Sunday, February 28, 2010

Social Security is based on poor business model

Published in The Tennessean, February 28, 2010

Social Security is based on poor business model

by Richard J. Grant

Suppose you decide that you need a vacation, and the price of that vacation just happens to be $5,000. But you don't have enough cash, so you borrow the $5,000 from your retirement account and place an IOU for that amount in your account. Now you can go enjoy your vacation and pay yourself back later – perhaps with interest.

What is the effect of this action? Instead of $5,000 in cash assets, you now have a $5,000 IOU from yourself, as well as a $5,000 liability to yourself. Instead of a $5,000 net-asset position, you have happy vacation memories. Also, you might be pleased that you do not owe the money to a bank: you "owe it to yourself."

If you are happy with this outcome, that is fine. But what does it mean for your future?

If the IOU is still in your account when you retire, what is it worth? Let's pretend you could sell it for $5,000. But you would still owe the buyer $5,000, so you really haven't changed anything except the amount of cash currently available. The cash goes into the same pool from which you will pay back the loan.

To pay yourself back before you retire, you must still save $5,000 and shift it from your bank account into your retirement account. So either way you come out the same: you have chosen to consume $5,000 as a vacation rather than have it available for your retirement. You might just "work harder" to make up the $5,000; but you could have done that anyway.

Now let's look at Social Security. Until recently, the Social Security system was running a surplus of payroll taxes over outlays and put the proceeds into its trust fund. These surpluses were lent to the US government by purchasing special Treasury securities that are not marketable but pay interest and can be redeemed at face value.

As part of the government's general fund, the borrowed funds were spent on the usual multitude of programs, most of which is current consumption. The US government owes this money, now totaling just over $2 trillion, to the Social Security Administration, which happens to be a US government agency. (It owes another $2 trillion to other agencies.)

From the government’s perspective, the situation resembles that of the individual in the example above. The government, through the Social Security Administration, has obligations that it must pay to eligible retirees. To fund these payments it must draw on payroll taxes (from other people) and, now that it is running a deficit, on redemptions of Treasury securities from its trust fund.

When the government is repaying cash to the Social Security system, it must divert that cash from other uses. It must cut spending in other programs, or increase tax revenue to the general fund, or borrow from another source.

Unless something changes, the Social Security trust fund will be exhausted by the year 2037. (This looks good in comparison to Medicare's Hospital Insurance Trust Fund, which will be exhausted by 2017.) It was never intended that Social Security be a true investment fund based on sound investment practices. It is a pay-as-you-go system, much like that used by Bernard Madoff, except that Madoff could not levy a payroll tax to perpetuate his business.

The fate of the Trust Fund is useful to us as a market signal. It shows us that Social Security is based on a poor business model. It is just another welfare program, and its associated taxes add to the income-tax burden on workers.

We know that higher marginal tax rates are associated with lower rates of economic growth. We also know that most of our government spending, far from being a "stimulus," also reduces long-term economic growth. Most regulations cause more harm than good.

Knowing this, we can change. But it does matter which direction we go.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2010

Sunday, February 21, 2010

Government regulations limit consumers' options

Published in The Tennessean, February 21, 2010

Government regulations limit consumers' options

by Richard J. Grant

A business succeeds by moving resources from less-valued uses to higher-valued uses. The willingness of customers to pay for the product is a visible sign of its value to them. If customers provide a stream of revenue that significantly exceeds the firm’s expenditures, then the managers can conclude that the business is worth continuing.

If the managers believe that the firm's capital could be better used in another line of business, then they will shift into that other use. Again, customer reaction will guide them in their decision as to whether or not to continue. If customers are not willing to pay enough to cover the firm's expenses, then the managers must act on that information and change course.

Though we speak in terms of "businesses" and "managers," all commercial activity involves individual people interacting directly with one another. Every agreement reveals information about people's desires and their abilities to provide goods and services to each other. The more free and voluntary the interactions that we have with one another, the better informed and able we are to serve one another.

All this changes when our interactions cease to be free and voluntary. When we are coerced to act, even in exchange for some good, an observer can no longer be sure that we are all benefiting from the transaction. For example, were a mugger to induce me at gunpoint to hand over my watch, we could conclude that I am worse off. But if that same mugger then handed me a $100 bill, would that necessarily make me better off?

The answer is no. Sure, I got away with my life and $100; but I might still have preferred to keep things the way they were. The mugger took that option away from me.

When transactions are coerced, we lose information. It is harder for us to know how best to serve potential customers and how much it will cost us to do so.

This is what we all experience each day when we must deal with some regulation, or tax, or expenditure by government. Regulatory compliance takes away many options that would otherwise be available to individuals and businesses. Too often, regulations exist for the benefit of special interests, not the general public.

In a free and voluntary relationship, people would be able to correct their situation. They would have the right to say “No” to a bad deal. But in a political situation any such right is far more difficult to exercise.

Congress can impose a tax on people, and then spend the proceeds on other people. Although a citizen might consider this to be unfair or even unconstitutional, the remedy is not as simple as saying “no.” Reversing this imposition might entail a long and expensive process requiring the agreement of many other people.

The more politicized our lives become, the less information we are able to share about the realities of our desires and abilities. No matter how good our intentions, we are less able to serve one another.

The US Budget for Fiscal Year 2011 projects Social Security outlays to be larger than the payroll taxes in every year from 2009 through 2020. This deficit in the Social Security system can be corrected only with a political solution. Ultimately, that means some combination of reduced benefits and higher taxes.

Medicare is worse. Already, Medicare payroll taxes cover barely 40 percent of Medicare outlays. This is not even including Medicaid.

In a free market, wise customers would have said no to all of this. We would not be facing this actuarial disaster.

Social Security and Medicare are nice things. But we would all be better off now if Congress had better understood James Madison’s words: "I cannot undertake to lay my finger on that article of the Constitution which granted a right to Congress of expending, on objects of benevolence, the money of their constituents.”


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2010

Sunday, February 14, 2010

Raising tax rates eventually results in smaller tax base

Published in The Tennessean, February 14, 2010

Raising tax rates eventually results in smaller tax base

by RICHARD J. GRANT

Ibn Khaldun, the 14th-century historian, observed that, "It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

Throughout history, governments have tried to squeeze more revenue from the people by progressively increasing tax rates. But beyond a certain point, and in the long run, increases in tax rates reduce the growth of the tax base. The amount of tax revenue the government is able to reap will be less than it would have been.

The modern geometric representation of Ibn Khaldun’s observation is called the Laffer Curve (after the Nashville-based economist, Arthur Laffer, who has done a superb job of explaining the benefits of lower marginal tax rates). The curve shows that for any tax base, such as capital gains or income, tax revenue will be zero not only when the tax rate is zero but also when the rate is 100 percent. At a tax rate of 100 percent, the government might capture a windfall, but the next year there will be nothing to capture.

Between zero and 100 percent, revenue will initially rise with rate increases but will eventually peak and then fall. If the government raises tax rates beyond the revenue peak, the resulting revenue will be smaller than what could have been realized at lower tax rates. What's worse, people's incomes and wealth will also be lower than they would have been at the lower tax rate.

Are we now beyond the peak of the Laffer Curve? About 30 years ago, two of my old professors, James Buchanan (who is now a Nobel laureate) and Dwight Lee, explained why governments have an incentive to raise tax rates beyond the revenue peak and have a disincentive to lower them again.

People respond to incentives, but responses take time and planning. When tax rates rise, people shift their activities toward those that are less-taxed. The tax base with the now-higher tax rate will shrink as people try to reduce their tax exposure. They try to maximize their after-tax income or wealth. This means that their pre-tax income and wealth will almost certainly be lower than it would have been otherwise. The sum of tax receipts and after-tax income will be less than the amount of income that would have been produced otherwise.

Why is it likely that governments will go too far? Politicians generally have time horizons that are shorter than those of their citizens. The next election is never more than two to six years away. But the consequences of their actions, whether good or bad, can take much longer to manifest.

All else equal, people do prefer to receive more government services, so politicians have an incentive to promise more. They also have an incentive to borrow, thereby spreading the tax burden into the future. That is why we now have such high government deficits. But there are limits to government's ability to borrow, even if it is only the embarrassment of being the cause of the deficits.

At any point in time, it is possible for government to get a short-term increase in tax revenue by increasing the tax rate. But there are two problems with this. First, long-run total tax receipts will be lower. Second, any attempt to reduce tax rates to more reasonable levels could briefly reduce tax revenue. This latter effect would be especially pronounced if the tax cuts were temporary.

Both the Kennedy and the Reagan tax-rate cuts unambiguously gave us higher revenue. Neither can be blamed for any increase in the budget deficits that followed. The blame lies with increased government spending. The same is true for the Bush tax-rate cuts, though these were temporary, and Bush's successor intends to let the cuts expire on the most dynamic portion of the tax base.

Solution: constitutional limits.


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2010

Sunday, February 07, 2010

Liberals take Bush's few foibles and multiply them

Published in The Tennessean, February 7, 2010

Liberals take Bush's few foibles and multiply them

by Richard J. Grant

In January 2001 when George W. Bush was sworn in as president, it probably never occurred to him that his administration’s economic policy would become the new standard of excellence for liberal Democrats. All of Bush's fiscal excesses, and there were many, are now the established benchmarks of liberal best practice. It is as if he has taken his place in history as the giant upon whose shoulders liberals now stand stretching out toward new adventures in profligacy.

Of course liberals won't express it that way: they really can't quite see Bush as one of their own. But they are very quick to use him as justification for their own excesses. Not having a coherent theory of how the world works, they are unable to distinguish between what is a relevant "fact" and what is not. Without a coherent defense of their proposals, and unwilling to admit that they are merely buying votes, they fall back on their childlike retort, "Well George Bush did it too!"

President Bush entrenched the US government in the prescription drug business. Then the Obama administration attempted to up the ante with a takeover of the entire medical industry. It turned out to be a hostile takeover with stakeholders pushing the administration back into a still-simmering stalemate.

President Bush sought favor with certain groups by trying to make home ownership easy for all. Even though this turned out badly by contributing to an unsustainable housing boom, the Obama administration climbed right in with the same kinds of wasteful and disruptive policies, treating symptoms rather than letting the market rid itself of policy-inflicted distortions.

With a bit more luck, the Bush administration might have finished its term with an economic record that was relatively unremarkable. It would have been remembered for the breadth and magnitude of its response to the terrorist attacks and the ongoing threat to our security.

But economic reality caught up. The conjunction of its fiscal and regulatory policies with a low-interest-rate policy led to the inevitable crack-up of the boom. Now the Bush administration will be remembered more for its panicked and excessive response to the resulting financial crisis.

The Bush response was, ironically, "conservative" in the old sense of the word. It was a flight to the familiar, an attempt to preserve the old order. But it was not conservative in the modern, classical liberal, sense. Neither were the policies that led to the crisis.

With the Obama administration now attempting to surpass the worst of the Bush economic policies, we can't help but notice its aversion to the best. Why is the administration happy to allow some of the Bush tax cuts to expire in 2011? This cannot be healthy.

They insist that it will affect only the "rich" – because that’s more emotive than "high-income." Marginal income tax rates for individuals with incomes over $200,000 will rise from 33% to 36%. For married couples earning more than $250,000 the rate will rise from 35% to 39.6%. They will also see their capital gains and dividends taxed at 20% rather than the current 15%.

This might sound like an exclusive group, but it will include a huge number of small business owners who will be left with fewer net resources for production and hiring. These are the very people that President Barack Obama will now pretend to be helping with other interventions.

Exhibiting a belief that anything business can do the government can do better, the Obama administration is now on the hunt for revenue from whatever source, and no one will be unaffected. This will be done in the name of reducing the deficit, while increasing spending (and the deficit) faster still. Federal spending is projected to be $3.72 trillion in fiscal 2010, and to rise to $3.834 trillion a year later. This is more than a quarter of our economy.

As President Bush used to say, "There will be consequences."


Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail: rjg@richardjgrant.com

Copyright © Richard J Grant 2010