The Flat Tax

Question - What are the disadvantages to having a 'flat tax' where the government took a fixed percentage of money any time it changed hands (no tax write offs for charitable contributions, no progressive tax brackets, no luxury/sin taxes, etc.). Congress would have a fixed budget and have a direct incentive to better their respective economies. People would know exactly how much they would owe and no one company could get the upper hand by hidden tax breaks tucked away in obscure bills. - At least this is what the Utopian point of view is. Are there any good examples of economies that have tried this? How have they dealt with national emergencies, paid for a military, unplanned expenses, etc.?

Response - Your questions possess many subjective qualifications. Obviously, there is no objective concept of 'disadvantage' or 'advantage.' What appears to be an advantage to one person may also appear to be a disadvantage to another. For example, the progressive income tax currently in place is viewed by some as 'good' and others as 'bad' for precisely the same reason: that those who earn more pay higher rates than those who earn less. Progressivity is 'advantageous' or 'disadvantageous' depending entirely upon whom one questions - and their views of what the 'best' outcome is.

One cannot even really ask which tax system is most efficient, because it depends upon the goal of that tax system and the structure of the bureaucracy implementing that tax system.

In other words, the starting point matters. So does the ultimate result desired. Each helps define the road taken from the former to the latter.

I could write an essay about the different goals of taxation. Should we care most about overall per capita standard of living? Maximizing overall tax revenues? Only generating as much tax revenue as is 'needed' (requiring the determination of some formal definition of 'necessary')? Who should possess the power to determine how these monies are spent - the bureaucrats, or the people? If the people should possess the power, how should this power be demonstrated and acted upon?

I don't think any of that, however interesting it may be, is necessary to tackle the various characteristics of a 'flat tax.'

So, let us assume we have a flat tax. All income, regardless of label (profit, capital gain, dividend, wage, rent, interest, etc.) is taxed at a fixed rate. There are no loopholes, no tricks, no gimmicks.

Now, this system can exist independent of a balanced budget. So, I'm not going to address budgetary issues.

The first wrinkle that must be addressed is: how do we determine income? Which costs are permitted to be counted against revenues to determine taxable income? We have the same issues, it seems, with a flat tax as we do with progressive taxation. Someone is going to have to determine what is permissible and what isn't when we subtract costs from revenues.

So, what would have to happen is the authors of the legislation to implement a flat tax would have to specify deductions that would apply to married versus single and parents versus childless.

It is possible that, over time, a tendency will arise for a gradual increase in complexity within the tax system. Remember, our current labyrinthine income tax system didn't come about overnight.

The authors would also have to deal with the problem of 'double taxation.' If corporate profits are taxed, and the money left over generates capital gains - and those are also taxed, then spending will be incentivized over investment. There would still have to be a lot of caveats within the legislation to cover as many of these issues as possible in order to avoid as many unintended consequences as possible.

Of course, it's perfectly reasonable to simultaneously have both a progressive and a flat tax. The taxpayer could then select how he wished to calculate his tax liabilities and pay his taxes.

Remember in class, how we talked about the fact that everyone's income is someone else's spending? The reason I'm bringing this up to you is because the main antagonists among those seeking to replace progressive taxation are those advocates for the flat income tax and those advocates for a national consumption (or sales tax). In either scenario transactions are still being taxed, it's just the tax is being funded from the buyer's hand in one situation and the seller's hand in the other. Same money. Different angle.

It's interesting to think about.

As far as nations using a flat tax are concerned, there are actually quite a few. Russia, Estonia, Latvia, Lithuania, Ukraine, Serbia, Romania, Slovakia, Georgia, The Channel Islands (Jersey and Guernsey), and Hong Kong (Hong Kong actually has a dual tax system - where you can choose either progressive or flat).

 Economic growth in many of these nations is pretty significant.

Personally, I think simpler is always going to be less costly than complicated. But, there's an entire industry built around the complications of the current tax system that will be extremely resistant to any change (tax accountants and tax attorneys, for example).

Also, remember, income taxation is only one way a government can raise revenues. Import tariffs and bond sales are others. Unplanned for (emergency) expenditures shouldn't prove to be a problem.

This is a subject that can get incredibly complicated and we could probably have an ongoing conversation that could last an entire semester, but I hope this short 'mini-essay' at the very least points you in the right direction cognitively and helps you better understand the topic.

Of course, let me know if you need anything else.

Money, Debt and Default

Question - How can the U.S. have trillions of dollars in debt when the debt (at least to me) appears to be in a currency we control? Inflation notwithstanding, couldn't we just print extra money periodically to pay this debt back? It seems an odd concept to me that a country can be in debt within the currency that it controls.

I know I'm dismissing the complexity of international currency here, but perhaps you could expand upon what it really means when a country is in debt to other nations.

Response - Your question touches on two issues that require clarification and explanation. First, what is debt? Second, what is money? Once debt and money are understood, your question becomes relatively simple to answer.

What is debt? Debt is one of the two perspectives in the relationship between a borrower and a lender (the other being credit). Whenever I deposit money into my bank, my bank becomes a debtor to me in the amount deposited. Whenever a business or a municipal, state or federal government sells a bond to me, that entity becomes a debtor to me in the amount contracted. A bond, after all, is simply a contract to pay a fixed amount of money at some predetermined date in the future. The difference between the amount I pay, and the amount I receive is the 'rate.' So, if I'm indifferent between $100 today and $105 one year from today, my effective rate is 5%. I will not be willing to loan you $100 today unless you promise to pay me at least $105 in one year. Likewise, I will not be willing to spend $100 to purchase a bond that pays any less than $105 in one year.

This is, of course, assuming I believe the borrower will have no problem paying me back. The higher I believe the risk of default, the higher the rate I'll require. For example, even though my effective rate is 5%, I may view the borrower as risky and demand 15%. The 10% premium serves as compensation for the risk I am taking that I may never see my money again. The initial 5% serves as compensation for the inconvenience of not having the money I'm lending at my immediate disposal. If a potential lender is not presented adequate compensation for the inconvenience and risk associated with lending his money to the borrower, then he will have no incentive to lend. The inconvenience and risk simply must be compensated by the rate offered by the borrower.

Ah, but how can the federal government default? Before I can answer this question, I need to explain what money is and how it functions.

Money often gets confused with wealth. Money is not wealth. Wealth is, in a nutshell, stuff. Stuff, and the knowledge and means of making it, inventing it, and innovating with it. As you can see, wealth is versatile. With wealth, one can create more wealth, or sell it for cash, or exchange it for other forms of wealth. Money, however, is only good for one thing: the purchase of wealth.

Money exists because barter is awkward. Money helps economies run smoothly, particularly as they grow in scope and complexity. For example, if I owned an apple orchard and decided I wanted to acquire a new chair for my home office, I might go to a person who makes chairs and offer an exchange of apples for a chair. But, how many apples is a chair worth? How many apples does the chair maker even desire? The chair maker may propose a counteroffer whereby I give him a receipt for 115 pounds of apples. So, whomever presents this receipt to me may expect me to deliver unto him 115 pounds of apples. This way, the chair maker receives something he can use to purchase other things he desires, and I get my office chair without having to cart around 115 pounds of apples. Nor does the chair maker have to worry about getting rid of 115 pounds of apples. He only has to worry about making chairs.

The chair maker may then decide he wants to purchase some bacon, so he goes to the butcher and offers him my apple receipt. Now, the butcher is not going to need all 115 pounds of apples as compensation for 1 pound of bacon. Not only that, but the chair maker won't want to give up rights to all 115 pounds of apples for 1 pound of bacon. Let us suppose, that the chair maker writes a receipt to the butcher signing over his rights to 11 pounds of apples in exchange for 1 pound of bacon.

The receipts for apples have become money in this economy.

What if I decide to start exchanging receipts for my apples above and beyond what my orchard can reliably produce? Well, what are the odds everyone will show up at once and demand their apples? Here's where the art of finance and banking come in. How much wriggle room do I have? If I take too many liberties with my receipts, my neighbors may lose faith in my ability to redeem their claims on my apples. If this happens, there might be a 'run' on my orchard and I'll be ruined. This threat will also create an incentive for receipts for other producers' goods and services to be used as cash as well. There might even arise a sophisticated multi-layered banking system whereby large banks issue widely accepted notes to serve as currency while holding deposits of a wide variety of producers' receipts as claims on actual wealth.

Money will only continue to operate as it is meant to when the production of wealth (upon which the currency is founded) keeps pace with the creation of money. When wealth creation outstrips the creation of money, or when available credit evaporates faster than any decline in the creation of wealth, the result is deflation - where the money circulating in the market may purchase more wealth per unit of currency than before the deflation. When wealth creation is surpassed by the creation of money, or when any decline in the creation of wealth occurs at a faster rate than any decline in available credit, the result is inflation - where the money circulating in the market may purchase less wealth per unit of currency than before the inflation. Naturally, deflation is most harmful to the debtor because the cash he is paying back to his creditor is worth more than the cash he initially borrowed. And, inflation is most harmful to the creditor because the cash he is receiving from his debtor is worth less than the cash he initially lent out. This is a main reason why governments that possess monopoly power over the production of currency would much rather err on the side of inflation than deflation. Inflation would make it easier to pay off debts while deflation would make that much more difficult. The reason governments want to possess a monopoly on coining and printing money is not because the bureaucrats are worried about producers and consumers seeking to con one another. Con men and fraud will exist regardless. Governments want to possess a monopoly on the coining and printing of money because the bureaucrats want power. Diversification and a credible threat of competition are the opposite of power. Legitimate power only exists when there are no other present legal alternatives and no threat of any future legal alternatives.

So, can the federal government default? Technically, no. You are correct in assuming the printing presses can simply be kept running until there is enough cash to pay off all of the bills. However, hyperinflating a currency is catastrophically destructive to a nation's economy. For a potent example, one may simply look at Germany in between the two World Wars. The monetary actions of the German government fleeced the German population of all of their savings and created a massive burden to present innovation and future growth by creating incentives for investors and potential investors to seek foreign opportunities in more stable markets. Money can serve as oil in the gears of the economic machinery. It isn't necessary for an economic machine to run, but it helps it run smoother. Hyperinflation is like pouring sand into those same gears while simultaneously removing the oil. The machine will break down and require extensive repair, if not outright replacement.

In short, you should hope your government does not seek to print its way out of debt. If it tries to do so, very unfortunate things are going to happen.

Adam Smith on Wine Consumption and Relative Drunkenness

Question - "In the Wealth of Nations on pages 525-526, Adam Smith states '... the cheapness of wine seems to be a cause, not of drunkenness, but of sobriety.'  Why is this a common vice in countries/societal classes where liquor is expensive and not a problem with countries that produce or classes that can easily afford it?

I've read this a few times. Smith seems to give good examples but not so much as to why it is so."

Response - Adam Smith identifies the justification for his observation of relative drunkenness when he states on page 525 (1994 Modern Library Edition), "People are seldom guilty of excess in what is their daily fare."

He wasn't so much making a statistically supported statement as he was voicing a general observation of human nature.

A similar example could be the way many Americans treat food during the holidays of Thanksgiving and Christmas. Many I personally know (and, I'd wager, many you personally know as well) have even stated vocally that, since it is Thanksgiving (or Christmas) after all, they can be excused for eating more than usual. The fact that many foods are more available during these times than others (egg nog, pumpkin pie, etc.) may also contribute.

Not many (if any) 'overconsume' peanut butter and jelly sandwiches, for example, or other comparably pedestrian meal options that are relatively cheap to create, easy to obtain and possess no significant ties to any kind of holiday emotions.

Copyrights

Question - Should a free market have copyright laws and if so to what extent? What incentive does this give to produce new products?

Response - I think copyright laws may be written to serve an efficient purpose. They may, as you hint at, create strong incentives to be creative by protecting the creator of the work from having his ingenuity 'stolen' from him by copycats. Piracy may certainly lessen the desire to place one's creations into the open market if they are going to be permitted to be copied and distributed without compensation by the pirates. The problem with copyrights comes when/if they are permitted to transform into perpetuities. If the author/artist/musician/etc.'s heirs and the heirs of those heirs ad infinitum are permitted to limit the use of the copyrighted material, then the copyright becomes an obstacle to creativity.

I do not think it would be unreasonable to limit the copyright to the life (however long or short it may be) of the original creator. After that, the work should be permitted to enter the public domain so it can be used by future creators without penalty.

The Federal Reserve and Interest Rates

Question - During the current recession, interest rates have been held at historically low rates by the Fed. They use the Keynesian argument that low interest rates "keep credit flowing freely." But it seems to me that the lower interest rates are, the less incentive banks have to give out loans. If this is correct, why is raising the interest rate (or at least leaving it alone) not the answer to getting credit flowing again?

Response - First, it is important to understand precisely what interest rates are. Interest rates are the price for borrowed money. However, this particular price works a little differently from the prices we encounter most frequently (for example, the price on a can of green beans at Wal-Mart, or the price of a gallon of petroleum at the gas station). Prices help allocate resources more efficiently by providing incentives for resources to flow from where they are plentiful to where they are scarce (from where prices are lowest to where prices are highest). As more goods flow in this manner, the price level begins to even out between the two locations.

Interest rates, however, help allocate resources more efficiently by providing incentives for resources to flow from one time period to another. The higher the interest rate, the more it pays to forego spending now in order to spend more in the future - so resources flow from the present into the future. The lower the interest rate, the more it pays to forego saving now in order to spend more now - so resources flow from the future into the present.

Let us assume that I am currently indifferent between $100 right now and $105 one year from now. My effective interest rate is 5%. In order to convince me to part with my $100 right now, you must offer me (at the very least) $105 a year from now. If, however, the majority of potential lenders is indifferent between $100 right now and $107 one year from now, the effective interest rate will be 7%. This is great from my point of view, because I was willing to lend at 5%. If I can get 7%, why should I settle for 5%, right?

This is how interest rates work. The Federal Reserve System does not set interest rates. The Federal Reserve System sets only the rate at which it charges banks for borrowing money from the Federal Reserve. Banks have the ability to borrow this money and then loan it out at interest. If the target rate set by the Federal Reserve is 2%, then the banks have to charge more than 2% interest when loaning out this money to borrowers in order to earn money. In this way, the Federal Reserve indirectly influences the overall interest rate offered by the banks.

However, it takes two to make an interest rate work. If I do not receive an offer of at least 5% (since I am indifferent between $100 now and $105 a year from now), then I will not be willing to part with my cash. I must receive a payment that satisfies the inconvenience of no longer having the cash in my possession as well as the risk I am taking that the loan will never be repaid. If I am not paid for this risk and inconvenience, then I will have no incentive to loan you my money.

Now, to your specific question. Why is raising the interest rate (or at least leaving it alone) not the answer to getting credit flowing again?

The higher the rate is that the Federal Reserve charges the banks for borrowed money, the higher the rate they will need to charge borrowers in order to make money. The higher the interest rate the banks charge potential borrowers, the fewer people will be willing to borrow. In this way, interest rates work just like every other price in the market. The higher the price (interest rate), the lower the quantity (of loans) demanded and the higher the quantity (of loans) supplied - at that price. The lower the price (interest rate), the higher the quantity (of loans) demanded and the lower the quantity (of loans) supplied - at that price. All other things being equal, of course.

Does this answer your question? Please feel free to ask any follow-up or clarifying questions you feel are necessary.