Limits to Taxation Will Blunt Social Program and Budget Deficit Growth

* A reader writes in with the following comment, in reaction to my blog from Tuesday:


“I like your description of our country’s legal system, and your attitude about jury duty.  There should be more people who think like you (in that respect!)  I also like that you considered the fact of income inequality.


With reference to Obama: I would say that he is trying to create a more level playing field – not bludgeon the spirit of capitalism.  It’s certainly not fair that the rich get richer and that many of their get rich schemes are making money off the backs of the less fortunate – for instance, talking people like my cleaning man, who was duped into refinancing his house during the housing boom, who took on more debt than he could afford once the teaser rates ended. And then he was coerced to pay for help to refinance his over-extended mortgage in the guise of lowering his payments – and then they took his money without really helping him.  And there are other schemes that are perpetrated on the poorer populations. Balancing budgets should first feature tax increases for the wealthy and elimination of tax loopholes.” (end of readers comments)


The problem is that all countries have a structural limit on how much they can tax their population. Once total revenues goes above a certain rate, then income goes underground, and those paying the bulk of the nation’s taxes start spending a greater amount of time trying to shelter income and avoid taxes, rather than undertake productive endeavors. So, the concept of taxing the rich only works to a point, but over time, the structural limits to how much of the nation’s income any country can tax is usually capped below 20%. Assuming a 20% maximum, that means that the government can tax up to $2.9 trillion a year, and according to Obama’s budget, he is going to test that 20% limit within the next 2 years. The attached chart shows that Obama’s budget plans also envision a drop in expenditures; his budget assumes that the economy has found a source of self-sustaining growth, and his budget deficit is supposed to drop below $1 trillion, based on the assumption of an expanding economy. Even with higher taxes on the wealthy, I do not see the economy doing much better in 2012 than today, and accordingly, I remain concerned that higher taxes alone are NOT going to solve our fiscal deficits. 


Instead, I believe that Obama should be focusing on spending his deficits wisely on infrastructure, and projects which will be around in 20 years or more. I do not see this happening on a scale which is relevant to the size of our economy. While I understand the need for a social welfare safety net, it seems to me that a greater and greater share of our budget deficits are spent on these safety nets, and are not an end of the spending, but should be viewed as a band-aid. Out of a $3.6 trillion budget, over $1.4 trillion is being spent on Medicare, Medicaid andSocial Security. There is another $570 billion of spending on “other mandatory programs” which is likely to cover such things as unemployment benefits and the like (because I could not find them in any of the other categories), which brings us to a $2+ trillion of expenses on this safety net, which is over 50% of the total spending. If you want to read a rather scathing essay on how poorly the Obama administration is spending its stimulus money, check out this link which a reader sent me:


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The point is that I do not see any major renewable energy initiatives getting announced, infrastructure projects, or other initiatives to spur the growth of new industries.


Also, when I refer to Obama’s socialist agenda, my concerns are that socialism blunts the effectiveness of a free-wheeling capitalist system. I agree that the government should be there to protect consumers, and will be the first to admit that the government blew its job as a supervisor of mortgage writing practices in the years leading up to housing’s peak in 2005. Alan Greenspan for one, as Chairman of the Fed, assumed that markets would self-regulate themselves. Rather, the capital markets became so sophisticated, that companies were able to completely insulate themselves from financial armageddon through the use of financial derivatives. Having that ability actually encouraged greater risk taking, as market participants felt emboldened to take unreasonable risks, knowing that they could hedge out these risks with a few phone calls. In turn, firms such as AIG, took on out-sized risks via derivatives, and others let their risks run, since taking risk was a profitable one-way street until 2006. This rewarded those who took risks, and penalized those who ran their business according to conservative guidelines. 


And the way in which Obama is encouraging lenders to forgive mortgage debt, moral hazard is being encouraged by rewarding those who over-extended themselves. (This is not to say that mortgage brokers, who talked unsuspecting folks, like the reader’s cleaning man, into a loan he could not afford once the rate was reset, should not be prosecuted for fraud). But my concern here is that we have embraced public policy which rewards the reckless, and penalized those who have been conservative. These policies are being extended into the present day. The fact that AIG is still allowed to operate is beyond me. Under the guise of trying to get back as much as possible for the government, AIG is still employing many people and paying its new chief millions of dollars. While this might be the right response for the government which wants to get back as much money as possible, it sets a really bad precedent, and continues a legacy of its morally corrupt idea of rescuing AIG. Having spent tens or hundreds of billions of dollars to save AIG, the government continues to throw more money into the well, in the hopes of a recovery of these dollars. Given my view of what is to come, this has to end. AIG will cost us a lot more than we are being told if they do not start liquidating its businesses.


As for income inequality, the system needs to evolve to a place where all classes of citizens are given the opportunity to rise above the shackles of their position in society. I am not sure how this should happen, but I do not believe that arbitrary income re-distribution for the sake of taking from the rich and giving to the poor is the wrong way to approach the problem. If you have any creative ideas to solve this problem, please send them in.


* Deflation lives – yesterday’s New Home Sales report depicts a rate of sales which has dropped to a level not seen since this data was first tabulated in 1963. Take a look at the attached chart of this time series. While this hits a new low, following the expiration of the home buyertax credit, it is quite likely that this reading could go even lower, as sales were front loaded into the period up until April 30th, and taken from the rest of 2010. The senate has already passed an extension of the home buyers credit, and with a reading like this, it is likely that the House will follow suit. Nonetheless, the damage might already have been done, since a good amount of buyers might already have committed to purchases, which means that the rest of 2010 might be abysmal, even without an extension of the home buyer tax credit.


A look at existing home sales, which takes into account a larger amount of home sales, does not show as bad a picture as the smaller “new Home Sales” data. But this data does show what happens when government incentives expire, as the spike into November of 2009 took home sales up by 2 million units (annualized) from its 2009 low, only to quickly give back 1.5 million of that increase. With the expiration of the April home buyer incentives, which also include tax credits for those who are not first time home buyers, existing home sales jumped above 5.7 million units, but well below the November 2009 peak. If the House passes an extension of this tax credit, my prediction is that the subsequent boon to home sales, new or existing, will produce lower results than the previous two versions of these incentives.


* Trading points: with bond yields pushing to new lows over the last couple of days, past the time period when the bullish seasonals have ended, suggests that there is more afoot than just the bond market seasonals. This fits in with a resumption of the bear market in stocks, which is once again below the 200 day moving average; S&Ps are at 1075, and the 200 day moving average crosses at 1111. While I have kicked out my 10 year T-Note holdings, I remain short stocks. A break below 1040 on the S&P will affirm a resumption of the down-trend. Stay tuned.