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Volume 9: Fiscal Policy, Part I: Taxes


The belly of the beast

Where does it come from?

“There’s one for you, nineteen for me.” – The Beatles

The U.S. Federal Government does almost everything on a massive scale.

The rest of the world shares eight aircraft carriers. The U.S. has ten. Eisenhower wanted some highways like the ones he saw in Germany? Let’s build 47,856 miles of Interstates. The Federal Government spends close to $1.1 trillion per year just on health. That’s more than the entire GDP of Mexico – and 180 other countries.

But the Federal Government is almost as good at collecting money as they are at spending it. To pay for all these goodies, they need to collect $3.6 trillion each year. That’s $10 billion per day, seven days a week, 365 days a year. The collection of this money greatly affects everything citizens do: how people work, invest and spend.

  • What is the difference between the deficit and the debt?

  • What are some principles of a good tax policy?

  • How does the Federal Government raise tax revenue?

What is the difference between the deficit and the debt?

Before we dive into the weeds, we’re gonna get some of our terminology and concepts straight. If you think you already know this, well, you can skip ahead at your own peril. But it isn’t an easy topic – so if we are going to talk about it, we need to agree what we’re talking about.

The Federal Deficit is the difference between what the Government takes in and what it spends. It is usually expressed as an annual number, but doesn’t have to be. If a government:

  1. Takes in $3 trillion from taxes, fees, penalties, et cetera and,

  2. Spends $4 trillion on Social Security, aircraft carriers, trips to Mar-a-Lago and the like,

Then the deficit for that year is $1 trillion(1). They need to come up with that amount from somewhere, usually by borrowing(2).

The Federal (or, more commonly, “National”) Debt is the total amount of all the Federal debt outstanding at a point in time. If the Treasury sells $50 billion of 4-week Treasury bills, the debt increases by $50 billion. When they are paid back in 4 weeks, it will decrease by the same amount (if no new debt is issued).

The deficit and debt are related. The debt is a snapshot, taken at a specific time. The deficit is the activity of the government over a period. As an approximation, the debt today is equal to the debt 1 year ago, plus the deficit over the last year(3).

I’ve heard many times – even in reputable sources – that “President Obama increased the deficit”. This isn’t true. When he took office, the deficit was $1,413 billion. The 2017 FY budget projects a deficit of $504 billion(4). So he decreased the deficit by around two-thirds. However, because there were deficits, it is true that the debt increased under President Obama.

To get a little more technical, the total (or “gross”) National Debt has two components:

  1. Debt held by the public: all the debt held by people, corporations, foreign governments and the Federal Reserve System. This is around $14.5 trillion.

  2. Intra-governmental debt: debt held by other Federal accounts. Most of this is in the Trust Funds for Social Security, Medicare and others. This is around $5 trillion(5).

When you talk about the debt, should you talk about the total debt or the public debt? Well, it depends; we’ll use both at various points.

What are some principles of a good tax policy?

Before getting into the details of how we raise the money, let’s discuss the theory, both economic and philosophical, of how we should fund our government(6).

As a society, what should be the goals of our tax policy? How do we design the tax code to create the best outcome for the citizens, while still raising the revenue we need? I don’t claim to be able to ignore my cognitive biases and interests – in Volume 3, I stated the opposite. But I think the following is a list of worthy tax policy goals, in my rough order of importance:

  1. Progressivity: The wealthy should pay a higher percentage of their income in taxes. Sounds controversial – but the math makes it necessary. If everybody paid the same income tax rate (or worse yet, the same dollar amount), many more people would be unable to afford basic necessities to survive.

  2. Simplicity: All else equal, minimizing the percentage of a country’s GDP which goes to tax compliance is a good goal.

  3. Good Incentives: We assume that citizens will attempt to pay as little tax as possible, as is their right. Try to make it so that in doing so, it creates a beneficial effect. However, we need to be careful about second-order effects and to not ignore Simplification.

  4. Diversification: When different methods of taxation are used, there is less chance of a certain group being taxed unfairly.

  5. Penalize Bad Behavior: This one isn’t as obvious – clearly using less oil is good for society for many reasons, and taxing gasoline will help accomplish this. But it is a slippery slope; these penalties often break Progressivity or Simplicity.

  6. Countercyclical: You want to raise more tax revenue in good times and less in bad. This will stabilize the economy without requiring any action be taken.

  7. Go Where the Money Is: We can’t take money from where there isn’t any to be taken. This principle implies a strong avenue for government revenues: taxes on assets. The United States currently has no “wealth tax”, but other countries do(7), and they are effective revenue raisers. It is also our first argument in favor of an estate tax. The Dead have money and won’t miss it.

One controversial principle is Inertia. I’m not certain about this one. On one hand, it’s better to have the second-order effects we know than the ones we don’t. On the other hand, is Inertia just an excuse to keep the status quo(8)?

I’m sure there are other principles, but this is a good starter set. Of course, in practice these principles are followed like a blind squirrel: we tend to follow them only through dumb luck.

How does the Federal Government raise tax revenue?

Now that we’ve been through the basics, it’s time to drill down and see specifically how the Federal Government takes all that money out of your pocket(9). Just over $3.2 trillion to be exact.

  • Personal Income Taxes: $1.5 trillion

This is the big one, representing 47% of all Federal receipts. Personal income taxes get the most attention in the press and deservedly so. There are two basic classes of Personal Income tax: Ordinary Income and Capital Gains.

Ordinary Income is what it sounds like: money received for labor you personally have performed, including wages, tips, and bonuses. But income from a sole proprietorship, as well as items like royalties, interest and net rental income, is also treated as ordinary income. Capital Gains are the profits from selling assets, like a stock or a bond; if the asset was held for more than a year, any gain is treated as Long-Term and taxed at a lower rate. So far, so good.

Ordinary Income tax rates are highly Progressive. The first dollar of taxable income faces a rate of 10%; above $441,000 of income(10), the marginal rate is 39.6%. They are also Countercyclical; when national income slows or decreases in a recession, Income Tax receipts slow faster, providing an automatic stabilizer.

However, for reasons good and bad, individuals can reduce the amount of their income subject to taxation in various ways. The purpose is usually to try to create positive incentives. For example, tax savings for minor dependents are critical for many to start families, which is important for society. These provisions are called deductions (or, sometimes, tax expenditures). The major deductions against personal income taxes are(11):

Deductions are strong candidates to break our rule and Create Bad Incentives. The fact that mortgage interest is deductible encourages homeowners to borrow more than they would otherwise. Deductions for state and local taxes can discourage local government efficiency; the Federal Government is picking up some of the tab. Economists tend to oppose deductions; there is good evidence that raising the same amount of tax at a lower rate, applied more equally, will help the economy. Politicians therefore talk about increasing the base and lowering rates. Unfortunately, most deductions are very popular. For instance, the rationale for charitable contribution deduction is dubious – why should my tax dollars go to support your charity? But I don’t know of any politician daring to get rid of it.

Another goal you hear frequently is to “simplify the tax code.” I have a humble suggestion on this front. An enormous amount of the effort is expended to structure income so that it is taxed at the lower Capital Gains rate. Eliminating the distinction between Ordinary Income and Capital Gains simplify things greatly. Now I know the argument – you don’t want to “discourage investment.” But I don’t see any valid economic reason to discourage work (i.e. Ordinary Income) more than investment. This change would raise around $93 billion per year and make our tax code more Progressive(12). If you liked, the top Ordinary Income brackets could have their rates reduced to make the change revenue neutral. There are some second-order effects to consider, but this is the best tax simplification plan I’m aware of(13).

  • Payroll Taxes: $1.15 trillion

We covered Social Security at good length in Volume 1, so I won’t belabor the details. Most Social Insurance taxes are withheld from wages at certain percentages. These withholdings are used to directly fund their related program: Social Security, Disability Insurance, Medicare, Unemployment (and a couple smaller ones).

However, because these withholdings are paid on the first dollar of income, and subject to a cap, they are Regressive: lower earners pay a higher percentage. There are good reasons why this is the case, for example the benefits are usually also capped. But, when you hear on the TV that around 40% of Americans pay no income tax, take it with a grain of salt. Everybody pays taxes, and payroll taxes are the largest component for most households. In fact, overall individual Federal taxes are not especially progressive. Warren Buffett was right – he likely pays a lower tax rate than his secretary(14).

  • Corporate Income Taxes: $0.3 trillion

Corporate taxes in the United States are ridiculously complex(15). Our fine nation has managed to create a system where we have one of the highest corporate tax rates and one of the lowest corporate tax collections. It’s impressive(16).

Clearly, Corporate taxes break a lot of our rules. They are not simple and create a ridiculous set of incentives. They seem as likely to reward bad behavior as to penalize it. I won’t even pretend to offer a way to improve the corporate tax system. Let’s leave this one to the experts.

  • Ad Valorem Taxes: $0.17 trillion

“Ad valorem” means “according to the value.” These are taxes that are charged (generally) when specific things are used. Think alcohol, tobacco, gasoline, airport usage and customs. It is a small part of the total, but helps with Diversification, Simplicity and Countercyclical. They define Penalize Bad Behavior, if that’s your thing. Unfortunately, they tend to be Regressive, like almost all consumption-based taxes.

  • Estate and Gift Taxes: $0.02 trillion

I put this separately so that we could check off the Tax the Dead box. The money has to come from somewhere. Recall that the first $5.45 million for an individual and $10.9 for a couple is exempted from the Estate Tax. From a societal perspective, is it better to collect tax on multimillionaire deceased persons (or their heirs), or middle-class families earning the median income of $51,939 per year?

I think the worst argument against the Estate Tax is that it is “double taxation,” taxing money that was already taxed. There are two major problems with the argument. First, a lot of taxes are double taxes. Sales taxes are paid with after-tax income, as are property taxes. Second, just because an asset is in an estate does not mean that it has already been taxed! Capital Gains taxes are paid only when an asset is sold. So, if an asset appreciates in value, is never sold, and the holder died, then the Estate Tax is the first tax applied. There are a lot of these types of assets in the largest estates(17).

  • Federal Reserve Deposits: $0.11 trillion

We might get into details of the Federal Reserve in another volume. For now, just know that it is a s