Debt Crisis: A Look at Tax Reform Solution

July 21st, 2011
in Announcements

by Guest Author Lance Roberts of Streettalk Live

This past week Paul Krugman wrote an article entitled "Getting To Crazy" in the NYT where he lambasts the GOP for, well, being crazy about not getting on board with the President and Democrats on the trillions in cuts being offered in order to raise the debt ceiling:

Follow up:

"President Obama has made it clear that he's willing to sign on to a deficit-reduction deal that consists overwhelmingly of spending cuts, and includes draconian cuts in key social programs, up to and including a rise in the age of Medicare eligibility. These are extraordinary concessions. As The Times's Nate Silver points out, the president has offered deals that are far to the right of what the average American voter prefers — in fact, if anything, they're a bit to the right of what the average Republican voter prefers!

Yet Republicans are saying no. Indeed, they're threatening to force a U.S. default, and create an economic crisis, unless they get a completely one-sided deal. And this was entirely predictable."

First of all, this is an obvious slanting of the facts. President Obama, nor the Democrats for that matter, have come forth with any defined plan to cut spending. Secondly, as the GOP rightly knows, the Democrats talk a good game but when it comes time to get down to action, things tend to fall well short of the goal line. Yet, we are told, the Republicans are the "crazy" ones for not signing on to a deal that is not defined simply in exchange for "revenue enhancements", which is simply code for tax increases.

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I have written a lot of articles about the issues with taxing the wealthy. The "wealthy", defined by the current administration as those making more than $250,000 a year, also happen to be the same group of individuals that comprise the largest percentage of small business owners - the group that creates the majority of jobs. Furthermore, when you look at the data, they are already paying more than their "fair share". The top 10% of wage earners pay more than 70% of all of the taxes while the top 25% covers almost 90% of all the taxes collected. Here is my "radically moderate" view point: Tapping the people who already pay 90% of the tax bill will not create more revenue. On the contrary, it will cause further economic weakness.

Let me explain. First of all, tax rates have been declining since Roosevelt was in office, with only small occasional upticks along the way. However, if you look at the next chart you will see that tax revenue is more closely associated with the rise and fall of economic growth. When tax rates have increased, the result has been slower economic growth. Of course, the knee jerk reaction to slower economic growth was to reduce tax rates — which, not surprisingly, led to economic recovery.

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Krugman clearly doesn't understand this when he states that "Beyond that, voodoo economics has taken over the G.O.P. Supply-side voodoo — which claims that tax cuts pay for themselves and/or that any rise in taxes would lead to economic collapse..." First of all tax cuts DO pay for themselves through higher revenue collections due to stronger economic growth. As the economy strengthens, more people are employed, which in turn creates more tax revenue. Secondly, tax hikes won't create economic collapse. Rather it will slow economic growth. The data is irrefutable.

Maybe Krugman should do one of two things: 1) Take a look at the data which shows that when tax rates rise, the tax base shrinks and ultimately reduces revenue collection or 2) just listen to John F. Kennedy when he said: "Our true choice is not between tax reduction, on the one hand, and the avoidance of large federal deficits on the other. It is increasingly clear economy hampered by restrictive tax rates will never produce enough revenues to balance our budget just as it will never produce enough jobs or enough profits."

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Raising taxes now could not be at a worse time. With unemployment at 9.2%, most economic indicators are now showing weakness as the massive injections of stimulus spending have run their course and consumer sentiment at recessionary levels. The last thing the economy needs now is higher taxes that cause real economic harm. Why? Because workers, employers, savers and investors all base their decisions off of after-tax returns.

It's A Spending & Debt Problem

Revenue is not the problem. It is the spending and debt. The true burden on taxpayers is government spending, because the debt requires future interest payments out of future taxes. As the debt burden on an economy falls, not surprisingly, economic growth increases which also results in higer levels of tax revenue. As debt levels rise economic growth is burdened by the debt load which reduces the ability to collect tax revenues.

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As my good friend Doug Short explains "There is a logic to the Debt-to-GDP ratio increases within the historical context of two World Wars and the Great Depression. Likewise, the steadily decreasing ratio over the next 35 years enabled the tax cuts in 1964. In contrast, the Economic Recovery Tax Act of 1981 was followed by an 18-year secular bull market that began the following year and, paradoxically enough, by a reversal in the direction of the Debt-to-GDP ratio. Correlation does not imply causation. Federal tax revenues did decrease fractionally in 1982 and by a more significant 6% in 1983. But the recession from July 1981 to November 1982 (culminating in 10.8% unemployment) was a key factor in the revenue slippage. There were other epic factors that played roles in the reversal — among them the gradual transition from manufacturing to a service-based economy, the dawn of the Age of Information, and a gradual relaxation of both private and public concern about debt."

This is the same problem that many households in America face today. Many families are struggling to meet the service requirements of the debt they have accumulated over the last couple of decades with the income that is available to them. They can only increase that income marginally by taking on second jobs. However, the biggest ability to service the debt at home is to reduce spending in other areas.

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This has been exacerbated by the decline in wages on a year over year basis as the transition from higher to lower growth rate economy has created on wage growth forcing households into debt to maintain a higher standard of living than what otherwise should have been.

The increase in total market debt has decreased economic output as savings and productive investment have declined. In addition, the servicing of the debt is consuming a larger and larger portion of the incoming revenue. This is critically important to understand, because if we continue down this path, we will theoretically reach the point at which the majority of all future revenues will be consumed by debt service. Where does this leave other spending needs, such as entitlements, defense and health care? We are clearly on an unsustainable trajectory, and income taxes can only be increased marginally due to higher rates.

Krugman's misunderstanding of the problem is symptomatic of the problems that plague our economy and our Administration today. Obama had it right we he said the "Jobs...Jobs...Jobs" was what America needed. High unemployment leads to lower economic growth.

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We now know that raising taxes does not increase revenue as higher taxes lead to lower economic growth. As shown in the chart if you want to increase revenue you need to produce economic growth. It will surprise most people that over the last 50+ years regardless of the level of tax rates - tax receipts as a percentage of GDP has remain mired between 16 and 21%.

Why? Because when you raise taxes you lower economic growth and therefore you collect less in revenue. This is why during recessions your tax collections are at the lower end of the range. Not surprisingly, during periods of economic growth, the tax collections are at their highest levels.

A reduction is spending is what is needed in order to start using more of the available revenue to pay off debt and reduce the interest payment burden on the budget. But even that isn't enough.

Tax Reform Is The Real Solution

Let's take a look at the first chart one more time. The problem is that 52% of Americans effectively pay the entire tax burden. If you want to create more tax revenue without inhibiting, and even potentially increasing, economic growth is to reform the burdensome, cumbersome and loop hole riddled tax code into a more efficient version that contains lower tax rates that encompass a broader base of economic activity and people. I have my favorite ideas in this regard but whether it is a consumption tax, fair tax, flat tax or just a massive simplification of the current tax code with an elimination of loop holes and credits - all will provide more positive economic results as long as they are combined with a reduction in spending and debt.

Just like the family sitting around the kitchen table that are faced with outgoing payments exceeding the level of income coming in - it becomes a matter of sacrifice, diligence and determination to pay down the debt and get their financial health restored. We can do the same thing in America. It is possible — it just won't be pain free and without sacrifice on everyone's part.

Maybe Obama should remember this quote:

"The fact that we are here today to debate raising America's debt limit is a sign of leadership failure. It is a sign that the U.S. Government can't pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government's reckless fiscal policies...Increasing America's debt weakens us domestically and internationally. Leadership mean that the 'buck stops here.'

Instead, Washington is shifting the burden on fad choices today onto the backs of our children and grandchildren. American has a debt problem and a failure of leadership. Americans deserve better."

That is what he said as a Senator in 2006 when we were talking about raising the debt ceiling from $9 Trillion. Today at $14 Trillion and counting; some real leadership would be a nice change.

But who knows...maybe Krugman is right and I am just "crazy".

Editor's note:  This article also appeared at Advisor Perspectives



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