Link: http://www.washingtonpost.com/wp-dyn/content/article/2009/04/20/AR2009042000641.html?hpid=topnews

Ah, President Obama finally got the message. All those protests on Tax Day actually got to him. He is hooking up the giant, ugly, obese federal government monstrosity to a liposuction machine and is going to suck out the fat and produce a lean, mean, efficient machine.

He has spoken about this often in the last few weeks, that every federal program will be looked at to cut wasteful spending. As the opening paragraph to the attached Washington Post article says:

President Obama plans to convene his Cabinet for the first time today, and he will order its members to identify a combined $100 million in budget cuts over the next 90 days, according to a senior administration official.

Hold on … wait a sec … that’s a misprint right? $100 million? Can’t be … is this a joke? Out of a $3.6 trillion federal budget (annually!), he’s asking (ordering! says the Post) his Cabinet to find $100 million, or 0.0028%, in cuts. That’s how much they spend every 15 minutes! And they have 90 days to find these cuts? And they don’t even have to each come up with $100 million, but only need a combined total (that’s asking for accountability, isn’t it?)?

This is like the fat man saying, “Okay, in the next 90 days I’m going to exercise … by walking three steps on day 90.” Or the alcoholic saying, “I’m going to stop drinking … for the next three seconds.” Or the smoker saying, “I’m going to cut back from my two packs a day … by smoking one less puff on February 29th.” It is a mockery. It is sneering at the whole idea of budget cuts. It is cheek.

In the 1890s, a Russian researcher studying the physiology of the digestion of dogs made an interesting discovery. As expected, dogs would salivate at the sight and smell of meat. But if the researcher team rang a bell before each meal, the dogs would also salivate when the bell rang, even if there was no food around. The association of the sound of the bell and food in the dogs’ minds generated a physiological response. The researcher called this a conditional reflex. He went on to win the Nobel Prize in Medicine in 1904.

Most everyone knows the story of Pavlov’s dogs. What is amazing is that a century later educated people are duped in exactly the same way, drooling over what they have been conditioned to hear is an indication of what their gut desires. Even if what they are served would make them retch after ingestion, they salivate like trained pups at the sound of bells. Conservatives, when they hear the words “tax cuts", are just such creatures.

During the presidential campaign, the genius of selling candidate Obama was in the packaging. Almost every initiative involved some use of a refundable tax credit, and his campaign, along with the docile media, referred to these as tax cuts. They were actually tax expenditures: government spending imbedded in the tax code. This left conservative and moderate voters mystified. If Obama has so many tax cuts, how could he be the liberal that the right portrays him as? While some conservative leaders rightly called the Obama policies “welfare” and “spending", the message was confused and garbled at best.

During the debate over the American Recovery and Reinvestment Act of 2009 (the “stimulus” package) in February, Republican lawmakers repeatedly demanded that “tax cuts” comprise a greater share of the spending. Yet real tax cuts were never considered. The entire total of the almost $300 billion of “tax cuts” in the stimulus package were actually tax expenditures (for details on the tax changes, see this CCH summary). None of these provisions were real tax cuts. None of these provisions helped people keep more of what they earned. All were government spending in disguise.

On April 3, Congress passed President Obama’s 2010 budget (the House and Senate versions must still be reconciled). Not only does it increase federal spending to levels not seen since the Second World War, but it also increases tax expenditures by attempting to make permanent the tax credits passed in the stimulus package.

Imagine two economies. Economy A taxes the top 20% of earners, takes the $100 billion in receipts, and spends it all on income security programs that give $5,000 each to the people with the lowest 40% of annual income. Economy B also taxes the top 20% of earners, but gives the bottom 40% of earners a $5,000 refundable tax credit, such that no net money is collected and none is available for any government programs. What is the difference between Economy A and Economy B? Essentially, nothing. Economy A has a government bureaucracy to manage the income security program, while B just has a bigger internal revenue bureaucracy to manage the refundable tax credits. But everyone ends up with the same amount of money in the end.

Economy A is Welfare Socialism. Economy B is Tax Cut Socialism. There is essentially no difference.

Now imagine that Economy A wants to stimulate its economy through fiscal policy. The income security program is unpopular, it being a welfare program. So the leader of its government says, “I propose a tax cut!” He introduces a $1,000 refundable tax credit to be given to the bottom 40% of earners. Is this any different from increasing spending on the income security program by 20%? No. Will it have any less of a negative impact on work incentives? No.

The conditional reflex conservatives have for tax expenditures is somewhat self-imposed. In 1995, as part of the Contract with America, the Republican Congress passed a $500 per child tax credit, and called it “tax relief". Despite the fact that it targeted families, a natural Republican constituency, would Republicans have supported it if, instead of subtracting the $500 from one’s tax liability on Form 1040, the $500 was distributed by a government agency? Probably not, since that sounds a lot like a welfare program. But if the tax credit is refundable (the child tax credit is actually partially refundable), it is basically the same thing. Not only is the child tax credit an unworthy conservative policy goal, it is actually very close to the kind of income redistribution and social engineering that conservatives despise. Still skeptical? In his 2010 budget, Obama calls for an expansion of the child tax credit.

Conservatives reflexively think that tax cuts are good and government spending is bad because the former shrinks the federal (or state, or local) budget while the latter expands it. But as this example illustrates, it is not the amount of money that is collected by the revenue agency and given to spending agencies that matters. The negative impact of government should not be gauged by the total revenue or spending but by the total amount of interference with natural liberty and incentives, be it through tax policy or spending programs.

Conservatives also think that, if we must influence people’s behavior or assist a segment of society, tax policy is favorable to government bureaucracies because it is more efficient. In some cases this is true. But in other cases, such as the fictitious income security program above, bureaucracies serve the purpose (albeit very inefficiently) that conservatives often laud private charities for: they provide attention to individual cases and inhibit fraud and abuse. The earned income tax credit (EITC), an incentivized income security tax policy, has more estimated fraud than any government program because it is self-reported and there is no oversight.

Tax deductions and credits are government spending in disguise. Similarly, the government also hides some spending by having the spending program raise its own revenue. Examples include Medicare benficiary premiums, user fees at National Parks, and off-budget federal programs. Some programs raise enough revenue within to “pay for themselves", resulting in no net increase in spending. But these programs increase the size of government and interfere with a free economy! Certainly for some programs this is actually better and more efficient than pulling general revenues from the taxpayer; the closer the user of the service to the payer, the better. But like tax expenditures they are a hidden cost of government.

So what tax “cuts” should free market advocates cheer, and what tax “cuts” are government spending in disguise? Any tax cut that results in a greater amount of money kept by the taxpayer (in comparison to the existing policy) when the taxpayer increases the activity that is taxed is a veritable tax cut. Generally, this only includes reductions in tax rates. All other tax changes should be suspect. Similarly, when tax deductions, credits, and loopholes are eliminated, conservatives should not bemoan these changes as tax increases; rather, they are spending decreases, and should be celebrated as such.

How big are tax expenditures? In President Bush’s fiscal year 2009 federal budget, there were an estimated $948 billion in tax expenditures, respresenting 6.6% of GDP. These are detailed in the Analytical Perspectives chapter of the president’s budget. Yet this was prior to the passage of the American Recovery and Reinvestment Act of 2009 (the “stimulus") in February, with its myriad of new tax expenditures as explained above. What are the updated figures from the fiscal year 2010 budget, just released by the Obama White House? We don’t know. For the first time, the Tax Expenditures section of the President’s budget was not included. President Obama has got something to hide.

Many Obama cheerleaders make note of the fact that while Obama increases spending in his budget, federal spending only goes up from 20% of GDP under George W. Bush to 23% in the Obama years of 2010-2014 (see my post Upside Down Equality). But if we were to include tax expenditures, not only would total federal government spending be higher (by 6.6% in 2009, prior to the stimulus package), but it would be even higher still with Obama’s new tax credits. Going back to our example, without tax expenditures economy B would be able to claim that government expenditures are 0% of GDP. Yet would the top 20% of earners, who are all taxed an average of $10,000 a year, say that the size of government is zero? Tax expenditures hide the size of government. Given the fact that so much of Obama’s expensive agenda uses the tax code, his politics is cynically dishonest and deliberately opaque.

Tax cuts are political red meat for conservatives and those who believe in economic freedom. But we must not judge a book by its cover or a policy by its label. Recently conservatives and Republicans who have been conditioned to slobber approvingly at the talk of tax cuts have been slobbering over crap. Pavlov’s dogs eventually got wise to the fact that the sound of the bell often meant that Pavlov was playing a trick on them. Let’s hope that those who truly desire limited government soon get wise to Obama’s tricks, and resist salivating before seeing the goods.

Republicans in the House of Representatives have put forth a federal government budget alternative that is not only preferable to the Democrats’, but also inspiring. It does not defer to the recent electoral advantage of Democrats by offering a paler, saccharine version of the New New Deal that progressives are attempting to muscle through Congress. Rather, it rightly senses the overreach of the left that is under way and boldly sets forth a sharply divergent course that is based firmly on conservative principles but still appears much closer to public sentiment than liberal alternative.

For a decent summary of the House Republican budget, see House Budget Committee Ranking Member Rep. Paul Ryan’s statement in today’s Wall Street Journal.

The most illuminating part of Rep. Ryan’s message is the accompanying graph, reproduced here. The spike in the middle is the current fiscal year’s (2009) budget, with TARP, the Obama stimulus package, and the Democratic spending reconciliation bill causing federal spending to reach close to 30% of GDP. That’s the starting point. As one can see, the Democrats’ budget never returns to the spending levels of the last thirty years. Their failure to reign in entitlements (and the creation of new ones) produces not only increases in spending as a percentage of the overall economy, but an accelerating trend of such increases such that by 2060 or so more than half of the economy is federal spending. This actually understates the problem: the graph does not include state and local government spending (it represents only federal government spending), and does not include tax expenditures, which are a large hidden piece of the Obama budget.

The Republican alternative, as one can see, returns spending to historical levels within the next few years and incorporates entitlement savings that keep spending at these levels for generations to come.

Looking at the specific budget items that Rep. Ryan outlines, we see solid fiscal conservatism, although with some tendency to acquiesce to redistributionism. Let’s look at each of them.

Deficits/Debt. The Republican budget achieves lower deficits than the Democratic plan in every year, and by 2019 yields half the deficit proposed by the president. By doing so, we control government debt: Under our plan, debt held by the public is $3.6 trillion less during the budget period.

Is this any surprise? With all the talk about the profligacy of Republican budgets during the Bush years, the House Democratic budgets produced as an alternative had more spending than Bush’s budget every single year. Democrats are simply more fiscally irresponsible than Republicans.

Spending. Our budget gives priority to national defense and veterans’ health care. We freeze all other discretionary spending for five years, allowing it to grow modestly after that. We also place all spending under a statutory spending cap backed up by tough budget enforcement.

Remember in the campaign when McCain said he would take a sword to the budget and Obama said he’d take a scalpel? How’s that scalpel working? The approach given here appropriately funds the fundamental function of the federal government (defense) while keeping all other programs at current levels. This leaves it to the appropriations process and executive branch good management to do the scalpel work, while generally keeping the size of the federal government the same.

Energy. Our budget lays a firm foundation to position the U.S. to meet three important strategic energy goals: reducing U.S. dependence on foreign oil, deploying more clean and renewable energy sources free of greenhouse gas, and supporting economic growth. We do these things by rejecting the president’s cap-and-trade scheme, by opening exploration on our nation’s oil and gas fields, and by investing the proceeds in a new clean energy trust fund, infrastructure and further deficit reduction.

Although I think that conservative objections to cap-and-trade are overblown, it is nevertheless a bad policy that unnecessarily burdens the economy in pursuit of a quixotic goal. Simply permitting domestic industry to explore and develop new sources of oil and gas will not only solve energy self-sufficiency and lower energy costs, but also produce federal leasing revenue. I like the idea of a “clean energy trust fund” as opposed to an “alternative” energy fund; it recognizes that alternative energy has externalities too. Ryan does not mention nuclear power–the government need not actively promote it but should remove current regulatory impediments.

Entitlements. Our budget also takes steps toward fulfilling the mission of health and retirement security, in part by making these programs fiscally sustainable. The budget moves toward making quality health care affordable and accessible to all Americans by strengthening the relationship between patients and their doctors, not the dictates of government bureaucrats. We preserve the existing Medicare program for all those 55 or older; and then, to make the program sustainable and dependable, those 54 and younger will enter a Medicare program reformed to work like the health plan members of Congress and federal employees now enjoy. Starting in 2021, seniors would receive a premium support payment equal to 100% of the Medicare benefit on average. This would be income related, so low-income seniors receive extra support, and high-income seniors receive support relative to their incomes – along the same lines as the president’s Medicare Part D proposal.

We strengthen the Medicaid safety net by converting the federal share of Medicaid payments into an allotment tailored for each state’s low-income population. This will enhance state flexibility and sensitivity to spending growth.

In one of the most valued government programs – Social Security – our budget begins to develop a bipartisan solution to the program’s pending bankruptcy by incorporating some of the reforms advocated by the president’s budget director. Specifically, we provide for a trigger that would make small adjustments in the benefits for higher-income beneficiaries if the Social Security Administration determines the Social Security Trust Fund cannot meet its obligations. This is a modest but serious proposal which would not affect those in or near retirement, but is aimed at helping develop a consensus, across party lines, toward saving this important retirement program. We also assure that benefits for lower-income recipients are large enough to keep them out of poverty.

The Medicare proposal sounds dangerously like a new entitlement and I would need to look at the details before commenting further. While I appreciate any efforts to reform entitlements, I don’t approve of the new tack on Social Security. Means-testing has somehow become more in vogue with Republicans in recent years, but it is still a form of discrimination and redistribution. I would prefer that more aggressive steps be taken with respect to the retirement age and to move towards private accounts. I suppose they are keeping mum on the latter due to the current weakness of equity markets, but I hope that it will resurface as an idea in future years.

Tax Reform. Our budget does not raise taxes, and makes permanent the 2001 and 2003 tax laws. In fact, we cut taxes and reform the tax system. Individuals can choose to pay their federal taxes under the existing code, or move to a highly simplified system that fits on a post card, with few deductions and two rates. Specifically, couples pay 10% on their first $100,000 in income (singles on $50,000) and 25% above that. Capital gains and dividends are taxed at 15%, and the death tax is repealed. The proposal includes generous standard and personal exemptions such that a family of four earning $39,000 would not pay tax on that amount. In an effort to revive peoples’ lost savings, and to create an incentive for risk-taking and investment, the budget repeals the capital gains tax through 2010 for all taxpayers.

On the business side, the budget permanently cuts the uncompetitive corporate income tax rate – currently the second highest in the industrialized world – to 25%. This puts American companies in a better position to lead in the global economy, promotes jobs here at home, and strengthens worker paychecks.

This is my favorite part of the Republican budget. While the income tax cut is still far from a flat tax (and no word on a consumption tax), lowering the top rate again to 25% is a bold policy proposal that makes no apologies for the Bush tax cuts (which were a resounding success) and would spark an economic surge that would bring a quick end to the current downturn. A permanent 15% capital gains tax rate is also welcome. Finally, the cut in the corporate tax rate is perhaps the single most effective tool for lifting us out of recession and keeping the American economy competitive. I also like that it is congruent with the top personal income tax rate, thus playing no favorites between different business structures.

Overall, this budget not only escapes the heavy fiscal burden the Democrats are attempting to place on the American economy; it also moves us in a positive direction away from the big-government budgets that have hobbled conservatism and the Republican Party in recent years.

In his address to a joint session of Congress on February 24, 2009, President Barack Obama said the following:

But let me perfectly clear, because I know you’ll hear the same old claims that rolling back these tax breaks means a massive tax increase on the American people: if your family earns less than $250,000 a year, you will not see your taxes increased a single dime. I repeat: not one single dime.

This echoed what he repeated many times on the campaign trail, including this on July 7th:

Now, no matter what Senator McCain may claim, here are the facts. If you make under $250,000, you will not see your taxes increase by a single dime, not your income tax, not your payroll tax, not your capital gains tax, no tax. The last thing we should do is – in this economy is raise taxes on the middle class.

Of course, this is very sloppy. Notice how in the address he uses the words “your family"? That’s because he’s talking about joint income tax filing status. But if your are single (not in a family?), these numbers don’t apply, even though he neglects to mention that on the campaign trail.

Regardless, President Obama has already discarded this pledge, even before his address to Congress in February. On February 4 he signed the State Children’s Health Insurance Program (SCHIP) Reauthorization Act (H.R. 2). In this legislation, excise taxes on cigarettes are raised by 62 cents per pack, in addition to other increases on cigars and other tobacco products. What happened to “not … s single dime … no tax"? The tax increase goes into effect on Wednesday.

Link: http://online.wsj.com/article/SB123672965066989281.html

In the Wall Street Journal today, former Federal Reserve Board Chairman Alan Greenspan authors an editorial titled, “The Fed Didn’t Cause the Housing Bubble“. The thesis of the article is that the rise in housing prices from 2002-2006 were caused by huge capital inflows from emerging markets and by low mortgage interest rates, not by the low Federal funds rate the Fed piloted during the period arising from the last recession (2002-2005). As such, the explanation that “the easy money policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess,” is the wrong one.

Mr. Greenspan’s asserts that he “agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages.” While this may be technically correct, it’s like saying that it’s the calories in the ice cream that make me fat, not my desire to eat it. All interest rates in the economy, to one degree or another, are influenced heavily by the short-term interest rates that the Fed controls. Blaming the consequences of one’s actions on some intermediate linkages is rather silly.

The Fed’s main policy intrument, targeting the Federal funds interest rate, is linked to home mortgage rates in the following way: they influence long-term risk-free interest rates (such as those on Treasury bonds) in conjunction with an interest-rate risk premium; and these influence long-term mortgage interest rates in conjunction with a varying default risk premium. While short-term rates are much more elastic than long-term rates, it is undeniable that the fulcrum Fed funds interest rate is much more deterministic of mortgage interest rates than either changes in the yield curve or variations in default risk premiums. The only interest rates that are not set by markets (or by reactions to other rates) are set by the Fed. They are the prime mover.

Another curious thing about Greenspan’s defense is his insistence that the fed-funds rate became decoupled from mortgage interest rates:

U.S. mortgage rates’ linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

This is overstating the case. The mortgage rates did not correlate well at this time because the fed-funds rate was so low: long-term rates on mortgages or other securities had hit rock bottom around 5.75% and did not move above 6% until the fed-funds rate approached 4%. Besides, if the correlation prior to this period was so strong, was Greenspan not even more reckless with his easy money policy? The average spread between mortgage rates and fed-funds rates between 1971 and 2001 was 2.85%. If that had applied during 2003 and 2004, we would have seen hideously low rates on 30-year mortgages below 4%.

The great improvement in monetary policy made by the Fed in the last thirty years was the narrowing of its policy focus to price stability and away from macroeconomic stabilization (this looks all but discarded by the Bernanke Fed). For this I give Greenspan much credit. During the years in question, from 2002-2005, inflation was well under control, and I suppose that gave Greenspan comfort. But as in other policy areas, chasing effects rather than employing sound process is where the source of the problem lies. As we now know, CPI inflation is not the only bad effect that may result from an easy money policy. Asset price inflation and over-investment are other effects that must be considered.

It is better yet to craft monetary policy that attempts to emulate the process that market participants would employ in a free banking system, absent a monetary authority. In other words, the Fed should have targeted a Federal funds rate that was their estimate of what would clear the market of savings and investment without interference. This may not be easy since market actors respond to the Fed and not vice versa. But it could certainly be said that it is in no way conceivable that such an interest rate was 1.00% between the summers of 2003 and 2004, as the Fed funds rate was.