by excessive tax cuts that were not removed when the nation went to war. As has been said, "You can pay now or you can pay later, but you will pay." It's no longer now, it's now later, and we will pay. Now, which candidate, if either of them, understands that dilemma?

Selecting Tax Breaks for Encouraging Investments

According to a recent report, one of the ideas being batted around Capitol Hill is a proposal to suspending capital gains taxes on securities purchased during the next two years. The rationale appears to be a belief that this move would encourage people to buy stocks, bonds, and similar investments. The proposal refocuses attention on the question of whether and to what extent the tax law ought to be used as a prod to influence behavior.

It is one thing to use the tax law for more than revenue collection purposes if the provision in question is designed to help people by reducing the economic impact of unavoidable losses. Thus, one can justify in a general sense, though criticizing the complexity of, the numerous provisions that assist the victims of natural disasters and war to put their economic and literal houses back in order. These tax breaks do encourage people to rebuild and restore life in disaster zones, something that people would be doing even without tax breaks, as demonstrated by a history of human reaction to disasters reaching back to times long before the existence of an income tax.

It is another thing to use the tax law for more than revenue collection purposes if the provision in question is designed to encourage people to do things that they otherwise would not do. Decisions to do something ought not be induced by tax breaks, even though there is now a long history of politicians using the tax laws for such purposes. If it takes a tax break to persuade someone to purchase stocks he or she would not otherwise purchase, what does that tell us about the person's opinion of the quality or investment worthiness of the stock?

But let's assume that the tax law should be so used. I'm not endorsing the idea, but simply exploring the paths that would then be open for the Congress. The current proposal is to eliminate capital gains taxes for stock purchased during the next two years. How is the prospect of zero capital gains going to encourage very many people to make these purchases? For some, they already face a zero capital gains rate because they intend to hold the investment until death, or may end up holding it until death even if not planning to do so. Is it not better to ask why people aren't making these investments, when in fact they were making them two, five, eight years ago when the capital gains tax was no lower than it is now? Some people aren't making these investments because they don't have the funds. These people aren't helped by elimination of taxes on capital gains. Others aren't making the investments because they are gripped by fear, or perhaps consider them to be too risky. What would help these folks isn't elimination of a tax they might not be paying in any event, but a tax break that switches their decision making in terms of risk or cash flow.

Perhaps a tax credit equal to a percentage of the investment would be enough to tip the scales and make the internal rate of return of the investment high enough to overcome the risk. One can take this even further. By allowing a tax credit, the government in effect is making a loan to the investor. Perhaps when the investment is sold or otherwise disposed of, the credit should be recaptured, perhaps on a reduced scale if the investment is held for some specified period of time. This would discourage panic disposition of the investment in the short run. In other words, the credit would be the equivalent of government investment, but rather than in toxic debt, in securities strong enough to generate purchase interest when the credit offsets the higher risk that has been triggered by the fear finding a home in the financial markets. Of course, it would also help if the government took steps to identify those who caused the problem, seize the illegally obtained profits, enacted provisions to prevent the same or similar frauds from being repeated, and enforced the laws already on the books. Perhaps a tax credit for those who provide information leading to the identification and arrest of people who made mortgage loans that ought not to have been made?

Surely there is a better way to deal with current financial problems than with the overused and discredited (sorry) "lower the tax rates" mantra. We've done the lower tax rate thing. We've seen where it took us. It's time for something new.

Children, Toys, Greed, Profits, Gambling, and Lessons from History

The Reuters headline says it all: "IMF Warns of Financial Meltdown." Or does it?

Of course, it does not say it all. It doesn't tell us how the problems can be solved. It doesn't identify the practices that need to be changed, the expectations that need to adjusted, and the cultural and social values that need to retuned. It doesn't use the words greed, corruption, secretiveness, collusion, ignorance or foolishness. The story accompanying the headline notes that while United States political and financial leaders ask for patience, the Internatlonal Monetary Fund warned that there isn't much time left to prevent a catastrophe. Some experts not that if the problems are not solved quickly, the world will enter a "dangerously deep recession." Hmm, if we tighten up that phrase, do we get Depression?

When a tool is misused, people tend to become very cautious when dealing with that tool. When a child uses a toy inappropriately, the responsible parent puts the toy out of reach, but also finds a way to instruct the child on the toy's proper use and why it is important to respect the purpose of the toy. Eventually the toy is returned to the child, who has a better appreciation of its purpose and treats it with the appropriate respect. Similarly, when the casino capitalists misuse debt and leverage, banks have become very cautious in making loans, but they, or someone, need to find a way to instruct the greed merchants on the proper use of debt and leverage and why it is important to respect the power of those tools to do generate not only financial benefits but also economic doom. And someone needs to find a way to then restore the use of debt and leverage in national and international business and consumer transactions.

For example, someone needs to step up and make it clear that a free market isn't a license to shift the consequences of bad decisions onto the unwitting and the unwilling. Recently I read a comment, and unfortunately I cannot find it, that equated greed with the seeking of profits. It's one thing to seek income and assets in order to meet what one needs to survive, to be comfortable, and to support one's dependents. It's a totally different thing to seek income and assets orders of magnitude beyone what is needed for survival and comfort. In today's economy, no one needs to own billions of dollars of assets or to earn tens of millions of dollars per year. Seeking these sorts of profits and accumulations of wealth is a matter of addiction, of thirst for power, or both. A person can eat only so much, can wear only so much, can drive only one vehicle at a time, and has only one body in need of health care. So what does one do with the excess income and wealth? One buys votes. One controls society through off-shore entities. One tries to arrange for one's children and grandchildren to live lavishly without needing to work. Are these behaviors good for society? I propose that the answer is no, because the efforts made to attain these options have imposed a huge price on society, and we're only beginning to see the extent of the damage that has been done. I can imagine there are those who would point the finger at the homeowners who applied for mortgages they could not afford, and the members of the so-called middle class who tried to "make a killing" in the markets for their retirement plans. No, I don't condone the foolish decisions of seeking debt beyond one's ability to repay or sinking 100 percent of one's assets into risky investments. But it also should be understood that many people in this position were so acting because the tax and economic policies of the past decade widened the chasm between the haves and have-nots, leaving the have-nots and those perceiving themselves to be at risk of becoming have-nots with what they saw as no choice but to gamble for their economic future.

Of course, some parents neglect to discipline their children. Some children fail to get the message. It doesn't always work out the way it ought to work out. Similarly, there's no guarantee that governments, and more specifically, their officials, will discipline those who abused the free market, and there's no guarantee that the casino capitalists will get the message. A similar message was sent in 1929, many people learned, their children and grandchildren viewed them as overly cautious, and the lessons were forgotten. History repeats itself. There's no guarantee that it will not.

Have Some Tax Pork

The bailout, excuse me, rescue bill, known as the Emergency Economic Stabilization Act of 2008, managed to get Congressional approval because hundreds of pages of extraneous provisions, mostly in the tax area, were attached to the bill that failed to get passed a few days earlier. Objections to this process rest on two grounds. First, combining unrelated provisions makes it difficult, if not impossible, to evaluate the legislation on its own merits. This creates the sort of trap that is used to trip up members of Congress who vote against legislation because junk has been matched with something worthwhile, so that voting against the bill because the junk ought not be enacted brings claims that the legislator opposed the good idea, whereas voting for the bill despite the junk because of the value of the good idea brings claims that the legislator voted for the junk. Second, if a bill cannot stand on its own merits, as was the case with the bailout, rustling up votes by tacking on other provisions is nothing less than a purchase of the aye vote.

Many opponents and critics of the legislation describe the tacked-on provisions as pork. Defenders claim that the additional legislation were simple "extenders," that is, provisions that extended tax breaks that had expired as of the close of 2007 or would expire at the close of 2008. Is this so? Several days ago I read, or should say skimmed much of and read some of, the Emergency Economic Stabilization Act of 2008, focusing on the depreciation deduction because I am splitting what is one Tax Management Portfolio into two. In the process of doing so, I must gather all the developments that have taken place since I updated the portfolio about a year ago. The list of things that require further revision grew much longer after I culled the bailout legislation for items affecting the depreciation deduction. So here they are, and I'll let you decide (a) if they are simply extenders, and (b) if they are pork.

1. Section 201 changes the definition and nomenclature for cellulosic biomass ethanol, for which an additional first-year depreciation deduction is available, to cellulosic biofuels, thus expanding the reach of that deduction.

2. Section 305 extends the termination date for the treatment of qualified leasehold improvements and qualified restaurant improvements as 15-year property.

3. Section 305 also expands the definition of qualified restaurant improvements to include new restaurant buildings.

4. Section 305 also adds qualified retail improvements to the 15-year property class, a recovery period shorter than that to which they otherwise would be assigned.

5. Section 306 adds qualified smart meters and qualified smart grid systems to the 10-year property class, a recovery period shorter than that to which they otherwise would be assigned.

6. Section 308 adds a new subsection 168(m), creating an additional first-year depreciation deduction equal to 50% of the cost of certain reuse and recycling property.

7. Section 315 extends the termination date for the assignment of Indian reservation property to recovery periods shorter than those to which they otherwise would be assigned.

8. Section 317 extends the termination date for assignment of motorsports entertainment complexes to the 7-year property class, a recovery period shorter than that to which they otherwise would be assigned.

9. Section 505 adds certain farming business machinery and equipment to the 5-year property class, a recovery period shorter than that to which it otherwise would be assigned.

10. Section 710 adds a new subsection 168(n), creating an additional first-year depreciation deduction for qualified disaster property.

11. Section 711 adds a new subsection 179(e) to provide increased first-year expensing for qualified disaster assistance property.

I count three simple extenders out of the eleven items. Though I may have missed something, I don't think I missed so many that the "27% extender" conclusion is way off the mark. Eventually I'll go through the legislation again to cull the energy-related provisions, as that is another project getting my attention. But from what I saw, there are even proportionately more changes and additions that are not extenders. Is it possible that some things were slipped in unbeknownst to most of the nation's citizens?

The Bailout as Good Solution. Not.

There's not much to like about the bailout. Before Congress enacted what I called A Financial Crisis Solution That Doesn't Solve the Problem, I explained, in both Where is the Money to be Found? and Funding the Bailout, that creativity was required in finding the resources, going so far as to make one suggestion, in Risk Premiums with a Greed Tax? Finding a solution, I noted in Greed, Stupidity, and Fraud: Lessons from Tax Law and Does It Matter Who or What is to Blame?, required understanding how the crisis arose. I explained, in Why Vote Aye for Bad Legislation?, how the legislative process once again failed the American people.

Advocates of the bailout, renamed rescue as though that changes its shape or smell, asserted that it ought to be given a chance, even though many of them admitted to ignorance with respect to the causes and solutions. Others argue as though they are omniscient, claiming that folks who take the position I have shared will be proven wrong.

What's been proven wrong is the notion that the bailout, excuse me, rescue, package would be of help. Since it was enacted on October 3, stock markets throughout the world have plunged. On Monday, the Dow Jones Industrial Average fell 370 points, and then on Tuesday it plummeted another 508 points. Most of that drop occurred after the Federal Reserve Bank took the unprecedented step of lending cash directly to corporations. Investors are sending a message, namely, they don't think the government can solve the problem taking the approach it has decided to follow.

It would not surprise me to hear the advocates argue that absent the bailout the situation would be worse. That reminds me of the story I heard as a child about the fellow who was asked why he was standing at a downtown intersection snapping his fingers. "It keeps the pink elephants away," He explained. When told there weren't any pink elephants, he triumphantly replied, "See? It works." So perhaps it would have been worse, but I doubt it. I think the markets view the most recent federal government actions, and those of other national governments, as ineffective. I think investors simply don't trust those who make policy, just as banks no longer trust most loan applicants, just as citizens don't trust Congress, just as voters don't trust politicians, and just as people don't trust the wizards of theory who used the world's population as guinea pigs in their monetary experimentation. We now have learned what happens when someone designs the "If all goes well, the financial elite win, and if it falls apart, everyone else loses" investment vehicle.

I previously spelled out what I think needs to be done. At this point, considering the ineffectiveness of the "solution" designed by the people who created the problem, perhaps it's time to try something else.

A Financial Crisis Solution That Doesn't Solve the Problem

To say that what Congress did on Friday was disappointing would be an understatement. What Congress did was, and remains, downright dangerous. A huge sum of money has been thrown in the direction of institutions and people who are either malevolent or ignorant. Banks and other institutions find themselves holding assets that have been significantly devalued because, surprise, someone discovered they were packed with toxic mortgages. If these banks and other institutions purchased these investments without knowing what was in them, then they were grossly negligent in not having done due diligence. And if they did know, then their actions in acquiring this junk are totally malevolent.

Now that the giveaway is underway, the industry already has started to prepare America for the bad news, namely, that this raid on taxpayer dollars won't solve the problem. According to this report, despite the legislation having passed, lending won't ramp up overnight, it might not get underway for weeks, and it might take even longer for things to get better. In the meantime, hundreds of billions of dollars flow into the marketplace and nothing happens? The folks who testified at Congressional hearings that they had no clue may have been telling the truth, but those who engineered this so-called bailout surely knew what they were doing. When they discovered that American opposed the idea, they worked out a deal. They added $150 billion of unrelated tax provisions to the legislation, and in turn persuaded several dozen legislators to switch their votes. Consider this quote from House Republican leader John Boehner, "We've made this bill better." Better? It's the same legislation, with a variety of "vote getters"tacked on, as I described in Why Vote Aye for Bad Legislation?.

According to various reports, such as this story, banks are drowning in cash but are reluctant to lend money. Why? We're told that they are "paralyzed with fear." Fear of what? That they are incapable of distinguishing a credit-worthy loan applicant from someone not qualified to borrow? That they are incapable of figuring out which fancy, exotic, smoke-and-mirrors creative investment packaged by the wizards of Wall Street they should buy? Here's some advice to the banks. Try making loans to people, one at a time. Ignore the packaged deals and other theoretically cool but pragmatically stupid investments cranked out by a generation of investment bankers who either outsmarted themselves or, as is more likely, embarked on one of the if not the most, outrageous greed-inspired money grabs in history. In other words, these banks don't need money. They need that unique combination of intelligence and honesty that is no less lacking in the financial services market as it is in the political arena.

What should have been done? The problem that should have been attacked with money is what underlies the crisis, not the symptoms and not the losses incurred by investment bankers, banks, and other institutions complicit in the crisis or negligent in their investment decisions. The crisis exists because a very small percentage of homeowners, perhaps as few as 3 or 5 percent, cannot meet their mortgage payments. Imagine what would happen if $700 billion were used to pay interest and principal on the roughly 1,500,000 home loans that are bad. The loans generate payments, the strange investment vehicles in which they are packaged recover their value, bank balance sheets return to normal, and the crisis is handled.

Instead, consider what will now happen. The Treasury will seek to borrow $700 billion so it can buy these bad mortgages, as described in Where is the Money to be Found?. What is the effect of that borrowing? I'll quote myself:

Borrowing money increases interest rates, which benefits some investors and hurts borrowers. Borrowing money also makes the nation even more beholden to those in a position to lend the money, namely, foreign countries and foreign investors rolling in dollars accumulated when Americans purchased foreign oil, foreign goods, and foreign services. Having a nation that spends beyond its means borrow even more money to bail out bad debts arising from individuals who spent beyond their means is not unlike pouring gasoline on a fire.

Good money is thrown after bad, while the folks who profited from this debacle chuckle all the way to their off-shore bank, leaving behind some underlings to take the FBI heat.

So the national debt increases by $850 billion, soon to be followed by the impact of $500 billion annual budget deficits. On the heels of that escalating national debt comes the looming crises in Social Security and Medicare. According to the 2007 Financial Report of the United States Government (Dec. 2007), as of September 30, 2007,the future unfunded costs of Social Security, Medicare, and other obligations has reached $53 trillion. Yet there are politicians who continue to advocate cutting taxes, and whose votes were obtained when tax reductions were tacked onto the bailout bill. Hanging onto the mantra that we can tax cut ourselves out of the mess, they seem to ignore the reality that we tax cut ourselves into the mess. Had the wealthy faced the tax rates in effect before the 2001 reductions, had they not had the advantage of special low tax rates for capital gains and dividends, and had they not available the tax breaks tailored to their wants, they would not have had the funds with which to play what someone else called "casino capitalism." I've always wondered what one does with a $10 million or $50 million annual income. Perhaps you have, too. Now we know. It's house money, and it lets the wealthy take enormous risks that they shift onto the rest of us. As the Secretary of the Treasury admitted, this bailout legislation puts taxpayers at considerable risk. Risk of what? We'll soon be finding out. It isn't going to be pretty.

Why Vote Aye for Bad Legislation?

So after the House of Representatives votes down proposed legislation that would give the Secretary of the Treasury $700 billion to use however the Secretary wished to purchase toxic debt that no one else wants, the Senate takes its turn. Despite knowing that citizen opposition to the proposal is overwhelming, the Senate decided that the way to get the legislation enacted would be to tack on a variety of unrelated legislative proposals as a sop to those who would otherwise vote against the bailout giveaway. For once, the public gets to see this very common legislative technique in stark relief.

So what did the Senate do? First, it increased the $100,000 limit on FDIC insurance for bank accounts to $250,000. The theory is that this will restore public confidence in the financial markets. Will it? It won't take long for someone to compute how much money the FDIC would need to find if all banks fail. Considering that the limit had not been increased for quite some time, and is not indexed for inflation, this change might make sense, but the FDIC is not permitted to charge the financial institutions for this insurance. Instead, it must borrow from the Treasury. That's just what the nation needs, more borrowing.

Second, the Senate extended the temporary fix for the alternative minimum tax problem that catches middle class taxpayers within a net designed to trap the ultra wealthy who find ways to avoid taxes. The irony is that the fix merely helps the middle class taxpayers but does nothing to deal with the ultra wealthy who continue to avoid taxes despite the existence of the alternative minimum tax. One must wonder whether the continued failure of Congress to reform the tax law and the continued success of the wealthy in avoiding the tax encourages some of them to be just as bold in finding other ways to increase wealth at the expense of other taxpayers.

Third, the Senate extended a variety of tax provisions that had expired as of the end of 2007 or that were scheduled to expire at the end of 2008. There's no question that extending these provisions does nothing to solve the financial markets mess. What is guaranteed is that the extensions will increase the federal budget deficit, which in turn will put more pressure on the credit markets, an outcome contrary to one of the expressed justifications for the bailout bonanza.

Fourth, the Senate enacted a new group of tax breaks for renewable energy. Again, this does nothing to solve the financial crisis. For several decades, the Congress has been using the tax law to deal with energy, enacting a variety of incentives to wean the country from its foreign oil addiction, surely a contributing cause to the increase in government, business, and consumer debt, and yet the country uses more and more foreign oil. Perhaps using the tax law to deal indirectly with the problem makes far less sense than dealing directly with it? Together with the extensions, these tax breaks add $110 billion to the cost of the legislation.

Fifth, the Senate enacted a requirement that health insurers treat mental health issues in the same manner that they treat physical illnesses. About the only connection between this issue and the financial crisis is that the latter is likely to cause a significant increase in the number of people with anxiety, stress, and other pyschological problems.

It's distressing to note that the Senate did not add provisions to fund the bailout, to track down the funds moved offshore by the perpetrators of the schemes, to hold accountable the decision makers who permitted the markets to become a casino, to require public education that reduces the opportunities for manipulators to dupe individuals and investors, and to lead by example in an effort to eradicate the greed mentality that infects society. Instead, the Senate pounced at the opportunity to saddle the legislation with unrelated provisions in which particular Senators were interested.

What should trouble the nation is the manner in which a legislator who thinks a legislative proposal is a bad idea and who would not vote for it on that basis nonetheless will vote for it if something that the legislator wants or likes is appended to that legislation. If a legislator thinks that the bailout is a bad idea, then it is a bad idea and the legislator ought not vote for it. Changing the vote from negative to positive, that is, doing something that the legislator otherwise would not do, simply because the legislator is getting something in return is very troublesome. To vote for something that is against one's principles because one is receiving some sort of unrelated benefit suggests that votes are for sale. A proposal ought to sink or swim on its own merits. That's not to say that amendments germane to the issue ought to be precluded, but the legislative practice of packaging bills so that everybody gets something and no one votes no even though most, if not all, of the provisions ought not be enacted is something that should end immediately. To say that this is the way Congress has done business is nothing more than an invitation to consider whether the crisis presently engulfing the nation is a product of the way Congress has done business. The federal government is trillions of dollars in debt, the federal budget deficit is growing at astronomical rates, the nation and many of its citizens have become indebted to foreign nations and investors, unemployment is rising, insufficient resources are allocated to health care, infrastructure repair, and development of new energy sources, and the dollar remains weak. Business as usual put us in this situation, and business as usual must be pushed aside. It is time for a change in how laws are enacted and administered.

Does It Matter Who or What is to Blame?

The current economic mess, which many doubt will go away simply because of a $700 billion government bailout of the financial services industry, has caused most people to focus on the question of how it ought to be fixed. Only a few people have considered what steps should be taken to prevent the problem, or some next-generation variant, from happening again. It has been suggested that there is no way to prevent the next problem because no one knows what that problem will be. There's some truth to that observation. So perhaps the question is whether there exists a way to insulate or cushion the economy from these sorts of episodes.

Quite a few people have brushed aside talk of ascertaining blame. I continue to challenge the nation's leaders to insist on responsibility. As I wrote more than a year ago, in Greed, Stupidity, Poor Judgment, and Taxes, " The solution to the problem is to shift the financial consequences of bad lending decisions onto the individuals who made those bad decisions." Assessing blame, we are told by the bailout advocates, is pointless. Nonetheless, the blame game has begun. There are those who point to section 121 of the Internal Revenue Code, as summarized nicely by Paul Caron in his TaxProf Blog poston the subject, replete with links to discussion throughout the blogosphere. Others claim that changes made to regulations under the Community Reinvestment Act by the Clinton Administration caused lenders to make loans to unqualified borrowers. And, as can be expected, the accusations and counter-accusations begin to fly. Almost all of the debate, though, appears to be less of an effort to identify the specific individuals and decisions that led to the crisis and more of an effort to tag one political party as the culprit and the other as the ignored prophet of doom. Perhaps the folks who dismiss the blame gaming do so because as it is practiced in postmodern America it generates these sorts of name-calling debates.

Yet it is important to cast blame, if that's the phrase people want to use for undertaking the identification of what went wrong. Though some people engage in this effort in order to justify attacking one political party or another, others do so because preventing recurrences In the future of the same or similar problems requires understanding what happened this time around. The irony of the current crisis is that too many people, including politicians, bankers, investors, and others, are admitting that they really don't know what happened, are unable to measure with any precision the scope of the problem, and are unsure what the ramifications are of moving forward or not moving forward with the proposed bailout. Even many of those who speak authoritatively probably have some deep inner doubts about the reliability of their public assertions.

It is not enough to put into place a variety of mechanical and human-regulated circuit breakers, filters, triggers, and reporting requirements. Though necessary, those techniques don't necessarily provide safeguards against the next scheme. The protections put in place as a consequence of the Great Depression did not prevent the dotcom bubble, the real estate housing bubble, or this toxic debt bubble, nor did they prevent the bursting of those bubbles. The creators of the next bubble is as likely to be undeterred by whatever legislation 2008 brings to the table as those recent bubbles were by the 1930s legislation.

Instead, what must be challenged is the culture that breeds the people and behavior that bring us these difficulties. One cause of the problem is the inability of people to understand the risks they undertake when they borrow money they are not qualified to borrow, that they are unable to repay, and that they accept because they are banking on an increase in housing prices under circumstances that suggest increases are far from certain. Something that definitely must be done is the education of the American nation with respect to finances, borrowing, budgeting, money, and economics. This isn't the first time I've pointed out this necessity. For example, in Preventing Foreclosure Through the Tax Law? Not This Time, I wrote:

What about a provision to fund high schools so they can teach their students some basic information about home buying, so that they are much less likely to be bamboozled by loan merchants with more concern about their up-front fees than the economic well-being of their customers?

And more than three years ago, in Economically Depressing?, I referred to "my expressed desire that K-12 education be revamped so that high school graduates enter society with the survival tools needed for life in the 21st century." According to the 2005 report of the National Council on Economic Education, the latest I could find, only seven states require personal financial education as a high school graduation requirement, one requires high schools to offer a course in the subject though it is not a required course, and one state requires that it be taught in middle school. There are 50 states in the union, plus the District of Columbia and some overseas possessions. Surely personal finance is no less important than other subjects being taught in middle school and high school.

Another cause of the problem is that postmodern Amercian culture is infected with greed and with the poor judgment and stupidity that accompany greed. As I pointed out in Greed, Stupidity, Poor Judgment, and Taxes:

The problem arises from a confluence of several underlying weaknesses in American culture. The first is the decision to live beyond one’s means. Fueled by advertising that makes people feel inadequate if they don’t own a home, live in a large home, drive a fancy car, wear the latest designer-brand fashions, and eat at the trendiest restaurant, people overspend and then end up in a financial dilemma. Greed? Maybe. Stupidity? Sometimes. Poor judgment? Definitely. The second is the proliferation of lenders, brokers, agents, and others who enable the decision to live beyond one’s means. It’s one thing to cut people a break so that they can afford a home, such as a small reduction in the required down payment or a slight reduction in the interest rate. It’s something else to eliminate the down payment requirement and to doctor the interest rate so that in two or three years the home buyer is trapped in a mortgage hell. Greed? Yes. Stupidity? Perhaps on the part of the borrower. Poor judgment? Yes, on the borrower’s part. The third is the perception that someone else, usually “the government,” will step in to insulate people and businesses from the folly of their bad decisions. The ever-growing inability or unwillingness of people to accept responsibility for the consequences of their actions increasingly erodes the core values on which this nation rests. Greed? Yes. Stupidity? Yes. Poor judgment? Yes.

But how does this mindset get reformed? So long as the message sent by advertisers, politicians, and the entertainment industry is "You can have it all and you can have it all now," then it's no surprise that people behave in ways that jeopardize not only the nation's financial health but its survival. One cannot expect advertisers to step up and advise people not to buy the products they hawk. The entertainment industry is in no position to send a contrary message, for its existence depends on that message. That leaves it to the politicians, ever anxious to avoid the delivery of bad news and ever reluctant to ask Americans to sacrifice. The "You can have it all and you can have it all now" perspective is what brought us tax cuts in a time of war. I made this point in Taxes and Sustaining a Civilized Society:

Whether or not one supports none, one, or all of the various military actions undertaken in connection with this war, it is inconceivable to me how one can disagree with the notion that if there is a war the war must be funded because wars cost money. . . . The failure to seek a tax increase, or at least to put the brakes on the tax cutting, probably reflected a policy of trying to make everyone happy even though the long-term cost is far higher than would be the cost of an immediate, and thus smaller, tax increase.

I expounded on this argument in A Memorial Day Essay on War and Taxation:

Politicians have chosen to fight without increasing revenue, imposing rationing, or deferring projects and activities. In their defense, they argue that none of these things are necessary, that a nation can have its guns without giving up its butter. I disagree, and I happen to think that politicians are reluctant to do what needs to be done because they are more concerned about maintaining their position in office than in making the tough decisions that war requires. So our national leaders have chosen to put the cost of the current war on our children and grandchildren. Those who decry the huge deficits, triggered in part by war and in part by the almost insane concept of decreasing tax revenues (mostly for the wealthy) during wartime, pretty much focus on the economic impact. They ask if, or suggest that, our grandchildren will be facing income tax rates of 80 percent in order to reduce an unmanageable deficit. I think it will be worse. I think our children and their children and grandchildren will become subservient to our nation's creditors. The sovereignty of the United States of America is far from guaranteed, and is at risk. Were these considerations discussed when those in power decided that war can be done on the cheap?

War cannot be done on the cheap. War is not free. War ought not be purchased on a credit card. War is a national commitment. Hiding the true cost of war in order to influence a nation's willingness to engage in war is wrong. Ultimately, the price to be paid will be dangerously high.

Perhaps the question is whether we are beginning to pay that price. With the rough going that the bailout proposal has encountered in the Congress, it appears that opponents of the plan are questioning the wisdom of borrowing more money in order to solve the problem of too much money having been borrowed.

Funding the Bailout

A report from BNA indicates that Peter DeFazio, a member of the House of Representatives from Oregon, suggested that the Congress should impose stock transfer taxes as a source of funding the proposed bailout of the financial services industry, but the idea was dismissed. As crafted, the representative's suggestion is too narrow. The existing mess cannot be attributable solely to stock trading, and the stock market ought not be singled out for revenues to finance the bailout. However, as a proponent of shifting the cost of the bailout to those who participated in creating the mess, I would modify the suggestion so that a tax, or what I would prefer to call a user fee, is imposed on all financial services transactions.

Would such a user fee, or tax, affect innocent people? Yes and no. A person or institution that purchases a collateralized debt security might not be manipulating the market, lying to investors, hiding bad loans, or making bad loans, but that purchaser is in a certain way enabling the market that affords the schemers and careless managers an opportunity to do damage. The fee is not unlike insurance. Careful drivers pay insurance premiums.

Would such a user fee, or tax, inhibit the financial markets? To some extent, yes. Surely there would be transactions that don't take place because the user fee, or tax, tips the analysis away from engaging in the deal. If the deal is that shaky, then the user fee or tax would have served its purpose. Imagine how many of the toxic transactions that contributed to the current mess would not have taken place had there been such a user fee or tax.

This user fee or tax could be constructed so that as the risk of the transaction increased, the rate of the user fee increased. Insurance companies do this sort of rating all of the time. Dealings in safer transactions would be subject to lower impositions than transactions in exotic financial instruments designed by someone who has a business school degree, a theory, a cup of coffee, and a dream to get rich quick. The rate of the user fee or tax could also reflect the identity of the parties, the location of the underlying assets, and other factors that indicate the degree of risk.

The latest version of the proposed legislation contains authority for the Treasury to impose premiums to pay for insurance to guarantee bad loans and assets originating before March 14, 2008. The premiums would be paid by financial institutions participating in the insurance program. The premium would reflect the relative risk of the particular bad loan or asset. It seems as though the premiums would be used to offset further declines in value, but do nothing in terms of generating a source for the $700 billion being sunk into the financial services industry money pit.

Taking a different tack, House Republicans advocate the use of private funds to bail out the failing institutions. According to this CNN report, House Republicans also want to ease tax laws so that private investors put their funds into the markets. Considering how eviscerated the tax laws have become during the past eight years, how can they be eased any further other than to eliminate them? I suppose the answer is elimination of taxes on investors so that wage earners bear the burden of financing government. The idea that private investors, who at the moment appear to be sitting things out because putting money into these failing institutions seems unwise, would return because of a tax cut on their income and thus proceed to dump their assets into sinking ships, seems a bit overdone. One must wonder why doing more of the same would generate any different of a result than what has already been produced.

Some claim that the bailout will pay for itself and thus does not need to be funded. Aside from the question of who finances the bailout, there's absolutely nothing to suggest that the bailout will pay for itself. The premise for this claim is that eventually the government will be able to sell at a profit the toxic junk that it purchases. If this is likely, why aren't private investors pushing each other aside in an effort to buy this "can't miss" junk? The answer is that they don't want it. Advocates for the bailout reply that only the government has the resources to make the purchases on a grand scale. Excuse me, what resources? The government is deep in debt, a debt that will continue to grow even without the bailout. Because it's very unlikely that the government will print money or raise taxes, it will finance the bailout by borrowing money. That presents two questions. First, if the government can borrow that money, why can't private investors collectively borrow it? If the answer to that question is the tightening of the credit markets, how will the appearance of the U.S. as a borrower seeking more loan funds loosen those markets? Second, if lenders are willing to finance the government's foray into this mess, because they think it is a good deal, why would they not finance private investors doing the same?

Something is terribly amiss and makes no sense. I read, in The Bailout: What's at Stake? that the cause of the problem is falling housing prices. Yet housing prices are falling because there are fewer would-be buyers financially capable of paying the higher prices, in part because of the credit crunch. So the credit crunch is causing the problem that is causing the credit crunch? I doubt it. Housing prices are falling because they are returning to levels that reflect their true worth. Housing prices are falling because they were pushed up by the bids of buyers who lacked the financial ability to pay those prices but who were being funded, and encouraged to buy houses, by the folks who decided they could make money by making bad loans because they grabbed their fees and sold the bad debts by disguising them in bundles of good debt.

According to the previously mentioned CNN report, it also has been suggested that the limitation on the deduction of compensation paid to executives be reduced from $1,000,000 to $400,000 for the five highest paid executives of each employer that is part of the financial services industry. That's equivalent to doubling the number of people standing on a corner snapping their fingers in order to keep the pink elephants away. The $1,000,000 deduction limitation has accomplished nothing because it is riddled with exceptions. Changing the number isn't the answer. A related proposal with respect to golden parachute payments would fare no less terribly because the existing golden parachute payment provisions fail to accomplish the intended result. If the tax law is going to be used to discourage high incomes, the simple answer is to increase the rates so that incomes over $1,000,000 are subject to higher taxes, incomes over $10,000,000 subject to even higher taxes, and incomes over $100,000,000 subject to what many would consider to be confiscatory taxes.

According to The Bailout: What's at Stake?, the National Association of Home Builders has announced that it plans to ask Congress for yet another bailout of between $40 billion and $90 billion. The article also explains that the investment bankers who benefit from the bailout will be using the funds to cushion themselves against similar problems in Europe and Asia. The managing director of the Economic Cycle Research Institute predicts that banks will not use the bailout money to make loans because they will prefer to improve their balance sheets. My question is this: then what will they do with the money? Pay off their own debts? Invest in something other than loans? What exactly are the taxpayers funding? The answer isn't the purchase of toxic debt. The answer is whatever it is that the owners of that toxic debt do with the money they get from the government when they sell the junk to the government.

The President and others claim, as the President stated in this report, that ""There is no disagreement that something substantial should be done." Well, depending on what "substantial" means, there is room to disagree. Surely the architects of the mess should be held accountable. Fees collected by mortgage brokers lending money to unqualified buyers should be seized. The sellers of debt instruments who hid bad loans in the packages and made misrepresentations about the risk levels should be required to disgorge their profits. Nothing in the proposed legislation would accomplish this result. The FBI investigation into the fraudulent activities in the mortgage and other markets should continue. Those investigations were underway before Congress and the Administration turned their attention to the matter. But what happens if there is no bailout? We're told that the existing credit crunch will continue. Is that a bad thing? Might it mean we must live within our means until the nation's assets grow and catch up to its debts? Would the spiraling debt vortex shut down, thus reducing the chance that some foreign nation or syndicate will end up owning America's assets?

The people who made this mess and the people who permitted this mess to unfold are now telling us how to solve the problem, and they seem intent on making taxpayers, rather than the perpetrators, responsible for cleaning it up. How much faith should one put in the solutions proposed by those who created the problem? One either assumes they made the mess because they do not know what they are doing, which is reason to reject their proposals. Or one assumes they very well knew what they were doing, which is reason enough to reject their proposals. Put bluntly, I don't trust them. Do you?

Greed, Stupidity, and Fraud: Lessons from Tax Law

In my last post, Where is the Money to Be Found, I examined one of the many issues raised by the proposed $700 billion bailout of the financial services sector. Throughout my analysis, I have looked at the situation as one of "greed, stupidity, and poor judgment." The continued gambling that took place throughout the past five or six years was fueled by greed, enabled by stupidity, and perfused with poor judgment, as I noted in Greed, Stupidity, Poor Judgment, and Taxes.

What I neglected to consider was another consequence of greed. And that is fraud. So I should not have been surprised to see this CNN headline on Wednesday: FBI Probing Bailout Firms. It turns out that the FBI is looking into the actions of Fannie Mae, Freddie Mac, Lehman Brothers and AIG to determine if their employees, particularly executives, engaged in fraudulent behavior. There are 26 companies being investigated, and 1,400 individuals, including lenders, brokers, and appraisers.

It's a bit of a guess, but I'm going to suggest what some of the issues might be. Were mortgages provided to borrowers on the basis of fraudulently over-valued homes? Were subprime and other high risk mortgages packaged into securitizations without disclosure? Is it true that information was withheld from people and firms that invested in these mortgages?

According to the CNN story, the FBI already has arrested more than 400 individuals who are charged with generating more than $1 billion in losses on account of mortgage fraud. The same story reports that the Mortgage Asset Research Institute has done a study showing that for the first quarter of 2008, the number of fraudulent mortgage loans was 42 percent higher than was the case in the first quarter of 2007.

The tax law provides not only for penalties on account of stupidity and carelessness, but also for fraud. Stupidity, carelessness, and other lapses in skill get swept together in what the tax law calls negligence. The negligence penalty is designed to encourage people to be more careful. The fraud penalties are designed not only as a deterrent, but also to recoup the burden that is placed on society by people who are not necessarily stupid, though very possibly infused with greed and poor judgment, and who let that greed lead them into fraudulent behavior. If the tax law can be designed with penalties against negligence and fraud, why can't mortgage lending laws be similarly designed? The answer is that they are. The more important question is whether there is any reason not to enforce them. Perhaps the lack of sufficient resources that plagues the IRS also hampers enforcement designed to keep the mortgage market a free market, that is, a market free of fraud, manipulation, and other nefarious practices.

And if the mortgage fraud laws are enforced, and the government's allegations are proven, then the defendants ought to be required to disgorge profits. If they stashed the cash overseas, there needs to be a way to retrieve it. Though advocates of the bailout toss that aside as an impossibility and as something that would cost to much to achieve, the people of this country are owed the effort. There are times when the cost of prosecuting a tax fraud case exceeds the revenue involved in the matter, but the lesson that is taught has a value that surpasses mere dollars. There's a reason that every April various U.S. Attorneys announce tax fraud indictments. And though deterrence is a factor, an even worthier reason is to let people know that those entrusted with protecting Americans, whether from outside threats or at-home theft, are doing their jobs. The nation ought not tolerate tax cheats and neglect to reprimand negligent taxpayers, and surely it does not bail them out. Why, then, tolerate the mortgage fraud, neglect to pursue the malefactors, and bail them out? So hooray to the FBI investigation and thumbs down to those who want to turn a blind eye to those who orchestrated this mess.

Where Is the Money To Be Found?

I don't get it. Perhaps I just don't understand "modern" finance. This latest bailout perplexes me. As I understand the proposed statutory language, the Treasury is authorized to buy "mortgage-related assets from any financial institution having its headquarters in the United States." Those assets are the bad debts held by those financial institutions because they lent money to people who were incapable of repaying the loans or, just as bad, purchased the loans from the folks who lent money to people incapable of repaying. In doing so on a large scale, the managers of these institutions have put the financial health, the national security, and perhaps even the continued existence of the nation at risk. One wonders whether these folks thrive on risk, of any sort, even if it means taking others down with them. The frustrating aspect of this situation is that even though others are going down, many of these gamblers stashed their profits overseas, tax-free, and are laughing all the way to the foreign bank at the financial ignorance of most Americans, borrowers and politicians alike.

In order to buy these bad debts, the Treasury needs money. The legislation authorizes up to $700 billion of purchases. Where does the Treasury get this sort of money? If the question was asked of you or me, the answer would be, "We don't." The Treasury, however, has several options. The legislation authorizes the Treasury to borrow money. Under the proposal, the nation's debt ceiling would increase to $11.315 trillion. The legislation does not appear to prohibit the Treasury from "printing" money, although other considerations may make that option unlikely. And though the legislation says nothing about raising taxes, that is not something the Treasury can do on its own, though it could ask the Congress to do so, an outcome unlikely so long as the current Administration is in office.

Each of these three options, including the two that are unlikely to be pursued, pose their own grave dangers to the economic vitality of the nation. Printing money kicks inflation into high gear. Raising taxes draws down the ability of businesses and consumers to pay their bills, make purchases, and pay off debt. Borrowing money increases interest rates, which benefits some investors and hurts borrowers. Borrowing money also makes the nation even more beholden to those in a position to lend the money, namely, foreign countries and foreign investors rolling in dollars accumulated when Americans purchased foreign oil, foreign goods, and foreign services. Having a nation that spends beyond its means borrow even more money to bail out bad debts arising from individuals who spent beyond their means is not unlike pouring gasoline on a fire.

The Secretary of the Treasury admitted that the plan puts taxpayers at considerable risk. He thinks that eventually the Treasury will be able to sell some of the assets it buys and thus recover some of the money. Excuse me, but who is going to buy these assets? If people aren't knocking down the doors now to acquire them, why will they do so in a month, a year, or a decade? The only answer is that perhaps things will change. Sounds like a gamble to me, a gamble not unlike the practices that have created this mess.

When I criticized the so-called economic stimulus payments, in Can a Tax Rebate Band-Aid Stop the Economic Bleeding? , I explained why it makes no sense to toss good money after bad:

The issuance of tax rebates will enlarge the federal deficit. At some point, that deficit will haunt the economy in ways that no tax rebate, even an abolition of taxes, will cure. So long as consumption exceeds production, so long as more wealth, particularly dollars, flow out of the country than flow into the country, so long as certain items remain in short supply and project to remain that way, the nation's economic and financial health will worsen. Tax rebates will not increase the supply of clean water, oil, natural gas, or any of the other resources mismatched to the demands of the world population. In some ways, it makes the question about who should get a tax rebate seem trivial, almost like fighting over a deck chair on a sinking ship.

That the debt crisis is a symptom of a deeper problem is apparent to those who think about the situation carefully. As I also wrote in Can a Tax Rebate Band-Aid Stop the Economic Bleeding? :

It gets better. To finance the tax rebates, the Treasury will need to borrow money, because it doesn't have spare cash sitting around. From whom will it borrow? Someone with dollars to unload. Who might that be? Could it be the People's Republic of China? Saudi Arabia? The United Arab Emirates? Some international bank? Whoever it turns out to be, they will be looking for two things. They will want interest, because they're not going to lend the money for nothing. And ultimately they will want the debt repaid. Who pays the interest? Who repays the debt? It will be the taxpayers of the third, fourth, and subsequent decades of this century. These taxpayers, already burdened with individual debt, will discover that they lack sufficient funds to buy the things they need and the luxuries they desire without going into more debt. From whom will they borrow? At what point do the creditors say, literally, "We own you."

This nation has been living beyond its means for far too long. Most people, though not all people, in this nation have been living beyond their means. Some people need to live beyond their means simply to survive. A family of four trying to live on income of $25,000 will be racking up some of that credit card debt that has reached a total of almost one trillion dollars. Some people live beyond their means because they simply must have what they want. A very small slice of the population does not live beyond its means because its means are so huge that the limits of time and space prohibit a person from spending that much money. So these folks join the creditor nations in making most Americans their economic vassals. And to think we concluded the middle ages ended a few centuries ago. What a surprise!

The irony in the proposal is that the investment bankers who are screaming for assistance from the federal government are the same people who were railing against government regulation and intervention when they were racking up profits constructed out of theoretical home value increases. In Greed, Stupidity, Poor Judgment, and Taxes, written about a year ago, I criticized attempts to "solve" the problem by using the tax law to grant tax relief to speculators and gamblers. I wrote, "People and industries who damage the nation’s economy, health, environment, or defense posture ought to face the consequences of what they have done." I pointed out that a nation whose economy rests on the notion of a free market is placed at risk when market freedom is squashed by greed, stupidity, and poor judgment. I noted that to the extent existing provisions in the tax law encourage the sort of speculator behavior that has contributed to the crisis, those provisions should be repealed or modified. I also asked why an industry that made money lending to speculators and collecting fees when placing questionable mortgages was unable to use its profits to tide itself over when times got tough. I suggested that the lenders should disgorge those profits, though I suspect those profits have been funneled offshore. Very recently, in Risk Premiums With a Greed Tax?, I proposed instituting a fee or tax to encourage future gamblers think twice before taking risks and then trying to shift the cost onto others.

In my mind, I see a nation five, ten years from now, saddled with crushing debt, populated by bankrupt and near-bankrupt individuals, riddled with all sorts of economic problems, and struggling to survive as a world debtor beholden to a few foreign nations, while those who profited from the unregulated economic free-for-all of the 2000s bask in the sunshine in some litigation-proof haven. I'm sure my vision will alarm those who decry my resurgent pessimism, and again, I hope I am wrong. I would be glad to be wrong. But when I consider the predictions I made a year ago and three years ago, and then take a look at the current headlines, I continue to have little faith that those who kept telling us that "everything would be fine" have the ability to make it so.

Introducing Mileage-Based Road Fees to the Pennsylvania Legislature

On Friday, Dwight Evans, Chairman of the Pennsylvania House Appropriations Committee, wrote a letter to the editor of the Philadelphia Inquirer in which he explained why the turnpike lease proposal deserves a vote by the legislature. He made two major points. First, though he has heard the arguments against leasing the turnpike, he hasn't heard a better idea. Second, raising the gasoline tax or increasing license renewal fees or similar items won't work.

On his second point, the Representative and I are in agreement. I explored the reasoning for my conclusion in Are State Gasoline Taxes the Best Source of Highway Revenue?. In summary, the economics of the gasoline market, when projected into the future, strongly suggest that even with increases the gasoline tax cannot provide sufficient funding.

On his second point, the Representative and I are in different places. What I know is that he has not read MauledAgain. If he had, he would have learned from Tax Meets Technology on the Road, from Mileage-Based Road Fees, Again, and from Mileage-Based Road Fees, Yet Again that another approach to funding transportation infrastructure does exist. It's the mileage-based road fee, which I describe and advocate in those posts. Those posts contain links to more fully developed, detailed explanations, reports by states that have experimented with the fees, and other useful information.

On Friday, I sent an email to Dwight Evans. I pointed him to the existence of mileage-based user fees, and to the cited posts. I am awaiting a response. It will be interesting to see if I receive one. It will be even more interesting to see if the concept of mileage-based road fees gets any attention from the legislature.