Pick Your Tax Increase

As the world analyzes the revised Congressional Budget Office projections for the U.S. federal budget deficit in 2009, 2010 and beyond, one thing must remain perfectly clear.

There is no way that the capital markets will put up with sustained U.S. budget deficits over 10% of gross domestic product.

Since the current political class is incapable of cutting spending (indeed, it appears to want to spend still more, in yet another "stimulus plan"), taxes will go up, no question. The interesting question is: which ones?

One tax that could usefully be deployed to do some economic good would be a Tobin tax. This is a tax by which transactions in stocks, bonds, commodities and foreign exchange would be subject to a very small transactions tax on each deal carried out.

The purpose of this would be to limit "high velocity trading," computerized trading with millisecond lead-times by which Wall Street sucks value out of the economy while destabilizing prices and making markets more dangerous and unstable for long-term investors.

The yield of such a tax would be only a few billion, but every little bit helps, and it would assist in re-diverting U.S. economic activity from Wall Street rent-seeking into something useful.

Similarly, a moderate carbon tax would be no more economically harmful than any other tax. Even from the perspective of global warming doubters, it might be worth imposing on the "precautionary principle," since it would divert energy usage into less carbon-dependent forms and encourage conservation.

There are other taxes which would also do little economic harm, possibly even some good, but would be met with huge opposition from "opinion formers." Two of these were proposed by the Obama Administration in its budget, but were declared "dead on arrival" in Congress.

One was a reduction in the tax deduction for home mortgages for those with incomes above $250,000. The U.S. political penchant for subsidizing housing, including the fearsomely expensive rescues of Fannie Mae and Freddie Mac, has proven hugely damaging in the last decade and promises to continue being so going forward.

It diverts resources from productive investment to building and buying houses that are both larger and more dispersed than is economically optimal.

Removing the home mortgage interest deduction, or at least capping it at $10,000 per year, would reverse this distortion.

Another noble but doomed effort by the Obama Administration was the attempt to cap the tax deduction on charitable donations. The ability to deduct such donations is an enormous and unjustified loophole in the U.S. tax code, protected by sentimental affection for everybody's favorite charitable cause. In reality it has spawned a gigantic nexus of political agitation organizations that have stretched the definition of "charity" beyond all meaning in order to attain favorable tax status.

The most tempting source of revenue to lovers of big government is a value added tax (VAT). It is tempting because, falling as it does on sales transactions and being incorporated into sale prices, it is much less visible to voters than an income tax.

It also has the virtue of being largely self-enforcing, since every business organization, including retailers, has the incentive to report every penny of VAT "inputs" they incur, and to charge VAT on their outputs, so evasion becomes very difficult. Political conservatives groan that VAT is especially burdensome on informally run small businesses — this is because most other taxes are easily evaded by them.

The VAT also has the virtue of taxing consumption, not income, thereby encouraging production and saving. In the U.S. economy, devoted as it has been to excessive borrowing and consumption, this is no bad thing.

Its main disadvantage is that, added to an income tax, it allows government to increase spending to French or Swedish levels, with consequent corrupting and debilitating effects on the economy and society.

Next in the tax cupboard are tariffs. These are universally despised by economists, but the economists are wrong. Governments must raise revenue somehow, and there is no obvious reason why modest taxes on imports are more damaging than income taxes. Indeed, the reverse is true.

Certainly a great deal of economic and societal damage was done by the "unilateral disarmament" of British economic policy between 1846 and 1932, in which tariffs were abolished without regard to the fact that foreign countries still had them.

By that policy, British agriculture and its rural-dominated society was almost wiped out, while the hollowing out of British industry — barred from its natural imperial markets by tariff-protected foreign competition — was only a few decades delayed.

Nevertheless, there are real global benefits from "comparative advantage," by which goods are produced in the most efficient market. Moreover, the political temptations are irresistible for governments to raise tariffs in economic downturns, producing the kind of economic death-spiral caused by the 1930 Smoot-Hawley Tariff — and fortunately avoided this time around.

International mechanisms for preventing unilateral tariff increases, like the World Trade Organization, are thus beneficial. In an ideal world, such organizations would allow uniform modest tariffs, by which revenues could be raised without huge distortion of "comparative advantage." In the real world, raising tariffs is probably too dangerous.

Finally, we come to income taxes and social security taxes. These have two principal problems. First, high marginal rates, significantly above 50%, have a large disincentive effect — and almost certainly yield no net revenue or even reduce revenue and damage the economy in general.

The 90% rates common in Britain before 1979 were thus both counterproductive in terms of revenues and hugely damaging to economic growth.

Second, if, as in the United States today, less than half the population pays effectively all the income tax, political incentives can become distorted. Even if social security taxes and sales taxes are paid by the great majority of people, an income tax levied at high rates on a minority is subject to incessant agitation by the majority for unjustified increases.

Hence, an increase in income tax rates significantly beyond their present levels (the marginal rate of which, including state taxes and social security, rises above 50% at several points in the income scale) would be economically unproductive.

Sadly, politics being what it is, it will almost certainly be the first resort of politicians when further borrowing becomes difficult. As discussed above, there are many superior alternatives to raise revenues.

Editor's note: This feature has been adapted from an article that first appeared on “The Bear's Lair,” published on the website Prudentbear.com.