The Economic Trauma of High Taxes

Occasionally an article comes along that is so good I agree with essentially everything in it. Two good economists, Arthur Laffer and Stephen Moore wrote a piece in the Wall Street Journal titled "Soak the Rich, Lose the Rich".

States are facing nearly $100 billion in budget deficits this year. They are required to balance their budgets. In the past, state governments have relied more on spending cut-backs. But now, they are trying to pursue the new paradigm: tax the rich, the top 1% -- 2% (or 5% in some cases) of earners in each state.

It will not work. One of the first laws of economics is extremely simple: people respond to incentives.

In their study Laffer and Moore show that Americans are more sensitive to higher taxes than ever before.
Tax differentials between low and high tax states is widening, meaning, for example, that a move from California to Nevada is increasingly more profitable. They found that between 1998--2007 1,100 people per day moved from the 9 highest income-tax states such as California and New York to the 9 tax haven states with no income tax. Also, incredibly, the no-income tax states created 89% more jobs and had 32% faster personal income growth than their high tax counterparts.

This study and many others provide powerful evidence that high state and local taxes repel jobs and businesses. The authors found a study that looked at 3 tax-the-rich states that increased taxes between 2000 and 2005 (Connecticut, New York, and New Jersey). All were rewarded by a significant reduction in the number of rich filers. "Amazingly, these 3 states ranked 46th, 49th, and 50th among all states in percentage increase in wealthy tax filers in the years after they tried to soak the rich."

Laffer and Moore then pointed out that Governor Rick Perry told them, "Our state is competing with Germany, France, Japan and China for business. We'd better have a pro-growth tax system or those American jobs will be out-sourced." They conclude that Texas has the jobs and prosperity model right. Texas created more new jobs in 2008 than all other 49 states combined!

My last thought is that the Texas message needs to be spread across America. Instead the Obama Nation is imposing greater bureaucratic costs on business, while contemplating its own tax-the-rich schemes. This can't be good for Texas or, indeed, the other 49 states.

Some Threats to the Economic Recovery

 

There is some light at the end of the proverbial tunnel on the economy. Some economic measures are showing modest improvements while others are still decreasing, but at a lessened rate. Forecasters are becoming more confident that the recession will end in the second half of this year followed by at least a modest recovery in 2010. Unemployment will continue to rise and may stay stubbornly high in the first half of 2010 (maybe around 10%). This forecast is consistent with Fed thinking as expressed by Fed Chairman, Ben Bernanke, on several occasions.

I believe this scenario is all but assured. Monetary and fiscal policies are more aggressive than in any period of U.S. history. Assuming there are no more hidden financial icebergs out there, this historic stimulus will jump-start the economy.

Monetary policy has lowered the overnight Federal Funds rate to essentially 0%. The Fed has pumped so many reserves into the system (leading to excess money creation) that the Fed's own balance sheet has more than doubled, and is still growing

Fiscal policy (government tax and spending policies) is also unusually aggressive. Last year's deficit was $458 billion. The projection so far this year is for a deficit of $1.8 trillion.

The problem with this much stimulus is the potential deleterious side effects starting in 2010 (hopefully not this year). Because of huge deficits and money creation we probably face high interest rates and inflation not too far down the road.

The challenge for policy-makers will be to unwind the stimulus so that the expected recovery will lead to a sustained economic recovery that does not peter-out into another recession, unusually soon after this one ends. I will be monitoring this over the next several years.

Today"s Topic: Divergent Economic Forecasts
The stock market has staged one of the most impressive short-term rallies (starting early March), since The Great Depression. A rule of thumb is that if the March lows hold, the economy should touch bottom (GDP wise) in this year's 3rd or 4th quarter. The stock market is watched by many more people than the bond market.

Watching the bond market is more tricky. An analyst can't just look at the yield on the 10-year Treasury bond (the bench-mark for the bond market). Treasury bonds have no, or very low, default risk (but that could change after 2009). Corporate bonds have higher yields than do comparable (in maturity) treasuries, ranging from relatively low spreads, for a company like IBM, and much higher spreads for a company like GM.

Three economists are publishing a paper on bond spreads. The essence of the study is that the wide spreads between corporate bonds and treasury bonds suggest this down-turn still has a way to go. Another economist pointed out that the gap between BBB-rated corporate debt (just a notch above junk bonds) and 10-year Treasuries remains high and has not improved due to the stock market rally. He claims that when the two markets diverge, in his opinion, frequently the bond market is proven correct. As a bond analyst, I concur.

Going forward then, stocks are flashing green lights and bonds are flashing red lights. Until this is resolved, the economic outlook is unusually uncertain. For the economy to do much better, bond spreads need to narrow. Then, companies will begin to increase investment in plants and equipment and re-employ workers.

Today"s Topic: The Fed and the Inflation Genie
One of the most powerful relationships in economics is the relationship between the amount of money in circulation and the price level. Classical economists (primarily those from the 17th--19th centuries) understood this and, for example, argued that a one-time increase in money of say 50%, would eventually lead to a roughly 50% rise in prices. This phenomenon is not that surprising and is still true in our time.

To combat this recession the Fed has added more liquidity (money) per time period than at any other time in its history. Fed chairman, Ben Bernanke, is an expert on the Great Depression. He argues that had the Fed pushed the money lever in the 1930's, as today, they could have limited one major cause of the recession and avoided deflation. This could have shortened the depression and perhaps it would have just been a really bad recession.

To stimulate the economy the Fed has more than doubled its balance sheet (printed money) and is expected to do that again in 2009--2010. Ultimately, this will lead to a major inflation if not checked. This is not likely to occur in 2009, with the unemployment rate expected to reach 10%. The money is out there, but with sentiment so low, consumers don't want to invest in capital goods and so on (it's like everyone is putting money under their mattress).

Once a recovery starts (late this year or early next year is the consensus), spending will increase and then we could have a serious inflation problem. The Fed says it will start taking money out of the system. However, it is not that easy as coming out of a long recession there will be enormous pressure on the Fed to delay to be sure that the economy gains traction. If they miss their timing, which has happened before, the inflation genie could get out of the bottle.

This issue will be definite concern over the next few years.

Today"s Topic:Economic Short Cycles
It seems recently that economic news is moving in short cycles. Recent reports, other than bank earnings, are negative. A survey of manufacturers indicates that this sector will continue to decline another 3-6 months and that federal stimulus spending will only be marginally effective. The Fed announced that its own index of industrial production is down 15% over the last year. By comparison, the decline in the 2001 recession was 6.8% as tabulated by the WSJ (Wall Street Journal). In addition, retail sales were down for March, after two months of improvement. Since consumption is about 70% of AD (aggregate demand), this does not bode well for a quick recovery.

Finally, there was mention of what, in class, we call a recessionary gap, a big shortfall in our current levels of output with our potential level of output. The emphasis was that with low levels of output and high unemployment, deflation, is the order of the day. We are experiencing a small amount of deflation, which so far is not worrisome.

The fear that the Fed has of deflation is that if the recession deepens AD will decline further and deflation will get worse. If this happens and consumers catch on, they may well respond by delaying major purchases to get better prices later. This would worsen the recession. Unfortunately this has happened in Japan a lot since 1990.

I believe the Fed should be able to avoid this, but it may take the bulk of this year to be sure.

Today"s Topic: Some Good News
We have some more good news on the economy. Wells Fargo reported first quarter earnings last week. Goldman Sachs reported first quarter earnings yesterday.

In fact, Goldman Sachs announced that it is planning to issue new common shares for $5 billion. Their intention is to use this money to pay back money received from the Treasury under the TARP program (Troubled Asset Relief Program).
The Federal government now must decide under what circumstances to permit Goldman Sachs to repay. Their pay cap restrictions for the banking giants are predicated on these companies receiving bailout money.

Returning the banks to private control is a long-term necessity but, there could be a lot of wrangling before this happens. Unfortunately, history shows that once government is involved in some area of the economy, it can be a long time (if ever) before the government declares their job to be done and exits the scene.

Students will soon be studying monetary and fiscal policies. They will learn that the massive stimulus programs will increase AD (aggregate demand) for U.S. production. We are beginning to see some evidence on this. The real problem will occur later this year when we will have to consider the inflationary side effects of these programs. We will look at this over the next few weeks.

Today"s Topic: Fed Minutes
The Fed (Federal Reserve System) released the minutes of its last meeting in March , on Wednesday. The (Federal Open Market Committee) is the policy setting arm of the Fed. They announced, to most economists' surprise, a plan to purchase over $1 trillion in Treasury securities and mortgage related securities. This was a surprise because, once again, maintenance employees will have to add some lubricants to the money presses. This creates an additional inflationary threat somewhere down the road, but in the short run, the Fed believes this action is required to stabilize the economy.

The minutes show that the Fed's outlook is deteriorating and they emphasized the frailness of the financial system and a sharp decline in net exports. They now expect real GDP to be flat in this year's second half before a slow recovery resumes in 2010.

It is interesting to note that the Fed is more pessimistic, just as many economists are more optimistic. This is unusual, but if the Fed is closer to being correct, it will delay inflation from taking off.