Sunday, December 19, 2010

No matter what Fed does, interest rates set to rise

Published in The Tennessean, Sunday, December 19, 2010

No matter what Fed does, interest rates set to rise

by Richard J. Grant

When speaking of national budget deficits, one of the magic numbers that has somehow emerged as a benchmark is 3 percent of gross domestic product (GDP). The International Monetary Fund often recommends this benchmark; and the European Union requires current and prospective members to keep their deficits below 3 percent.

Although 3 percent is way too high, let us not quibble. For the last couple of years the national budget deficit in the U.S. has been running around 10 percent. If we keep overspending at this rate, our national debt will increase by the size of our GDP every seven or eight years. Given that the total public debt outstanding is now more than 90 percent of GDP, the debt itself will double sooner.

We might console ourselves with the fact that the government owes one third of its debt to itself. Government agencies (such as the Social Security Trust Fund) hold U.S. Treasury securities, which are, rather inconveniently, IOUs on future taxpayers. This means that, when accounting for the interest cost on the debt, the government can net out payments to itself.

The Congressional Budget Office (CBO) currently estimates the federal government's net interest outlays to be about 1.4 percent of GDP. Although net borrowing has increased by $3 trillion, a significant decline in interest rates has reduced net interest costs from $253 billion in $2008 to $197 billion in 2010.

Interest rates are currently at very low levels. This is partly due to increased savings rates in households and corporations, all of whom are being a bit more careful in dispensing their cash. Also, the U.S. Federal Reserve is deliberately pushing interest rates down below market levels by creating huge quantities of new dollars.

How long can the Fed keep doing this? The more money it creates, the higher will be prices compared to what they would have been. At current levels of money creation, it won't be long before the Fed achieves its stated desire of pushing price inflation up to 2 percent. Then what?

As inflation expectations increase, so will interest rates necessarily increase. Otherwise, lenders would expect to lose value due to inflation. But once this begins to happen, the Fed will have to slow down its money creation in order to avoid overshooting its inflation target.

This means that, unless savings rates continue to rise, the Fed will have trouble keeping interest rates down below market levels. If it continues to inflate the money supply to hold down real interest rates (which are observed interest rates minus the effect of inflation), then it risks increased price inflation and a weaker dollar. But if it slows its money creation, then it reduces the availability of reserves to the banking system. This will also cause interest rates to rise.

Either way, interest rates are headed higher. And as the federal government refinances and increases its debt, its interest payments are also destined to rise.

To add to the joy of the season, Congress is currently attempting to rush through a 1,924-page, $1.2 trillion omnibus spending bill, spruced up with 6,715 Christmas decorations sometimes called “earmarks.”

By the CBO's reckoning, all this will cause government interest payments to rise to 3.4 percent of GDP by 2020. Now we have one more reason to be glad that we are not inclined to join the European Union.


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 2007-2010

Richard J Grant archived at The Tennessean

Sunday, December 12, 2010

We should cut, not increase, top income tax rates

Published in The Tennessean, Sunday, December 12, 2010

We should cut, not increase, top income tax rates

by Richard J. Grant

Just as there seems to be a universal speed limit, the speed of light, there seems also to be a limit to the proportion of economic output that can be turned into tax revenue. With apologies to Einstein, if we were to accelerate a rocket, it would seem to shorten and grow heavier as we approached the speed of light. We would have to inject increasing amounts of energy for each mile per second that we eke out.

Since the middle of the 20th century, the U.S. government has applied a wide range of top marginal income-tax rates, from 92 percent down to 28 percent. But so far, the level of tax revenue as a proportion of Gross Domestic Product (GDP) has not managed to break above the 20-percent level (though it did test that level at the peak of the tech boom). This is a historical observation, sometimes called “Hauser's Law,” after Kurt Hauser of the Hoover Institution at Stanford University. The 20-percent “barrier” could change over time as legal and social institutions change.

Why should we care about this? Some people believe that we can increase government spending and then fund it by increasing the top marginal tax rates. But Hauser's Law suggests that the only way the dollar amount of government tax receipts can be increased is through an increase in the size of the economy. This further suggests that there is a range of top marginal tax rates above which both economic growth and high-income tax revenues will be reduced.

This has implications for the size of the national debt as well. Budget data over the last 20 years show the actual proportion of tax revenue to GDP fluctuating between 14 percent and 20 percent. During the same period, the level of government spending as a proportion of GDP has fluctuated between 18 percent and 25.5 percent. The Hauser phenomenon suggests that the limit on government revenue collections at any given time is not merely political but also natural. In contrast, the ability of the federal government to borrow raises significantly any natural limit on government spending, at least in the short term. We have federal budget deficits because the federal government spends more than it is currently capable of funding through taxation.

Perhaps if our governments, at all levels, were to reduce the scope and distortion of their fiscal, monetary, and regulatory activities, then the economy would grow more quickly for any given set of tax rates. Similarly, for any given set of spending and regulatory institutions, we are more likely to observe increased economic growth rates when we reduce top marginal tax rates on income and capital than when we increase such rates.

In recognizing the Hauser phenomenon, we are really just looking at the Laffer Curve through a different window. The Laffer Curve describes the relationship between the marginal tax rate on a particular tax base and the amount of tax revenue obtained from that base. The importance of understanding this relationship is that it warns us against inadvertently reducing people's incomes in a futile attempt to increase government revenue by increasing tax rates on relatively fluid tax bases.

The more the government tries to take, the shorter the supply of everything and the heavier the burden on everyone. It's not rocket science; it's a bit more complex than that.


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 2007-2010

Richard J Grant archived at The Tennessean

Sunday, December 05, 2010

Lame ducks should not let tax rates rise

Published in The Tennessean, Sunday, December 5, 2010

Lame ducks should not let tax rates rise

by Richard J. Grant

They say that a wounded animal is a dangerous animal. This would seem to apply also to a lame duck, as exemplified in our present lame-duck liberal Congress.

Despite the recent electoral repudiation of big-government liberalism, Democrats continue to grasp for any fin du rĂ©gime advantage that they might pull out in their last days as the majority. They continue to push the canard that their intended January tax-rate increases will affect only “the rich.” When they say “the rich” they really mean “high income earners,” but the needs of rabble-rousing demagogues will always trump language accuracy.

It is difficult to find real economists who would support tax-rate increases at a time of weak economic recovery and high unemployment. Even those economists who believe that such tax-rate increases might increase tax revenue will, nevertheless, recognize the danger of dampening growth at this time.

For those who put statist ideology ahead of the general welfare, none of this matters. They are holding hard to their story that it is only fair that the rich pay more and that the higher tax rates are needed to increase government revenue. And if wishes were horses, the statists’ dreams would come true. But they aren't and they won't.

The least-productive tax base is the one that is most likely to melt away under the glare of high tax rates. That is more likely to describe high income earners rather than low income earners. It is more likely to describe capital gains taxes rather than payroll taxes. The most productive and creative among us are also likely to be the most agile in the avoidance of tax burdens.

This is not to suggest that anyone can really escape the burden of high tax rates. The mere act of avoidance causes a shift of resources away from their most productive uses. The net aggregate effect is reduced incomes. Special deductions for politically favored interest groups will, of course, bring special advantages to some of those groups, but that cannot apply to the collective whole.

Whether “the rich” are defined as those earning over $250,000 or, as Sen. Charles Schumer is now desperately suggesting, $1 million, the biggest impact of these tax increases will be on Subchapter S corporations and other small businesses. The bottom line is that a tax on employers is ultimately a tax on employees, and on those who would like to be employees. What possible consolation could it give an unemployed worker to know that his former employer pays a higher tax rate than he does?

An increasing number of studies by economists find that government spending provides, at best, only a weak short-term stimulus effect. Whatever stimulus effect there is tends to wear off quickly and turn negative. Even such spending that is financed by deficits (i.e. increasing government debt) creates a need for present and future tax revenue. Whatever immediate stimulus we might get from consuming our “seed-corn” capital, when the effect of the tax burden is added in, the net result of these so-called stimulus programs is glaringly negative.

If Congress fails to extend the current tax rates in December, then all income-tax rates, as well as the rates on dividends, capital gains, and estates will rise in January. We need to get the lame-duck liberals behind us and give the capitalist pigs their wings.


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 2007-2010

Richard J Grant archived at The Tennessean