The Buffett Rule and the reality of taxation

The Warren Edward Buffett rule or The Art of Illustrating The Unfair Tax System is legislation proposed by the Obama administration, named after the esteemed head of Berkshire Hathaway that would enact a 30% tax rate on all Americans bring in more than $1 million in income, inspired by the namesake's outrage that he pays a lower tax rate than his secretary.

In truth, I hope that Buffett would. With his wealth I would think he would have an army of accountants at his disposal to make sure he can secure every last advantage in the American tax system.

As for the Democratic Party, it's another folly (estimates put it at only a potential $50 billion in revenue that would be brought in) that is designed to score political points (by putting it voters mind that the Republican Party is still the party of the wealthy), in yet the latest example of how not to implement Keynesian economic strategies (no matter how much Paul Krugman favors legislation like this).


Candy Crowley's "spoiler" was humorous, yet true: this legislation has no chance in hell of passing. We're more likely to see Mitt Romney be consistent in his campaign banter that we would see tax-increasing legislation.


It's time to address the one thing that we long had to address: the reality of taxation. Before, I begin, there are two fundamental truths in regards to the current fiscal state of the United States government:

1. The government spends too much.
2. The government doesn't make enough money.

While the latter may seem preposterous, and there are some people accusing the government of actually being a corporation, in a way, as one of my friends put it who graduated with a degree in economics, the government is somewhat organized as a corporate firm.  The President is the chief executive, the Congress is the Board of Directors, and the constituents are stockholders. As with any company, spending is only one part of the problem: a company still needs adequate income to appropriately function. What your idea of "appropriate function" is in the eye of the beholder, in accordance to your political philosophical beliefs, of course.  For me, the function of really any government is to protect the civil liberties and civil rights of its citizens, to adequately defend the citizens of its country, and to soundly participate in a more interdependent world.

Cue the grumblings of debate. Let me stop before I digress any further.

Combine this with the expectations people have about what government should do, a distorted quandary is born. Cute pleas for tax cuts, tax credits, and the such.
So there are five fundamental facts that people should realize about "tax cuts":

1. They never pay for themselves (see the fiscal success of the Reagan and Bush tax cuts).
2. Most people do not make enough money in income to really see a benefit to tax cuts, beyond that, most people don't even pay enough in taxes to really see a benefit to tax cuts.
3. As long as private debt is high (the individual debt to income ratio stood at 112% last year), tax cuts will yield little to no economic benefit.
4. Tax cuts are a useless way to stimulate demand -- it stimulates the demand to have money to pay off debts, if you want to look at it in a smart ass, sarcastic way. Then again, in a way that is a legitimate argument.
5. Tax cuts create more fiscal issues than they resolve.

However, there are four fundamental facts about "taxing the rich":

1. Taxing the rich is of questionable economic benefit.
2. Marginal tax rates in the United States are at historical lows.
3. The wealthy actually pay more than their fair share in taxes, which may shock some people.
4. The wealthy (which for this statement, I'll consider the top 20% of income earners), for the most part still has substantial buying power after taxes over most Americans.
5. Because the wealthy take on so much of the tax burden, increased taxation on the wealthy yields little fiscal benefit, for that there are not enough Americans paying income taxes.

(Before I go any further, I wanted to elaborate on point #3. In 2009 the Congressional Budget Office released numbers that were interesting: the wealthiest 20% of Americans made nearly 56% of all pretax income in the United States, yet paid close to 70% of all federal taxes, a 14% discrepancy. The overall effective tax rate in the United States was 20.7%, which is not even top 50 in the world). Further more, the top 1% paid 28% of all federal taxes in 2007, and a 40% share of income taxes that same year. 

Now that I got "tax cuts" and "taxing the rich" out of the way, it's time to further illustrate the silliness of the American tax code:

1. 47% of American households did not pay income tax for the 2010 tax year. Of that 47%, nearly a third had incomes of $10,000 or less (which automatically puts them in the poverty threshold); of that 47%, nearly two thirds made less than $20,000; of that 47%, nearly 90% of them made less than $40,000. 
2. University of Michigan economists Joel Siemrod told NPR that while the top 10% of income earners pay 70% of the income taxes, they only make 40% of the income. It should be noted that entry into the the top 10% income club begins $110,000 for the 2011 tax year.
3.  Tax rates would have to increase by 50% on all levels to even possibly begin significant reduction of the federal deficit, Siemrod said in the same interview. However, I don't think it took into account spending cuts as it was not mentioned. 

A lot of economists are beginning to argue in favor of the value added tax system (you heard of it called "consumption tax", "luxury tax", or "FAIR tax"). While it would expand the tax base to force more people to contribute to it and end the income tax system, it comes at a cost -- it would have an adverse effect on consumption considering that a value added tax system punishes those with lower incomes. As such the cycle would begin once again in regards to loopholes, exemptions, and credits.
In truth, there are two reasons why the American tax code fails to work:

1) The tax code does not work as it was designed: For the most part, the tax code was designed to be fairly straightforward. The only issue is, the tax code got designed and redesigned for political points and pandering. The ones that benefited the most from these changes in the tax code are the wealthy and the married with children.

2) The tax code depends too much on one thing - income: As the tax code primarily depends on income for it to work properly, its vulnerable to changes in the economy and individual economic behaviors. 

So what's the solution?

A two-tier tax system that would combine two fairly brilliant ideas:

1. A value-added tax system that would equate to being roughly equal to one half of the average sales tax rate of all 50 states in the United States, with deductions placed only on food and medication.
2. A income tax system that reconciles each tax bracket to the poverty level income threshold. I wish I still had the link to where I read that idea (I do not take credit for it). The only difference would be that I suggest a multiplier system (i.e., 1.5 times over the threshold, 2.5x over the threshold, 3 times over the threshold, and so on.), with the poverty threshold formulated using the proposal by the U.S. Census Bureau put forth in 2011, which would be a vastly improved and more realistic alternative to the "thrift-basket model" that's been in use since the 1960s. 

At the same time, numerous tax credits, deductions, special case of income (i.e., a separate tax rate for capital gains taxes), and other loopholes would largely be eliminated. It forces more people to pay taxes, eases the evasion and regressive taxation issues of the value added tax system, and still maintains a progressive tax structure in regards to income.

Fareed Zakaria wrote that the best tax code would be one that can be written on two pages. Mine would take no more than five.

Close enough.

I'm well aware that I did not delve into federal spending. This post was not about federal spending -- it was about taxation, and taxation only.

Could we learn something from the Canadian model?

I came across a highly interesting column concerning early 1990s Canada, who which saw their debt to GDP ratio skyrocket, slow growth stemming from high interest rates, and downgrades by the major credit rating agencies. Canada's welfare state grew under Prime Ministers William Lyon Mackenzie King, Lester Pearson, Pierre Trudeau, and Brian Mulroney, but reached a point that by the 1980s, fiscal issues stemming from the expansive social programs along with the slowing growth were looming and would eventually explode heading into the 1990s. Further exacerbating this issue was the weakness of the Canadian dollar.

After a Liberal Party budget released in 1994 to widespread criticism for the fact that it still included spending increases despite the numerous reforms that were included in the budget package, Chretien, then Finance Minister Paul Martin, and the rest of the Liberal Party broke out the scissors, shears, axes, chainsaws -- whatever adjective that describes cutting that you want to use -- and took to reducing Canada's debt.

Canada's debt-to-GDP ratio reached its all time peak in 1995-96 in the midst of the implements of the cuts. Growth actually did stagnate, according to a CBIC study, whenever Martin called for widespread spending freezes in 1996. Chretien would push for departments to cut budgets -- which ranged from as little as 5% to as much as 65%. In addition, the ratio of spending cuts to revenue increases were 7 to 1, as Chretien would note in his interview with Reuters it was about "what was needed most." The spending cuts did have adverse effects as Canada's Medicare system suffered budget cuts that lengthened medical waiting lists (which is what you hear of constantly when United States conservatives deride the Canadian healthcare system) and put many provinces in a serious bind as they depended on the federal government for funding of some services.

The final component of the turnaround came when the Bank of Canada lowered interest rates in 1996, allowing Canada to finally reap the benefits of the fairly positive global economy, spurred by the United States and China's economic growth. Canada's budget returned to black ink in 1997 and remained so until the global financial crash and North American auto industry crash of 2008 and 2009. There's also the fundamental difference between the Canadian outcome from the recession as opposed to the outcome in the United States -- Canada emerged from it a year later as the most fiscally healthy country of all the G7 nations.

There are two key things about the success of Canada -- for one, the Canadian government scaled back to a more manageable proportion of size and role versus population it is supposed to serve. Let's not get confused here -- Canadian social programs are held to high regard and are fairly popular in Canada, even though some of the Canadians I spoke to complain about the Goods and Service Tax.  In addition, and probably the most important thing, is that the Canadian government was largely united in tackling the deficit.

However, here in the present-day United States, we're treated to ideological warfare between a left that is sick of concessions and a right that is exercising reactionary power play. Austrian economists such as presidential candidate Ron Paul (R-TX) argue for spending cuts, tax cuts, and reduced government while Keynesian economists such as Nobel laureate professor and New York Times columnist Paul Krugman that argue against draconian cuts because of the harm they would do to the economy. I cite Paul as an example because Paul has demonstrated to be the only person on the Republican side that truly has an understanding of economic theory. I cite Krugman, not because of him being a Nobel Prize winner in economics, but because he is the largest trumpeter for the mixed economy.

The Canadian government's austerity push in the mid-1990s proved both of them to be right. As stated before, spending freeze mandates and tax cuts actually stagnated Canadian economic growth (proving Krugman right), while at the same time allowed the Canadian government to become leaner and more efficient (proving Paul right). However, the fundamental difference was how instrumental the central bank was in Canada's recovery -- something that would be to the chagrin of Paul, but not exactly -- the Bank of Canada decided to finally rectify years of poor monetary policy by reducing interest rates. The Federal Reserve's monetary policy is pointless -- low interest rates really only work when banks see credit extension as an asset and not a liability.

The true value of Canada's turnaround is not necessarily about luck; its about how political leaders put aside ideology for the greater good of a nation in recognition of what needed to be done. The Liberal Party cutting spending is similar to the Republican Party reversing Bush era tax cuts, but as much as the Liberal Party hated to do it (as then Finance Minister Paul Martin once disclosed), the Party had to set aside its ideological platform of social welfare expansion for the greater good of Canada. The Liberal Party actually demonstrated that neither political party has been able to demonstrate down here -- putting aside a staunch ideology stance to bring needed stability to the country instead of only having a narrow minded view through the eyeglasses of their beliefs as to how to achieve it. The greatest failure, in my opinion, of Washington these days is that a political party's need to triumph in political chess is outweighing getting anything done -- especially in the case of the Republican Party.

There was an additional footnote that Chretien and others noted that politicians can still win elections despite massive austerity measures. However, one thing that kept Chretien in power for 10 years as Prime Minister was the growth of the Canadian economy in the late 90s to the early 2000s. If people can see a beneficial payoff of a given administration, then people will keep that administration in power. People saw the payoff in keeping Ronald Reagan in power in 1984, Bill Clinton in 1996, and George W. Bush in 2004.

So what is the greatest lesson that can be learned from the Canadian austerity model of the 1990s? Its not the spending cuts and tax cuts and those said cuts exceeding, by proportion, increased taxation. The reason why the measures taken by the Liberal Party of the mid-1990s worked for Canada is because Canada provided a welfare state that was way too big for a population to be able to pay for and had an economical system that allowed for the federal government to carry too much weight in the mixed economy balance. The issue in the United States is less about the welfare state and more about entitlement spending and an eroding tax base augmented by a complicated tax code that actually does more bad than good to the fiscal health of the United States. The biggest lesson learned is that the controlling Liberal Party set aside ideology to solve a problem. The United States government needs to solve problems first and worry about how that problem solving abides to ideology second (preferably, not really worry about it at all). A continued failure to do that will only exacerbate problems and quite possibly lead the United States to that "decline" from the perch of secured supremacy in an insecure world.