Friday, November 20, 2009

why not propose a cut on investment taxes in isolation?

There are two main reasons why I raised the issue of tax reform in my last post as opposed to just tax cuts. The first is general and strategic while the second is relatively technical and economic.

Fiscal conservatives should not be proposing tax cuts without doing so in tandem with proposals for either how the tax revenue loss can be made up OR specific program spending cuts. While spending cuts is the preferred route, the political reality is that when the government steals from Peter (the taxpayer) to pay Paul, possession is effectively nine tenths of the law meaning trying to claw an "entitlement" back from Paul after he's got it is a far more difficult negotiation (and much of politics is a negotiation) than working towards a structure that doesn't see every last request of Paul indulged in the first place.

Some US Republicans have latched on the Laffer curve to contend that tax cuts pay for themselves, and while that can be true with respect to some capital taxes (capital generally being quite willing to move to the most competitive jurisdiction), it is an overstatement with respect to income taxes ("dynamic scoring" is a more precise way of acknowledging the fact that the new incentive for economic activity post-tax cut will bring SOME of the revenue loss back to the treasury) and pretty much simply misleading when mentioned in the context of a proposed consumption tax cut.

I realize that the "starve the beast" argument exists, but this line was thrown out repeatedly while the GOP ruled the roost in Washington and last time I checked, the belly of the Beltway beast was bigger than ever. Deny the beast its tax revenue and the beast's agent may just go out there and sell debt.

Fiscal conservativism needs to be coupled with some cultural conservatism that appreciates the self-indulgent reality of human nature. Economists sometimes talk about how wages are "downward sticky." When business conditions cycle downwards, wages typically do not go down in tandem with the revenues of employing corporations. The same applies to government spending, such that creating a consensus around program cuts is like herding cats. It follows that a conservative agenda would put a stop to the "step up on the wave peaks" strategy of government expansion by demanding measures that would reduce the volatility of government revenues. Moving towards a flatter tax structure and replacing the taxation of investment returns with a broad-based value added tax would help substantially in this regard, with the clincher being a hedging program.

Advocates who are not prepared to cut programs FIRST and THEN cut taxes should not call themselves fiscal conservatives, because all they are typically doing is calling for deficits and leaving it to the next generation to show true fiscal conservatism. "Starve the beast" is akin to the notion that the best way to get people with massive credit card debt to be fiscally responsible is to cut their salary. The people who think that this would actually work have an optimism about our capacity to act rationally and responsibly that I would not characterize as conservative.

re the second reason, allow me to introduce Alan J. Auerbach. After completing his PhD in economics at Harvard, Auerbach served as a Research Associate at the National Bureau of Economic Research and was Deputy Chief of Staff to a U.S. Joint Committee on Taxation in 1992. He's also a former Chair of the Economics Department at UC Berkeley and is currently Professor of Economics and Law at Berkeley while serving as Director of the Burch Center for Tax Policy and Public Finance. Auerbach has written extensively on taxation, but of relevance here are his observations in the Wall St Journal:

... eliminating capital income taxes would do the opposite, providing a windfall to owners of existing assets. Such a windfall would not only lower progressivity... but would also substantially reduce potential growth effects.
Providing windfalls to existing capital costs lots of revenue. The revenue loss could be made up only by higher taxes on future labor income, which would reduce incentives to work.

The idea here is that if, for example, we just announce that taxes on capital gains are to be eliminated, everyone tax-resident in the jurisdiction would prepare to sell their old capital assets to buyers outside the jurisdiction and consume the proceeds in the consumption tax-free environment that continued following the introduction of the capital gains tax relief. Capital income tax relief thus has to be implemented as a package deal with a consumption tax change.

Auerbach goes on to note that "A consumption tax could increase GDP substantially in the long run."

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