Tag: fiscal deficit

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Raising taxes: 73% of nothing is nothing

President Francois Hollande recently increased the top income tax rate in France to 75 percent — for incomes in excess of €1 million. This is part of a wider trend with President Obama targeting the wealthy in his election campaign, promising to raise taxes on incomes in excess of $1 million. Shifting the tax burden onto the wealthy might be clever politics, but does it make economic sense? To gauge the effectiveness of this strategy we need to study tax rates and their effect on incomes in the 1920s and 1930s.

By the end of the First World War, Federal government debt had soared to $25.5 billion, from $3 billion in 1915. Income taxes were raised to repay public debt: 60 percent on incomes greater than $100,000 and a top rate of 73 percent on incomes over $1 million. When Andrew Mellon was appointed Treasury Secretary in 1921, he inherited an economy in sharp recession. Falling GDP and declining income tax receipts led Mellon to observe that “73% of nothing is nothing”. He understood that high income taxes discourage entrepreneurs, leading to lower incomes and lower tax receipts — what we now refer to as the Laffer curve. By 1925, under President Coolidge, Mellon had slashed income taxes to a top rate of 25 percent — on incomes greater than $100,000. The economy boomed, tax collections recovered despite lower rates, and Treasury returned budget surpluses throughout the 1920s.

US Income Taxes and GDP 1920 to 1940

Interestingly, Veronique de Rugy points out that taxes paid by those with incomes over $100,000 more than doubled by the end of the decade.

US Income Tax Rates and Tax Receipts in the 1920s

Andrew Mellon was a wealthy banker and investor: in the mid-1920s he was the third highest taxpayer in the US. His strategy of cutting income tax rates may appear self-interested, but showed an understanding of how taxes can stimulate or impede economic growth, and succeeded in rescuing the economy from prolonged recession in the 1920s.

A decade later, President Herbert Hoover spent liberally on infrastructure programs in an attempt to shock the economy out of recession following the 1929 Wall Street crash. By 1932 Hoover and Mellon raised income taxes to rein in the growing deficit. Tax on incomes greater than $100,000 was increased to 56 percent and the top rate lifted to 63 percent — on incomes over $1 million.

The budget deficit continued to grow. Higher tax rates were maintained throughout the 1930s, under FDR, but failed to achieve their stated aim and may have contributed to the severity of the Great Depression.

US Income Taxes and Budget Surplus 1920 to 1940

GDP rose steeply after 1934. Income tax receipts recovered to pre-crash levels but declined again after 1937, when President Roosevelt introduced payroll taxes. Increased taxes reduced the fiscal deficit but caused a double-dip recession: GDP contracted, income tax receipts fell and the deficit grew.

US Income Taxes and GDP 1920 to 1940

Comparing the 1920s to the 1930s it is evident that Barack Obama and Francois Hollande threaten to repeat the mistakes of the 1930s. Increasing taxes in the middle of a recession does not reduce the deficit. It merely prolongs the recession.

Sources:
Cato Institute: 1920s Income Tax Cuts Sparked Economic Growth and Raised Federal Revenues by Veronique de Rugy
National Debt History
Wikipedia: Andrew W Mellon
Wikipedia: Laffer Curve
The Politically Incorrect Guide to the Great Depression and the New Deal by Robert Murphy

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When Austerity Fails

Austerity decimated Asian economies during their 1997/98 financial crisis and similar measures have failed to rescue the PIIGS in Europe 2012. David Cameron’s austerity measures have also not saved the UK from falling back into recession. So why is Wayne Swan in Australia so proud of his balanced budget? And why does Barack Obama threaten the wealthy with increased taxes while the GOP advocate spending cuts in order to reduce the US deficit? Are we condemned to follow Europe into a deflationary spiral?

How Did We Get Here?

First, let’s examine the causes of the current financial crisis.

Government deficits have been around for centuries. States would borrow in order to finance wars but were then left with the problem of repayment. Countries frequently defaulted, but this created difficulties in accessing further finance; so governments resorted to debasing their currencies. Initially they substituted coins with a lower metal content for the original issue. Then introduction of fiat currencies — with no right of conversion to an underlying gold/silver standard — made debasement a lot easier. Issuing more paper currency simply reduced the value of each note in circulation. Advent of the digital age made debasement still easier, with transfer of balances between electronic accounts largely replacing paper money. Fiscal deficits, previously confined to wars, became regular government policy; employed as a stealth tax and redistributed in the form of welfare benefits to large voting blocks.

Along with fiscal deficits came easy monetary policy — also known as debt expansion. Lower interest rates fueled greater demand for debt, which bankers, with assistance from the central bank, were only too willing to accommodate. I will not go into a lengthy exposition of how banks create money, but banks expand their balance sheets by lending money they do not have, confident in the knowledge that recipients will deposit the proceeds back in the banking system — which is then used to fund the original loan. Expanding bank balance sheets inject new money into the system, debasing the currency as effectively as if they were running a printing press in the basement.

The combination of rising prices and low interest rates is a heady mix investors cannot resist, leading to speculative bubbles in real estate or stocks. So why do governments encourage debt expansion? Because (A) it creates a temporary high — a false sense of well-being before inflation takes hold; and (B) it debases the currency, inflating tax revenues while reducing the real value of government debt.

Continuous government deficits and debt expansion via the financial sector have brought us to the edge of the precipice. The problem is: finding a way back — none of the solutions seem to work.

Austerity

Slashing government spending, cutting back on investment programs, and raising taxes in order to reduce the fiscal deficit may appear a logical response to the crisis. Reversing policies that caused the problem will reduce their eventual impact, but you have to do that before the financial crisis — not after. With bank credit contracting and aggregate demand shrinking, it is too late to throw the engine into reverse — you are already going backwards. The economy is already slowing. Rather than reducing harmful side-effects, austerity applied at the wrong time will simply amplify them.

The 1997 Asian Crisis

We are repeating the mistakes of the 1997/98 Asian crisis. Joseph Stiglitz, at the time chief economist at the World Bank, warned the IMF of the perils of austerity measures imposed on recipients of IMF support. He was politely ignored. By July 1998, 13 months after the start of the crisis, GNP had fallen by 83 percent in Indonesia and between 30 and 40 percent in other recipients of IMF “assistance”. Thailand, Indonesia, Malaysia, South Korea and the Phillipines reduced government deficits, allowed insolvent banks to fail, and raised interest rates in response to IMF demands. Currency devaluations, waves of bankruptcies, real estate busts, collapse of entire industries and soaring unemployment followed — leading to social unrest. Contracting bank lending without compensatory fiscal deficits led to a deflationary spiral, while raising interest rates failed to protect currencies from devaluation.

The same failed policies are being pursued today, simply because continuing fiscal deficits and ballooning public debt are a frightening alternative.

The Lesser of Two Evils

At some point political leaders are going to realize the futility of further austerity measures and resort to the hair of the dog that bit them. Bond markets are likely to resist further increases in public debt and deficits would have to be funded directly or indirectly by the central bank/Federal Reserve. Inflation would rise. Effectively the government is printing fresh new dollar bills with nothing to back them.

The short-term payoff would be fourfold. Rising inflation increases tax revenues while at the same time decreasing the value of public debt in real terms. Real estate values rise, restoring many underwater mortgages to solvency, and rescuing banks threatened by falling house prices. Finally, inflation would discourage currency manipulation. Asian exporters who keep their currencies at artificially low values, by purchasing $trillions of US treasuries to offset the current account imbalance, will suffer a capital loss on their investments.

The long-term costs — inflation, speculative bubbles and financial crises — are likely to be out-weighed by the short-term benefits when it comes to counting votes. Even rising national debt would to some extent be offset by rising nominal GDP, stabilizing the debt-to-GDP ratio. And if deficits are used to fund productive infrastructure, rather than squandered on public fountains and bridges-to-nowhere, that will further enhance GDP growth while ensuring that the state has real assets to show for the debt incurred.

Not “If” but “When”

Faced with the failure of austerity measures, governments are likely to abandon them and resort to the printing press — fiscal deficits and quantitative easing. It is more a case of “when” rather than “if”. Successful traders/investors will need to allow for this in their strategies, timing their purchases to take advantage of the shift.

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Ex-Fed Kohn: 'Huge Risk' US Won't Take Steps On Debt, Deficit By Year End

NEW YORK -(Dow Jones) – There is a real danger U.S. authorities won’t take the necessary steps to fix the country’s debt and deficit problems between the elections and the end of this year, former Federal Reserve Board Vice Chairman Donald Kohn said Monday. “What’s required to put the fiscal deficit on a sustainable path are some difficult decisions having to do with entitlement spending and taxes in the United States,” Kohn said at the Europlace forum……. Kohn added the U.S. political system has become “soap opera-ized” with such a huge gulf between the country’s political parties there is a real risk debt and deficit will continue to grow past the end of this year.

via Ex-Fed Kohn: ‘Huge Risk’ US Won’t Take Steps On Debt, Deficit By Year End.

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John Mauldin: Hoisington Q1 Review and Outlook

John Mauldin: Lacy Hunt kicks things off with a bang in Hoisington’s Quarterly Review and Outlook, this week’s Outside the Box:

“The standard of living of the average American continues to fall.”

The reason, in a word: debt. Lacy explains what happens:
“Efforts by fiscal and monetary authorities to sustain growth by further debt accumulation may produce some short-term benefit. Sadly, these interludes fade quickly as the debt becomes more destabilizing. The net result of increased indebtedness then becomes the opposite of what policymakers intend when they promote economic growth by either borrowing funds for increased government expenditures or encourage consumers to borrow with artificial and temporary incentives.”

In other words, you can’t get to real, sustained growth of an economy by growing debt after a certain point — one that, sadly, we have already reached.

John Mauldin: Hoisington Q1 Review and Outlook.

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Spain Is Turning Into An Economic Tragedy

Marc Chandler: The new fiscal compact had just been signed last week, which includes somewhat more rigorous fiscal rule and enforcement, when Spain’s PM Rajoy revealed that this year’s deficit would come in around 5.8 percent of GDP rather the 4.4 percent target. This of course follows last year’s 8.5 percent overshoot of the 6 percent target.

The problem that for Spain is that the 4.4 percent target was based on forecasts for more than 2 percent growth this year. However, in late February, the EU cuts its forecast to a 1 percent contraction. This still seems optimistic. The IMF forecasts a 1.7 percent contraction, which the Spanish government now accepts.

This will be the third year in 5 that the Spanish economy contracts. Unemployment stands at an EU-high of 23.5 percent in February. The strong export growth seen in recent years, the best growth in the euro area, is stalling. Domestic demand has been hit by rising unemployment and government austerity…..

via Spain Is Turning Into An Economic Tragedy.

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Deleveraging is over — it’s time to cut the deficit

US commercial bank loans and leases bottomed in April 2011, after shrinking more than $1 trillion in the previous two years. The annual rate-of-change has now recovered to positive territory, relieving downward pressure on asset prices, including stocks and real estate. Deleveraging has come to an end and is only likely to resume if the economy suffers further financial shocks.

US Commercial Bank Loans and Leases (incl. Securitized Loans)

You would expect the gap between savings and investment to close when net debt repayments cease, but a significant shortfall between Gross Private Savings and Domestic Investment warns of continued instability.

Gross Domestic Private Investment and Savings

The Investment – Savings gap is reflected by strong, negative Net Private Investment on the chart below. If it were not for the fiscal deficit, the US would risk a significant contraction in national income.

Net Domestic Private Investment and Fiscal Deficit

For the benefit of those who may have missed my earlier coverage of this issue:

Debt repayment after a financial crisis/balance-sheet recession creates a gap between savings and investment that has serious implications for the economy. The resultant shortfall between spending and income risks a sharp contraction in national income. The gap may be relatively small but, like a puncture in a car tire, the impact can be huge. It only takes each of us to withhold 2% of what we earn (e.g. to repay debt) for a gap to appear between spending and income. A for example may earn $1.00 but now only pays 98 cents to B, who will pay 96.04 cents to C, who will pay 94.12 cents to D, and so on through the entire supply chain. By the time we get to L, they will only earn 80 cents where they previously earned $1.00.

The solution, as Keynes pointed out, is for government to offset the shortfall by running a fiscal deficit. The chart above shows that Treasury has been doing exactly that — spending more than they collect by way of taxes — in order to prevent a contraction. The problem is that continual deficits have two serious side-effects. The first is a loss of investor confidence as the ratio of public debt to GDP rises. The second is inflation — if private investment recovers and starts competing with government for ever-scarcer resources. By inflation I do not just mean an increase in the CPI, but also rising asset prices as experienced in the 2004 to 2008 housing bubble, when government ran a deficit while net private investment was positive.

As the chart shows, the fiscal deficit is being funded by net savings (plus a little help from China). So what would happen if we cut the deficit?

  • An optimistic view would be that cutting the deficit would restore confidence and encourage more private investment, shrinking the savings – investment shortfall.
  • Pessimists, however, would warn that private sector balance sheets have been impaired by falling asset prices and investors are reluctant to borrow even at current low interest rates. A shrinking deficit without a counter-balancing rise in investment would send the US back into recession.

The truth lies somewhere in between. Corporate balance sheets are generally in good shape while small-to-medium business and home-owners have suffered significant impairment. And one of the major factors inhibiting investment is the uncertain political/economic environment.

Deleveraging has ended and the time has come to start cutting back the government deficit — but cautiously. Cutting the entire deficit in one hit would be more of a shock than the economy could bear, but setting out a four-year plan to cut the deficit by say 2 percent a year would do a lot to restore confidence and set the economy on a path to recovery.

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BOE’s Monetary Gamble Nears Its Endgame – WSJ.com

So where once investors worried that it [the Bank of England] had got policy plain wrong, there’s now a chance they’ll start to fear that the bank has got things all too right, after all, and that the U.K. really does need policy settings appropriate for an economic ice age……

And a government focused on austerity measures is in no position to offer fiscal support even if it wanted to, and, according to the treasury’s pronouncements, it doesn’t. It’s sticking with the deficit-cutting plan A, come what may.

So this is clearly an economy with huge problems anywhere you might care to look. Its remaining cardinal virtue, perhaps, is that it isn’t in the euro zone, so the bloc’s more pressing concerns have shielded it from harsher scrutiny. It can’t rely on that shield for all time.

via BOE’s Monetary Gamble Nears Its Endgame – WSJ.com.

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