Q&A on Taxes Jude Wanniski March 5, 1999

Don Carroll: I am appalled that polls do not show a bigger desire for a tax cut now that we have surpluses. I almost would tend to believe that the electorate actually desires more government since we seem willing to pay for it. What do you think?

JW: The Republicans simply have no leader at the moment who understands that half the Americans in the work force pay no income taxes and view their payroll taxes as being directly connected to their old age pension and Medicare accounts. Half, in other words, would not get any tax cuts back in their pockets anyway. Others have all the money they need and believe the surplus should be used for proper public purposes, including paying down the debt. They know there is a long-term problem in Social Security and Medicare, so they do not think it logical to have a policy that "puts money back into people's pockets" when that money comes out of a temporary surplus in the trust accounts. The GOP continues to confuse Ronald Reagan's success with his tax cuts, when Reagan's promise was to Get the Country Moving Again with the kind of tax cuts JFK gave us. In other words, there was a strategic objective. Republicans are simply proposing to hand out cash like candy, in order to win elections.

Barry Schneiderwind: It seems to me that even in a system where the price of gold is fixed it would be possible to print too much or too little paper currency. Do you think this is correct or is it impossible in a fixed system for money to be too tight? If too much paper money is printed a country's gold stocks come under pressure as the people seek to exchange the excess money for gold. The fear that the gold might run out could cause the gold price to exceed the fixed price. That, I understand, was the case in the late 60's early 70's. Conversely it would also seem possible to print too little paper money. This might cause people to want to exchange their gold for the paper money they need. A rise in gold stocks might indicate too little paper money is being printed (too tight of a monetary policy). If the gold price is fixed and the government will always pay the established price for gold, how would you expect the excessive tightness to manifest itself? I can see that in a system pegged to a range of gold prices, when the price of gold started to move we could tell that there was too much or too little liquidity in the system but in a fixed price system there would have to be some other indication. What would it be?

JW: You get an "A" for your analysis. In a fixed-price system using gold, the government establishes a buy/sell range called gold points. If the price of an ounce was $350, the government would buy gold at $349 and sell it at $351. It could then manage the liquidity in the system to prevent the gold price from hitting either point, thus making it unnecessary for the government to buy or sell any gold. This is how the Bank of England ran the gold standard and how we ran it, until the decision was made in the late 1960s to use monetary policy to expand the economy. This meant breaking through the points and brought an end to the Bretton Woods gold standard. The correct measure would have been to lower the tax rates instead of levying a new Vietnam war tax. If you do not use gold as the indicator of whether you add or subtract liquidity, there must either be agreement on some other signal by the managers of monetary policy. To target the Consumer Price Index is of no use, because it is a trailing indicator of liquidity needs and demands. Once a series of commodity prices has fallen, there is less need for liquidity to trade them in the exchange economy. By the time the CPI reflects a change in demand for liquidity, it has already passed. In the same way, an "M" money-supply target has no utility as the central signal or indicator in a fixed system. This is because the velocity, the demand for money, can not be determined for several months after it already has been reflected in the gold price. In all these considerations, it is critical to understand the impact that changes in tax policy have on the demand for liquidity. If the tax rate that is cut was too high to begin with, the economic "system" becomes more efficient and there is increased demand for liquidity. If the tax rate being cut is not increasing the efficiency of the economy, it simply will lower revenues. In that case there is less likelihood to be an increase in demand for liquidity.

Q. Have you written about this in the past? I don't remember this being part of supply-side tax cutting.

JW: I discuss it in The Way the World Works which was published in 1978, but I first wrote about this process in long essay I wrote for the Public Interest quarterly in the spring of 1974. It was called The Mundell-Laffer Hypothesis: A New View of the World Economy. The first place it appears is in a long footnote, #4, in the 1974 article. Here it is:

4 Taxes should be cut and government spending maintained through deficit financing only when a special condition exists, a condition Mundell and Laffer say exists now. "There are always two tax rates that produce the same dollar revenues," says Laffer. "For example, when taxes are zero, revenues are zero. When taxes are 100 percent, there is no production, and revenues are also zero. In between these extremes there is one tax rate that maximizes government revenues." Any higher tax rate reduces total output and the tax base, and becomes counterproductive even for producing revenues. U.S. marginal tax rates are now, they argue, in this unproductive range and the economy is being "choked, asphyxiated by taxes," says Mundell. Tax rates have been put up inadvertently by the impact of inflation on the progressivity of the tax structure. If the tax rate were below the rate that maximizes revenues, tax cuts would reduce tax revenues at full employment. But a multiplier effect operates if the economy is at less than full employment, and the tax cut then raises output and the tax base, besides making the economy more efficient. Even if a bigger deficit emerges, sufficient tax revenues will be recovered to pay the interest on the government bonds issued to finance the deficit. Thus, future taxes would not have to be raised and there would be no subtraction from future output. Tax cuts, therefore, actually can provide a means for servicing the public debt.

I've run this paragraph in boldface to underscore its paramount importance in supply-side economics. It is one thing to grasp the idea that there is a law of diminishing returns on tax policy. It is quite another to understand that only some tax rates can be reduced in a way that makes the economy more efficient, enabling the tax cuts to "provide a means for servicing the public debt." There was a time I became totally frustrated with journalists and politicians making fun of supply-siders, because they said we PROMISED that the Reagan tax cuts of 1981 and 1986 would be immediately followed by budget surpluses. I printed out footnote number four in 14-point boldface type and faxed it to those journalists who never bother to ask questions of the people they are making fun of. Most financial journalists are of this variety, happy to make their editors happy by writing to preconceived paradigms. But that is another story, having to do with why it is so hard to advance new ideas like supply-side economics.

The concept in this boldface paragraph is central to the debate now taking place over the projected surplus in the federal budget. Different camps are staked out arguing for different kinds of reductions in tax rates, increases or decreases in federal spending, or a reduction in the national debt. Oddly enough, there is a right/left coalition trying to form around the idea that it would be wrong to pay down the national debt as long as there are good uses to which it can be put via lower tax rates or higher spending levels. In other words, if tax cuts can be used to service the public debt -- by bringing in enough new revenue to pay interest on the new bonds and some of the old bonds. Even a cursory glance back at the Reagan tax cuts of 1981 and 1986 reveals that while they did precede an expansion of the federal budget deficit, they also were accompanied by lower bond yields. That is, they were doing what Mundell and Laffer said they would do. In the current debate, I have argued against the Republican proposals to fix the marriage tax penalty or give tax credits for children on the grounds that they would not finance themselves and the Congress would do better to address the problems they are supposed to solve by targeted spending.

Q. The footnote mentions that tax rates can be cut and finance themselves when the economy is not at full employment, because a multiplier effect takes place. Can you explain this?

JW: Mundell and Laffer were originally trained as Keynesians and Mundell to this day still uses the language of the Keynesians in explaining his ideas. The idea is that when all available manpower is employed, an extra tax cut or extra spending increase will cause a squeeze that will push up prices. Alan Greenspan and other Fed governors worry about this in making monetary policy, afraid that if the economy "overheats," wages will be bid up in the competition for labor and the profits of enterprise will diminish, causing a decline in investment. This is not a supply-side concept per se, although I recognize that the phenomenon exists. When the United States entered the First World War, the government borrowed heavily in the bond market to quickly finance the war effort. Prices were bid up even though the dollar/gold price remained constant. Technically, it was not a monetary inflation, but a forced expansion that would correct itself at the end of the war.

In the supply model as I understood it from Mundell and Laffer and from my independent readings, an economy would not be at full employment even if everyone was working. That is, if half the population is working in the criminal justice system -- the police and parole officers, the lawyers, the judges, the prison guards, and the construction workers building new prisons -- the Labor Department would count them as being fully employed, but I would argue the tax and monetary and regulatory policy of the government was probably creating the underlying conditions that pushed much of the population into a life of crime. This is why I argue the economy is not close to full employment today, because such a high percentage of the work force is engaged in work -- much of it at very high salaries -- coping with the chaos wrought by our tax system and our floating exchange rates.

If we could find tax rates that could be cut or spending programs that could be increased which would expand the economy and increase its efficiency so there would be fewer workers required to do non-productive work, then we should do so. There is no need to worry about a "tight labor market," as Greenspan does, when there are so many opportunities to increase the productivity of the economy. The would be a point at which all available labor is working and all capital also is gainfully employed. Then we could talk about domestic "full employment." Even that would not limit the potential of the U.S. economy, because we would then be able to increase the efficiency of the world economy by exporting surplus capital in exchange for debt and equity claims on the rest of the world.

Kevin Isbistser posed this question on January 10, 1997: What are the "taxable things" (in our society in particular)? I realize that anything, whether possession or action, can be taxed if the government dictates it and the constituency's disapproval doesn't cut into the government's power. But, historically, are most taxes basically of three types: taxes on earned income, taxes on property, and taxes on investment earnings?

JW: When the United States began, there was only one type of federal taxation, a tariff on all imported goods. The Constitution preserved this tax for federal purposes and prohibited states from exacting duties on goods entering from other states. Among Alexander Hamilton's most important contributions as Treasury Secretary to President Washington was to have the national government assume all the debts of the 13 states, which they carried into the union. In exchange, the states agreed to sit still for a federal excise tax, to help fund the debt. The tax applied to whisky and led to the whisky rebellion in Pennsylvania, which was put down. The consolidated debt with a hard source of revenue enabled Hamilton to persuade the nation's domestic and foreign creditors that our sizeable federal/state debt could be paid in gold, which is how the U.S. began life on a gold standard instead of a fiat money system.

Revenues from these sources and from the sale of public lands were sufficient to meet federal expenses, and there came a point where the U.S. might have paid down all its debt. Military expenses grew, skyrocketing with the Civil War, which led to a variety of taxes including a small income tax -- which the Supreme Court deemed unconstitutional. Unable to finance the war with higher taxes and, in the absence of winning early battles, President Lincoln took the nation off the gold standard and thereby raised revenues by simply issuing greenbacks -- dollars that were not redeemable in gold or silver.

It was not until 1902 that modern governments seriously began taxing income, when the British began the practice in a small way to finance its imperial burdens. The United States imposed a progressive income tax in 1913, after it was made constitutional by the Sixteenth Amendment. It started small, with a bottom rate of 1% that you did not pay until you reached an income that today would be $60,000 for a single person and $80,000 for a couple, and a top rate of 7% that would apply to annual income above what today would be about $10 million. But as the United States entered the European conflict, the top rate shot up to as high as 77% in 1918, which would apply at an income of $1 million, which at today's gold price would mean an equivalent of $20 million. A capital gains tax was passed in 1921 to lighten the tax burden on gains from invested capital, which represents after-tax ordinary or wage income.

There are a multitude of ways to think about how we tax ourselves, most of them becoming part of our language since the 1930s. The personal income tax became a more and more important part of government finance in the Great Depression, especially after the dollar was devalued from $20.67 per ounce of gold to $35 in 1934. The inflation that followed began the process we later saw as "bracket creep," in which tax rates designed for the rich began to apply to the middle-class. At the time of WWII, there were no income taxes levied by state or local governments. The burdens of war and Cold War and the expansion of the welfare state caused all governments to look for more and more sources of revenue. We now are roughly at the point the British found themselves in back in 1815, at the end of 22 years of Napoleonic wars. Almost everything under the sun is taxed at least once, and many things are taxed two and three times.

The way I personally conceive of our tax system is that there are three forms of tax. The first is a tax on the original production of goods or services by a human individual or a corporate entity. The second is a tax on the transfer or exchange of what remains of the original production after it has been taxed once as income. The third is a tax on after-tax income that has increased in value, having been put at risk.

The first is a tax on original production, by an individual or by a legal entity owned by an individual or individuals. When an individual or a corporate bakery produces ten loaves of bread and the government applies a tax of 10%, it takes one loaf. The income tax applies to production. All taxation on production that has already passed through an income-tax gate is a tax on the consumption or transfer of wealth. That is, wealth is what you have after you have paid your income tax. When you save your nine loaves, you are not taxed. If you use the nine to exchange for other goods and services, the government can exact another tax. It is in this sense that a sales tax is a tax on wealth. A property tax is a tax on wealth. A gift or estate tax is a tax on the transfer of wealth.

For a business entity that has borrowed funds to conduct business, it can deduct the cost of interest paid as a cost of doing business. The entity (a bank or insurance company or credit union) that has loaned the funds can expect to pay a tax on the profits it makes on the interest received. To that part of the interest it has borrowed from depositors, it can deduct the interest paid out as a cost of doing business. The depositors are subject to income tax if they have received a portion of the interest paid. If, on the other hand, a business entity sells a part or share of itself to another entity, and pays it a share of the after-tax profits as a dividend, the individual who receives the dividend is subject to income tax on it. This double-taxing of a business dividend can be avoided by reinvesting the profits instead of paying the dividend. The funds thus continue to remain at risk. If this reinvestment of profits by a business entity is accomplished by buying back the shares of itself originally sold, the original investor may enjoy a capital gain if the price he receives is higher than the price he paid.

This capital gains tax is a third form of taxation. It is not a tax on the interest received for the use of credit, nor is it a tax on a dividend received for a share of profits on capital put at risk. A capital gain can only occur if after-tax income is put at risk in an asset that increases in value.

These three categories constitute the universe of possible taxation. A tax on production. A tax on the transfer of wealth. A tax on an increase in the value of an asset put at risk.