Why do we pay taxes?

The following is an e-mail communication with Dr. L Brownstein of the University of Leeds in the UK. It is in reference to the post on student loans from a couple of days ago (here). Dr. Brownstein argues that the losses from defaults on the loan portfolio held by the federal government would not accrue to the taxpayer. This would mean that the taxpayer is not “footing the bill” on other losses such as Freddie and Fannie bailout, etc. It’s quite a counterintuitive statement because it begs the question of why we pay taxes at all. The answer – which works under the assumption that the federal government and the central bank are one and the same - is below. Thoughts, comments?

Dr. L Brownstein: When you mention that the taxpayer is footing the bill, this is a macroeconomic error. To check this, have a look at Randall Wray's Modern Money Theory. Taxes don't underwrite government expenditure - they are irrelevant to it. Taxes serve other economic and social functions.

Sober Look: Thanks for your comment. If "taxes don't underwrite government expenditure - they are irrelevant to it", why are we paying taxes at all?

Dr. L Brownstein: There are a number of reasons to pay taxes. One is to legitimate the currency, as your taxes can't be paid in any other currency than the one legitimated by the government. This means that you have to use this currency and no other. Another function of taxes is to serve as an economic redistribution mechanism, which is a political function that sometimes works well and at other times not so well. At present, it isn't working well in this sense at all. A third function of taxation is to control spending, sometimes as an aid to reduce inflationary pressures. Whether this is the best mechanism for doing this is a matter of some debate.

None of this has anything to do with supplying the government with money to spend. The type of economic system we have now is what is known as, and called so by Keynes, a fiat system accompanied by a floating exchange rate with foreign currencies. In a fiat currency system, money is created by government fiat, that is, ex nihilo, out of nothing. Should anyone else attempt to create this currency, they become counterfeiters. Where else can it originate?

If the government creates all the money, then it must spend it before anyone has any of it to pay any taxes that might be owed to said government. In a deflationary situation in which we currently find ourselves there is a good argument for substantially reducing the tax burden for both companies and individuals. In an inflationary situation, this may be a good time, depending on circumstances, to increase taxes, which would hopefully calm economic activity.

This means that a government with its own sovereign currency can never go broke. The US Constitution mandates the government to pay all its debts. Congress may interfere with this but this becomes a political issue. The US, the UK, Japan, and other sovereign nations with their own sovereign currencies are not like the members of the Euro, who have surrendered their own sovereign for a foreign currency over which they have very little if any control. Neither the US nor the UK are in the position of Greece or Spain. These countries can go broke. And, like California and other individual states of the US, must balance their budgets. There is no need whatsoever for a sovereign government to balance its budget, as it is under no economic constraints given that it is the creator of the currency in the first place.

There are a number of consequences that flow from looking at the system is this way and I have no space to go into them now, so instead I invite you to read Wray's Modern Money Theory. This issue, among many others, is discussed there.

SoberLook.com

From our sponsor:

This is what happens when regulators don't understand the market place

Dumb regulation will usually result in "unintended consequences". In the area of securities regulation, it is often the "unintended participants" who end up paying the price. Just as the derivatives regulation in the US is potentially hurting energy merchants (see discussion) and could even disrupt the energy markets, the latest anti securities industry drive in France is not achieving what it was supposedly designed for.

After Hollande claimed that his main adversary “was the world of finance”, he pushed to implement transaction tax on those evil speculators. Except that it didn't quite work out the way he intended it.

SFGare: - As France begins collecting its financial-transactions tax this month, it is becoming evident that President Francois Hollande’s levy is hitting all but the people it was aimed at: speculators.

Hollande, who called finance his “main adversary” during his election campaign, pushed through in August a 0.2 percent transaction tax on share purchases, making France the first and only country so far in Europe to have such a levy. Many investors have been escaping the tax using so-called contracts for difference, or CFDs, offered by prime brokers that let them bet on a stock’s gain or loss without owning the shares.

The small investor will indeed end up paying that tax. But the larger, more sophisticated players, including institutional funds, will simply move to the CFD market. A CFD contract is basically a forward agreement on a stock, and index, a commodity, or anything else for that matter (see attached overview). It is illegal in the US to trade forwards on a single stock, but the practice is quite common in Europe, Asia, and Australia.

In fact a fund that wants to trade a French stock (including shorting it), can simply execute a CFD with a UK (or some other) broker. One doesn't physically own the shares, but will get all the economics of the stock without fully paying for it. That's right, not only does the "speculator" avoid the new French tax, but the CFD market allows these investors to put on leverage that would be difficult to achieve in trading the stock directly. It is also a more efficient way to short stocks.

So while the small French investors are paying these new taxes, the institutional "speculators" that use leverage, active trading, and shorting, have a loophole that would be quite difficult for French regulators to close. Well done, Mr. Hollande.



CFD market information sheet

SoberLook.com

US top dividend tax rate will become the highest in the world; tax increase will hurt savers, economy

Starting January 1 of 2013 the top tax rate on dividends in the US will officially become the highest in the developed world. If you live in NY for example, the top rate on stock dividends will be close to 50% - which is significantly higher than France.

Source: JPMorgan

Capital gains tax will also increase from 15% to 25%. Many in the US will of course say "great, tax those fat cats". But there are a few problems this policy.

1. With negative real interest rates hurting US savers (see post), for many investors who are trying to save for retirement, high dividend stocks have been a good option. But no longer. Savers have been penalized by the Fed for holding cash and now they will be punished by the government for owning high dividend stocks.

2. According to JPMorgan, this dividend tax will reduce mature firms' valuations by $1.5 trillion. That's going to hit private and state pensions as well as IRA, 401K, and 529 accounts. But that's OK because the "fat cats" deserve it.

JPMorgan: - Capitalizing this foregone capital income generates a $1.5 trillion reduction in equity market value, or about 6% of the $24 trillion value of corporate equities at the end of 2Q. Standard wealth effects suggest this will reduce consumer spending by a little over $50 billion, or about 0.5%.

3. Many firms will choose share buybacks instead of dividends. That hurts those who rely on dividend stream for income (such as retirees). It will also hurt the government because rather than getting some dividend tax revenue as they did in the past, in such instances the government will get none.

4. Smaller firms will have a tougher time raising capital due to the increase in capital gains tax. That will have a direct spillover into job creation.

With GDP growth under 2% and anemic labor markets, this is just what the US economy needs now.

SoberLook.com

Summary of tax rates in the Eurozone

Here is a good summary of key tax rates across the Eurozone as well as recent changes. As always it's a delicate balance between revenue and growth. In Spain (and Italy to some extent) tax increases have materially dampened economic activity.

Source: GS

Below are Goldman's observations on taxation in the Eurozone:

GS: Many countries implementing fiscal adjustment have increased their VAT rate. ... the three programme countries - Greece, Portugal, and Ireland - have the highest current VAT rate, at 23%. Italy raised its standard VAT by 1ppt to 21%, with another increase planned for next year. Spain also increased both its standard and reduced rates this month. This contrasts with France, which has not changed its VAT rate. Indeed, the newly elected parliament voted against a planned hike in VAT initiated by the previous government. The measure was intended to allow a reduction in French employers' contributions to the social security system. But the new government judged the measure ‘unfair’ for the French consumer. Finance minister Moscovici has moved away from any increase in VAT or CSG social taxes to cut the budget deficit, although they cannot be ruled out, in our view.

... Corporate tax rates have shown more stability. Since 2009, the corporate tax rate has changed in just two countries: Portugal has gradually raised it from 26.5% to 31.5%, while Greece has lowered its rate from 25% to 20%. Ireland in particular has a much lower rate than in the other countries.

SoberLook.com

Japan's catch-22

The Japanese government has made some progress in its efforts to generate additional tax revenue. The increase in the national consumption tax was finally passed. Japan urgently needs to begin addressing its runaway fiscal problem.

WSJ: - Japanese Prime Minister Yoshihiko Noda won a major victory in finally securing the passage of a hard-fought tax-increase package last week, but analysts argue that a provision in the law to consider economic conditions before implementation means the battle to achieve the tax increase isn't yet over.

The law to raise the national consumption tax to 10% from the current 5% in two stages by 2015 was passed Friday after a dramatic week of political brinkmanship that forced Mr. Noda to promise general elections "in the near term" in return for opposition support for the legislation.
... 

Once at the full 10% rate, the tax is expected to generate an extra ¥13.5 trillion ($172 billion) annually, which could help stem the country's mounting debt pile, now at nearly ¥1 quadrillion and equal to more than 200% of annual gross domestic product.

Debt vs. deficit for developed nations (source: GS)

Outside analysts and ratings agencies have stressed that a tax increase is a vital first step in repairing Japan's finances, but insist that more is necessary, including measures to boost GDP.

This tax increase however is by no means a done deal. The law requires the government to consider economic growth conditions before implementing the tax.

WSJ: - The provision in the law says the government should consider the overall economic situation before implementing the increase and calls for policies to achieve annual average economic growth of about 3% in nominal terms, or about 2% in real terms, by fiscal 2020. But these figures are a stretch for a deflation-hobbled Japan that hasn't seen such growth rates since the early 1990s.

This is a no win situation. Waiting for strong growth, particularly in this environment maybe futile. And the longer Japan waits the less likely they are to achieve target economic expansion. The latest analysis from Goldman shows that Japan's rapidly aging population will soon begin to severely impede growth.

Japan's percentage of "productive" population is declining faster than that of any other major economy (also discussed here). With restrictive immigration policies and low birth rates, the "vacuum" created by the aging boomers is not filled.

Japan's working age population % (source: GS)

Because of this decline in productive population, Goldman predicts that Japan's capacity to grow economically will become more constrained in the next few years.

Japan's growth forecast (source: GS)

At no point going forward is Japan expected to grow at 2%. So when should the government implement this tax increase? Some in Japan argue it should not be implemented at all because the last increase in 1997 ended up pushing the nation into a deflationary spiral.

WSJ: - Critics have blamed the last tax increase in 1997 for wiping out the nation's fragile post-bubble economic recovery and triggering deflation, which continues to plague the economy 15 years later.

It truly is a case of "catch-22". Raising taxes now risks putting the nation into another recession and is not permissible unless the government believes they can improve growth. At the same time waiting for growth that may never come (per model above) will certainly accelerate the deterioration of Japan's fiscal conditions.

SoberLook.com

We are approaching a US fiscal cliff

Unless the US Congress takes action this year, the nation will be facing a "stimulus" reduction via changes in tax rates and federal spending provisions, all taking effect in late 2012 and early 2013. Here is the list of these provisions:

1. The Alternative Minimum Tax (AMT), currently at 28% for those filing jointly with incomes of $74K or greater, will drop down to $45K. That means that middle class families making over $45K will not be able to use deductions (medical, etc.) to pay less than 28% in taxes - a substantial tax increase on the middle class.

2. The so-called "doc fix" provision, which is currently keeping the government from implementing a 25% cut on physician payments by Medicare, will expire unless Congress acts.

3. The Payroll tax cut will expire at the end of 2012, increasing from 4.2% back to 6.2%.

4. The Super Committee's inability to reach a decision last year will force mandatory cuts (sequester) in the US government's discretionary spending. A great deal of that will hit the defense industry.

5. Unemployment benefits for workers who have exhausted the standard 26 weeks of benefits will be phased out.

6. Numerous temporary research and development tax benefits to corporations will expire.

7. The 2001 and 2003 tax cuts are set to expire. This includes tax rates on those making over $250K as well as qualified dividends and in particular the 15% rate on long term capital gains. People are wondering why we are having a string of large IPOs this year (including may private equity backed IPOs), even in a less than friendly IPO environment. Part of the reason is that the current cap gains tax rate may be the lowest that the owners will be paying in the foreseeable future.

8. At the end of the year the infamous debt limit will hit again, potentially forcing further cuts.

According to Goldman Sachs, the total of amount of dollars the US government will be taking out of the private sector and households is about $600 billion. Clearly some of these provisions may be modified or extended. But given the sharply divided Congress and the contentious election year, the political impasse is likely to continue. A large portion of these tax increases and austerity measures may take effect. These changes will potentially be a positive for the US budget deficit, but for an economy that is still fragile and somewhat dependent on government stimulus, it will certainly generate a material drag on the GDP growth.

SoberLook.com

Who pays the taxes in your neighborhood?

Here is an interesting exercise. Download the 2008 tax spreadsheet from the IRS website for your state to see who files returns along with amazing amount of other information - dependents, mortgages, deductions, etc.

You will be able to chart who pays the taxes in your area. And the chart will probably look like this, with the highest earners (the famous 1%) paying the bulk of the taxes.   Enjoy.

California running out of options

The great State of California has been backed into a corner. Here are some recent facts:

• California's unemployment rate is now at 11.5%
• Sales tax in LA is now 9.5%
• Fresno County is a federal disaster area hit by a three-year drought. It's destroying California’s agricultural industry. Fresno county unemployment is near 17%.
• The rating agencies are threatening to crush the CA bond ratings.

From Moodys:

NEW YORK, Jun 19, 2009 -- Moody's Investors Service has placed the State of California's A2 general obligation rating, as well as the ratings for lease debt and other state-backed debt listed below, on Watchlist for possible downgrade. The Watchlist action reflects the following: an expected budget gap of over $20 billion (or more than 20% of the state's General Fund budget) in the state's fiscal year 2010 budget; the announcements by the state controller that without solutions the state will not be able to meet all its financial obligations in July; the continued political stalemate that has resulted in inaction by the legislature thus far; and the limited solutions available to the state. Although the executive branch has proposed a package of budgetary and cash measures, thus far no meaningful solutions have come out of the legislature.

In addition, Moody's has placed the Aa3 global scale rating assigned to the California Federally Taxable General Obligation Bonds and Stem Cell Research and Cures Bonds, Series 2007A, and the A2 global scale rating on the California Judgment Trust Certificates of Participation Series 2005 on Watchlist for possible downgrade.

The difficulties the state is facing include the following:

* After enacting a budget for fiscal year 2010 in February, the economy has continued to deteriorate and the state is now expecting budgetary gaps for fiscal year 2010 of over $20 billion.

* Budgetary solutions are more limited now that the voters did not authorize the state to issue deficit bonds secured by lottery revenues.

* Without legislative and executive solutions, the state is expecting to run short of cash beginning in July.

A downgrade will significantly limit California in issuing new debt. An impasse over taxes leaves them with very few options. The document below from the governor's office shows just how limited.

Some difficult questions: Should CA be massively cutting the educational system, the prison system, or Medi-cal? Maybe raising the already ridiculous state taxes, putting the state deeper into recession? Or defaulting on their debt? Unthinkable until recently. The impact on various retirement funds will be unprecedented. Will the US taxpayers come to the rescue?

California crisis is looming.