The Wrong Kind of Thinking

One misconception that helped bring about the worst financial crisis this century (and which persists to this day) stems from a failure to acknowledge the natural limits that apply in every aspect of our lives.

It's one thing, for example, to believe that home prices can keep going up over the long run; it's an altogether different story to assume, as many did during the bubble, that prices could outpace rents and incomes until the end of time. People now know this is ridiculous.

The same holds true when it comes to the issue of debt burdens. Back when credit was easy to come by, many believed that individuals, households, businesses, municipalities, and countries could take on virtually unlimited amounts of debt as long as they could handle the short-term carrying costs. As we've learned from the latest European debt crisis, this perspective is dangerously short-sighted.

The notion that certain industries, including finance, real estate, and retailing, could garner an ever-growing share of the economy is another example of simplistic and short-sighted thinking. In the end, it is clear that this kind of outcome is the result of bad policies and unsustainable malinvestment, and is not a natural course of events.

A similar delusion about the mess Washington has created is also coursing through mainstream discussions about what needs to be done. Many "experts" argue that a debt burden like ours can be wiped out by sustained growth, even though the assumptions involved are unrealistic and largely unprecedented (not to mention the fact that there are other serious financial challenges ahead).

In contrast, others say that the real "solution" is for our government to extract more ransom resources from the existing tax base. But again, such thinking seems seriously misguided. As David Ranson notes in a Wall Street Journal commentary, "The Revenue Limits of Tax and Spend," history suggests this just won't happen.

Whether rates are high or low, evidence shows our tax system won't collect more than 20% of GDP

The Greeks have always been trendsetters for the West. Washington has repudiated two centuries of U.S. fiscal prudence as prescribed by the Founding Fathers in favor of the modern Greek model of debt, dependency, devaluation and default. Prospects for restraining runaway U.S. debt are even poorer than they appear.

U.S. fiscal policy has been going in the wrong direction for a very long time. But this year the U.S. government declined to lay out any plan to balance its budget ever again. Based on President Obama's fiscal 2011 budget, the Congressional Budget Office (CBO) estimates a deficit that starts at 10.3% of GDP in 2010. It is projected to narrow as the economy recovers but will still be 5.6% in 2020. As a result the net national debt (debt held by the public) will more than double to 90% by 2020 from 40% in 2008. The current Greek deficit is now thought to be 13.6% of a far smaller GDP. Unlike ours, the Greek insolvency is not too large for an international rescue.

As sobering as the U.S. debt estimates are, they are incomplete and optimistic. They do not include deficit spending resulting from the new health-insurance legislation. The revenue numbers rely on increased tax rates beginning next year resulting from the scheduled expiration of the Bush tax cuts. And, as usual, they ignore the unfunded liabilities of social insurance programs, even though these benefits are officially recognized as "mandatory spending" when the time comes to pay them out.

The feds assume a relationship between the economy and tax revenue that is divorced from reality. Six decades of history have established one far-reaching fact that needs to be built into fiscal calculations: Increases in federal tax rates, particularly if targeted at the higher brackets, produce no additional revenue. For politicians this is truly an inconvenient truth.

The nearby chart shows how tax revenue has grown over the past eight decades along with the size of the economy. It illustrates the empirical relationship first introduced on this page 20 years ago by the Hoover Institution's W. Kurt Hauser—a close proportionality between revenue and GDP since World War II, despite big changes in marginal tax rates in both directions. "Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP.

What's the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue.

For budget planning it's wiser and safer to assume that tax receipts will remain at a historically realistic ratio to GDP no matter how tax rates are manipulated. That leads me to conclude that current projections of federal revenue are, once again, unrealistically high.

Like other empirical "laws," Hauser's Law predicts within a range of approximation. Changes in marginal tax rates do not make a perceptible difference to the ratio of revenue to GDP, but recessions do. When GDP falls relative to its potential, tax revenue falls even more. History shows that, in an economy with no "output gap" between GDP and potential GDP, a ratio of federal revenue to GDP of no more than 18.3% would be realistic.

In this form, Hauser's Law provides a simple basis for testing the validity of any government's revenue projections. Today, since the economy already suffers from a large output gap that is expected to take many years to close, 18.3% must be a realistic upper limit on the ratio of budget revenues to GDP for years to come. Any major tax increase will reduce GDP and therefore revenues too.

But CBO projections based on the current budget show this ratio reaching 18.3% as early as 2013 and rising to 19.6% in 2020. Such numbers implicitly assume that the U.S. labor market will get back to sustainable "full employment" by 2013 and that GDP will exceed its potential thereafter. Not likely. When the projections are tempered by the constraints of Hauser's Law, it's clear that deficit spending will grow faster than the official estimates show.

Mr. Ranson is the head of research at H. C. Wainwright & Co. Economics.

Comments

[GYSC]

Tax reciepts have been way below estimates going on 6 months now. The "line" we are given is that the US is ok as a risk because taxes are low so they could be raised. This ignores how stretched the US middle class really is. Any more tax hikes and rhe rich will walk and the middle clas cannot shoulder the tax burden.

[Baltimore Investment Management]

You really do have to wonder about the contrast between perception of our economy and the actual conditions that exist in our economy. How is it possible that policy-makers can have such outlandishly misinformed takes on the national and global economy and base decisions on those views?

[Brian Allen]

Politicians need to learn they can't have their entrepreneurs and eat them too...

You can either foster production or you can tax it into oblivion; but you can't have it both ways.

[Sydney]

This is very interesting, I have heard this before, that no matter what you do with taxes, the overall tax rate paid by taxpayers stays right around 20% of GDP. I accept that. What it says to me, though, is that no matter what congress does with taxes, this will always be true, so stop worrying about it, we will never pay more than 20% of GDP.

What I would like to see support for is the assertion that you make that "any major tax increase will reduce GDP and therefore revenues too." I would like to see a chart that shows tax rates vs. GDP. Perhaps you are right, but I'd like to see it rather than accept it as a universal truth.

[dearieme]

That 20% figure is fascinating - are there equivalents for other countries?

[sharonsj]

Isn't the reason revenues went down in 2000 because when Bush came in, he cut taxes on the very rich and he started wars in Afghanistan and Iraq? It will be interesting to see what happens when those tax cuts expire at the end of the year. It would be even better if Obama would gets us out of the Middle East.

I agree we've had the wrong kind of thinking, but it's been on the part of big business, which looks for quick profits at the expense of workers, and our government, which never met a corporation it didn't like.

[Hello]

This article relates to posts about city and state financing through the bond market. A common subject on this site.

http://preview.bloomberg.com/news/2010-05-18/conspiracy-of-banks-rigging-state-finance-converged-with-mortgage-meltdown.html

[Paul in Pasadena]

Starting wars would not make tax revenues decline. If anything, additional defense spending would add to taxes paid by individuals and companies.

[moral failings affect us all]

Tuesday, May 18, 2010
Goldman Sachs: A moral failing

Joseph Stiglitz: The problem on Wall Street is that we had bought into the idea that
money is everything, and that the metric of whether you are doing well for the economy is how much money you were making for yourself. To me there were two very serious moral failings. One is that so much energy went into exploiting the poorest Americans; selling them houses they knew were beyond their ability to pay, with mortgages that were exploitive. There were people who called themselves mortgage brokers supposedly looking for the best mortgage, but in fact were looking for the worst mortgage. The whole hosts of mortgages that are designed to maximize fees basically rob the poorest people of all their life savings. The irony was that the financial markets were hoisted on their own petard, as I point out in my book. That is to me, one of the most serious moral failings on the part of the financial markets. The second is while Bernie Madoff represented a pyramid scheme engaging in illegal activity, much of what the financial markets were doing was perhaps legal, but clearly unethical, or borderline. That the financial markets did not seem to see much distinction is a severe criticism. A good example is what Goldman Sachs did; how they sold products that they knew were bad, so bad that they were actually selling them short, betting on the fact that they would lose money. The whole debate in their mind is whether what they did was legal or not. The unanimity that it was immoral that they did not disclose to the buyers that they thought these were so crappy that they were going to lose money on them and the fact that they see nothing wrong with that suggests that they live in a parallel universe, a different world, a different moral compass than the rest of society.

http://tinyurl.com/23kwok3

[Tyler]

It's BS
You're still pulling your words.... what for? In an interest to garner "credibility"?

Heck, it's all unraveling as we speak. This Ponzi scheme of a government/economic system.

Fraudulent. Simply that.
Just imagine, a system built where as debt.... creates money.
Hello..... earth to humans, you live in a world of FINITE resources and yet you have an economic system that presumes infinite growth.
Hard to reconcile that.
Add rampant crony capitalism/corruption and it spells ...DISASTER.

Enjoy the meltdown .... 'cause America, you've certainly earned it.