High Taxes and Tax Avoidance

The most profound comment in the news yesterday was, in my mind, this quote:

“The highest tax bracket income earners, when compared with those people in lower tax brackets, are far more capable of changing their taxable income by hiring lawyers, accountants, deferred income specialists and the like. They can change the location, timing, composition and volume of income to avoid taxation.”

This comes from the keyboard of Arthur Laffer of Supply-side economics fame. (See, http://professional.wsj.com/article/SB10001424052748703977004575393882112674598.html.) Laffer then gives several examples of such avoidance behavior: Senator John Kerry of Massachusetts, former Senator Howard Metzenbaum, and former Chairman of the House Ways and Means Chairman Charles Rangel.

I totally agree with Laffer on his major point.

This avoidance behavior also exists in the presence of an “inflation” tax. Whereas inflation has been touted as benefitting the “less well-to-do”, this is just a short-run help. Over the longer run, the “less well-to-do” cannot protect themselves very well against rising prices and so end up with lower real wages, real wealth, and fewer job opportunities.

As in the case of government assessed taxes, those individuals in the highest tax brackets or who have accumulated the greatest amounts of wealth are more capable of protecting their real income and real assets from an inflationary depreciation “by hiring lawyers, accountants, deferred income specialists and the like.” They can find many ways to avoid inflation that are not available to the “less well-to-do.”

There are three points that I would like to make relative to the above comments. First, many policies that attempt to help one class of people in a democratic society at the expense of another class of people may succeed in the short run. However, in the longer run, these policies tend to rebound on the former class of people, making them worse off, while achieving little or nothing in terms of the latter class.

In some cases these efforts produce a “negative-sum game” result in which everyone loses something. And, this leads me to the second point. By facing off “one class” of society versus “another class” of society, antagonisms are created, suspicions are raised, and society tends to be worse off. This is not what is supposed to happen in a liberal, democratic nation.

A liberal society works where people cooperate with one another and build community. To quote Ludwig von Mises on a liberal society: “It is important to remember that everything that is done, everything that man has done, everything that society does, is the result of such voluntary cooperation and agreements.”

I am not arguing in this post for or against renewing the “Bush tax cuts”. What I am arguing for
is a change in the rhetoric surrounding discussions about the federal budget, the rhetoric surrounding discussion about the financial reform bill, and the rhetoric surrounding many other issues in front of the American public these days.

Yes, arguing for one class against another may seem like good politics, but in America this really doesn’t win elections. Arguing for one class against another is a form of populism and the very politically astute Bill and Hilary Clinton have stated that elections cannot be won on a populist platform. (One reference on this point to Hilary Clinton can be found in Robert Rubin’s book “In An Uncertain World”.) I still remember watching Al Gore, in the 2000 election campaign, speaking in Mark Twain’s home town on the Mississippi River, Hannibal, Missouri, re-framing his campaign in populist terms. My immediate reaction was…Gore has just lost the election! And, he was well ahead of dubya in the polls at the time.

My third point is that very often people (and especially politicians) get caught up in the consequences of actions, which are current, and fail to see the causes of the these outcomes. This is a big problem in economics: many economic causes occur long before the consequences of the cause are recorded. For example, rent controls on apartments may lower housing costs for renters in the short run. However, if the owners of the apartments fail to maintain the units over time because of the reduced cash flows from the lower rental revenues, many will blame the “owner” and not the rent controls, for the now shoddy apartments .

An important example of this is the government caused inflation over the past fifty years or so. The gross federal debt increased by a compound rate of more than 7% per year from 1961 through 2008. A lot of this debt was monetized so that inflation increased at a compound rate of more than 4% per year during this time period accompanied by numerous asset bubbles which resulted from the excessive creation of credit. Financial innovation prospered in such an environment leading to greater and greater use of financial leverage, the taking on of greater amounts of risk, and the growth of “creative” accounting practices. Ponzi schemes also thrived in such an environment.

Why did businesses succumb to the taking on of excessive risk? The answer: in an inflationary environment, that is where the incentives are. If a company is out-performing its competitor by ten basis points then the competitor may assume more risk or take on greater financial leverage to pump up returns to match the competitor. The environment is cumulative in that more risk begets even more: or, as Chuck Prince, the CEO of Citigroup stated, “If the music keeps on playing, you have to keep on dancing.”

And who gets blamed? The greedy bankers…and not the government that created the inflationary environment. This point was made by the economist Irving Fisher in 1933: “If it is inflation and the one who profits is the business man, the workman calls the profiter a ‘profiteer.’ The underdog reasons as follows: ‘How did I get poor while you got rich? You did it, you dirty thief. I don’t know just how you did it; your ways are too subtle, sinister, dark and underground for simple me; but you did it all the same’

But, none of us—neither the farmer, nor the workman, nor the bondholder, nor the stockholder—thinks of blaming the dollar. So the real culprit stands on the curbstone watching us poor mortals as we beat out each other’s brains, and has the last laugh.”

Working together can result in a “positive-sum game”. The wealthy and those earning high incomes, at least most of them, believe that they should pay taxes. Maybe a new approach needs to be tried rather than attacking them and then trying to penalize them by enacting highly restrictive rules or excessive tax structures which they will spend great amounts of money to avoid.

The old methods don’t seem to work. Maybe we need to work to balance the tax laws so as to maximize tax revenues rather than punish one group of people over another. Maybe we need to think about creating a more open and transparent financial system that allows the economic process to work rather than saddle the economy with rules that dictate “outcomes”.

However, the old methods are built into the political system and will not change before this November. Guess we will just keep on shooting ourselves in the foot!