by Bruce Webb

In comments to his last post A Response to Megan McArdle, Again Cactus put the following up as a summary of the Economic Right’s approach to tax cuts:
1. tax cuts mean people are encouraged to work harder
2. people work harder
3, growth

Another version of this was posted, without apparent irony, on a MY post on the soda tax. How to Think about Pubic Health Taxes (bolding mine but actually echoed when MY later quoted himself)

Think about the case for taxing income, via the income tax and FICA. Why do it? Well, to get the money. That’s how we finance Social Security, the Department of Defense, Medicare, interest payments on the national debt, Medicaid, federal aid to schools, veterans’ health care and benefits, the FBI, etc. Now what’s the case against taxing people’s income? Well, it’s that it discourages work and it discourages investment. And that’s bad for the economy. Now we go back and forth over whether any given expenditure has a value that outweighs the economic costs. Liberals, like me, tend to think that a relatively high level of expenditure is justified whereas folks on the right tend to disagree.

But that simply shows, and not for the first time that some of our progressive wunderkinden have simply internalized the central tenet of supply side voodoo, the idea that income taxes are a tax on work and capital gains taxes are a tax on investment, and that like proposed taxes on soda or existing taxes on liquor and gasoline the more you tax something the less people are inclined to expose themselves to that tax.

This I think is a profound misunderstanding of the psychology of work and investment. Those who care about why I would think that and those who are just dying to mock the whole idea can follow me below the fold.

Now there are some people who work just for the sake of work itself. In fact a lot of people will spend many hours on work that comes with no monetary compensation at all. We call these people ‘hobbyists’ and ‘unpaid volunteers’. And I suppose if you taxed these people directly on their time there would be some tendency to reduce that time, or at least the time reported to the tax man. But most people do not approach work as some sort of dispensable hobby, instead work is the means to some other desired end whether that end be subsistance, or fame, or fortune with its attendant material objects, or in some cases simple sociality (e.g. some people live to organize office birthday parties). Mostly though people are one way or another working for the paycheck.

But even the paycheck amount is not an end in itself, at least not for everybody, and particularly not for those people who work outside the hyper-competitive world of Wall Street, not every clerk dreams of being office supervisor, not every framer dreams of being site superintendent. some times what you have is good enough.

And when we examine history we can see that in most times and most places this is the norm, sure there are always strivers and always some measure of economic mobility but particularly in largely pre-industrialized societies people tend to end up at some equilibrium. And that equilibrium point is mostly established by a desired level of consumption.

I first came across a formalized version of this in Chayanov’s The Theory of Peasant Economy. I just now ran across a pretty good version of Chayanov’s overall thesis here Russian History Encyclopedia: Peasant Economy

Perhaps the greatest theorist of the peasant economy was a Russian economist named Alexander Chayanov, who lived from 1888 to 1939. Chayanov published a book entitled Peasant Farm Organization, which postulated a theory of peasant economy with application for peasant economies beyond Russia. He argued that the laws of classical economics do not fit the peasant economy; in other words, production in a household was not based upon the profit motive or the ownership of the means of production, but rather by calculations made by households as consumers and workers. In modern terminology, the family satisfied rather than maximized profit.

According to Chayanov, the basic principle for understanding the peasant economy was the balance between the household member as a laborer and as a consumer. Peasant households and their members could either increase the number of hours they worked, or work more intensively, or sometimes both. The calculation made by households whether to work more or not was subjective, based upon an estimate of how much production was needed for survival (consumption) and how much was desired for investment to increase the family’s productive potential. Those estimates were balanced against the unattractiveness of agricultural labor. Households sought to reach an equilibrium between production increases and the disutility of increased labor. In short, households increased their production as long as production gains outweighed the negative aspects of increased labor. This principle of labor production in the peasant economy led Chayanov to argue that the optimal size of the agricultural production unit varied according to the sector of production at a time the official policy of the Communist Party of the Soviet Union was pushing for large collective farms. As a result of this disagreement with Marxist economists and the Party line, Chayanov was arrested in 1930 and executed in 1939.

Chayanov came to his understanding not from a position of armchair theorist but by doing some serious data analysis of the surprisingly (to us) abundant documentation of peasant work life in Czarist Russia. And the result was that he found some very large divergences in work effort over the course of the standard peasant work-life with the peasant couple stepping up their work hours during some periods (for example while children are small and when setting up children with their own holdings) and then dialing it back.

Now even in the Peasant Economy there are strivers who undertake to raise their equilibrium point, your German ‘kleinbauer’ maybe wanting to rise to the status of ‘bauer’ and your ‘bauer’ to ‘grossbauer’, but equally the shift could go the other direction in any given generation, but the whole effort was not particularly driven by the profit motive but instead by the desired outcome.

Which is where supply siders get their psychology reversed. They see the income tax as a tax on work and as such a disincentive to work itself. Just as they see a tax on capital gains as a tax on capital and so a disincentive to invest. The historical reality generally shows the exact opposite, the higher the tax the more you have to work to achieve your desired consumption outcome, and similarly the same is true for investment, more tax means more intensification of investment activity. Now certainly there are limits to how far this process can go, if you tax labor output down to subsistence and sub-subsistence levels you risk your serfs and/or wage employees simply running away, and contrawise if you tax capital at rates up to 98% it is no wonder that the Beatles ran away from England as well. But there is no evidence that current levels of taxation are actually above the sweet spot where taxes mean more work and more capital investment rather than less.

Meaning we need to redraw that Laffer curve to include consumption equilbrium points for various income levels. If a person’s current income is above his own personal equilibrium point he might well react to a tax cut by reducing his hours of work. If instead a tax increase takes him from above equilibrium to below he might react by increasing hours. And the same is true for the investor. If as a group a society’s top 5% or top 1% are living large at current returns and rates, a tax cut might just lead to them commissioning artists or patronizing writers and scholars. Traditionally aristocracies have sought to reduce or eliminate their overall tax burdens, and it was not because they had a burning desire to spend every day working their fingers to the bone. Instead that tax exemption enabled them to maintain or even expand their consumption.

Supply side psychology treats ‘work’ and ‘investment’ as ends subject to direct incentives or disincentives from taxes. But historical reality shows they the are instead means to other ends that include such things as consumption and display. Calculating the impact on any given tax change on any given group requires some deeper understanding of the sociology involved among that group. History is full of instances where people scraped and scrapped behind the scenes simply to maintain appearances at Court or its socio-economic equivalent (think ‘Sunday Go to Meeting Clothes’ among the working classes).

How hard are you willing to work to keep that Bass Boat and the Lake Cabin even as the taxes on them are “killing you”? Are you really going to cut back your overtime in response to a tax increase if it means giving up your Season Ski Pass?

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Just when we think we’re running out of things to write to you about, something or someone usually comes to the rescue…

So this morning we have a full plate on offer to us. But we can’t cope with them all, so the ANZ Bank’s $2.85 billion capital raising, Bendigo Bank’s $615 million tree exposure, and Rio Tinto’s iron ore negotiations can wait for until tomorrow and Friday.

This morning the subject is tax. We’re looking at it for two reasons, one is the “12-page lift-off Smart Tax Guide” from today’s Australian Financial Review (AFR), and the second is thanks to an email from Money Morning reader Graeme Beal.

Mr. Beal sent through an email last night to the Money Morning Mailbag [moneymorning@moneymorning.com.au] writing:

“Recently I felt moved to give the Tax Review panel my take on tax policies here and abroad which I contend contributed mightily to the recent shemozzle in financial markets.”

Mr. Beal sent a copy of his submission to us. It’s 26 pages long. Unfortunately, we haven’t had time to read it yet – but we will. Therefore at this stage we’ve got no idea whether we agree with Mr. Beal’s proposals or not.

But that’s not the point, we’re grateful he’s sent it to us as it’s highlights an important fact…

Australians pay waaaaaaaaaaaay too much tax. We’ve highlighted before that the government’s total tax intake is around 40% of GDP. We’re aware the government enjoys expressing things as a percentage of GDP, although we haven’t heard them mention that statistic too often.

So, we thought we would pay a visit to the Australia’s Future Tax System website, and in particular drop-in on the terms of reference for the review.

Remember, this is the review that the omnipotent treasury secretary Ken Henry is running.

Take a look for yourself by clicking on the above link, it’ll only take you a few minutes to read.

It’s a perfect example of how government’s in general claim to be helping out, whereas in reality all their proposals (whatever the political party) will only succeed in destroying everything they claim they are building.

We don’t have the space to reprint everything here, but even the first paragraph serves up so many untruths it’s not funny:

“The tax system serves an important role in funding the quality public services that benefit individual members of the community as well as the economy more broadly. Through its design it can have an important impact on the growth rate and allocation of resources in the economy.”

Actually, let’s rephrase our comment above. It’s not that all their claims are untrue at all. In fact they are right. Only not in the way they believe.

The tax system does have “an important impact on the growth rate and allocation of resources in the economy.” It’s just that the government has a negative impact on growth, and ends up allocating the resources in all the wrong areas.

Thanks to government interference and meddling, more resources than necessary are diverted into parts of the economy such as construction at the expense of say, manufacturing.

Simply because the government taxes excessively but then provides tax breaks back to property developers and investors, capital is drawn towards funding those ventures.

Yet something of intrinsic value, say manufacturing, is hampered due to restrictive government policies (again, it’s all parties) such as the minimum wage. Who would invest in domestic manufacturing without the ability to freely negotiate the cost of labour.

In a free market neither the property sector nor the manufacturing sector would be assisted nor handicapped by the government.

But that aside, there was another paragraph in the tax review’s terms of reference that stuck out like a sore thumb. It was this:

“The review’s recommendations should not presume a smaller general government sector and should be consistent with the Government’s tax to GDP commitments.”

In other words, don’t even think about suggesting the government spends less. Although in reality the inclusion of such a clause is purely academic. As if a public servant would recommend less government spending.

But how can you have a tax review where one important part of the outcome is already decided. Namely government expenditure.

Therefore the review cannot possibly recommend an cut in taxes if it is to propose a balanced budget. The outcome of the review must and can only conclude that current levels of taxation – at least – are necessary.

The result will be not so much of a tax review, but rather a tax reshuffle.

And that’s not all, I mentioned above how government’s claim they are helping but only succeed is harming, well, here’s how they believe they can help:

“The review should make coherent recommendations to enhance overall economic, social and environmental wellbeing, with a particular focus on ensuring there are appropriate incentives for:

• workforce participation and skill formation;
• individuals to save and provide for their future, including access to affordable housing;
• investment and the promotion of efficient resource allocation to enhance productivity and international competitiveness; and
• reducing tax system complexity and compliance costs.”

We can sum this up very quickly. Workforce participation and skill formation become lower the more government is involved. The first home-buyers bribe and high taxes make it hard and for some impossible, to save for housing.

A government cannot by any stretch of the imagination promote “efficient resource allocation.” Do we really believe a government bureaucrat can better manage the allocation of resources than a truly free market? We don’t think so.

And as for the last point, that’s the double whammy. This will be Ken Henry’s coup de grace. It will be the recommendation that individuals not be burdened with having to complete tax returns every year…

That it takes up too much time and too much money, and that it is best for the individual to just pay tax and not have to worry about filling in a form.

This will ensure that many taxpayers lose complete control of how much tax they pay. But of course, it won’t be marketed that way. It will be marketed as a way to “help you” or in real government-speak “responsibly helping working families around the kitchen table.”

And you can bet the tax office will increase the number of audits and prosecutions of tax payers just to drive home the point that filling out a tax return is too hard. “Which would you prefer? A $500 tax refund, or a 6-month jail term? Your choice!”

The final point that drew our attention was this:

“The review should take into account recent international trends to lower headline rates of tax and apply them across a broader base, as well as domestic and global economic and social developments and their impact on the Australian economy.”

Well, that’s just another way of saying keep the rates as high as they can get away with, but increase the number of things that are taxed…

I mean, they state it clearly what their intentions are, “apply them to a broader base.”

The biggest tax grab will come from carbon taxes, or emissions trading, or greenhouse taxes – whatever they want to call it.

But to put it simply, just think of anything that isn’t currently being taxed, write it down and then look at your list in a couple of year. Because by then chances are the government will have found a way to tax it.

Kris Sayce
for The Daily Reckoning Australia

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All of this stimulus talk chafes me the wrong way, given that we don’t have $815 billion lying around to spread around the economy, we’re going to have to borrow it. I figure at some point, someone is going to call our tab, and that can’t mean anything good for the average consumer here in the U.S. With that said, if you’re a homeowner, the stimulus package that President Barack Obama recently submitted (and passed in the house) does contain some provisions that could mean some savings and tax credits for you.

First time buyers, for example, could be looking at a $7,500 tax credit assuming they buy in the near future. It’s really a modification of the first tax credit in the already passed Housing Recovery Act, except that it isn’t a loan that has to be paid back within 15 years. Instead, you won’t need to repay it at all. Considering the HRA didn’t really do much to bring buyers out of the wood work with an additional loan (even with no interest), perhaps free money will entice those on the sidelines to get back in the game, assuming you qualify anyway. To do that, you’ll have to be a consumer who hasn’t owned a home in the past three years, and the new home must be your primary residence.

If you didn’t qualify for the “other” stimulus act that was passed last year, you also have a shot at that money this year if you had a kid or if your income dropped in 2008. If you had a kid you’ll also be rewarded with an additional tax credit of up to $1,000 per child this year for 2008. That’s in addition to the $3,500 exemption you get for each dependent you claim!

The bill is still currently being tossed around, though, so don’t count your chickens just yet. It passed in the House, but is well on it’s way to the Senate, where the few Republicans that are actually left are opposed to the amount of pork the bill contains. Whatever your political leanings are, it’s tough to argue that homeowners don’t need at least some relief from the bottomless drop in housing, but we’ll see how this plays out.

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