Why There is Wealth Inequality

There is a lot of talk about fairness and income inequality in the media as they try to make wealth redistribution policies more palatable to the public. Don’t get me wrong, I do not have a problem with taking more taxes from Warren Buffet or Bill Gates. The problem starts when they start taking money away from me and I do not believe this is helping anything! When they take money away from me, I have to cut expenses elsewhere. In my case I cut my savings rate. The extra money taken from my paycheck reduces my retirement money and more dependent on social security. It is that simple!

As a country we have long since passed the point where we have a balance between spending and saving. Our defined pension plans and 401K plans are woefully underfunded and our social security system is a sham. The problem with the middle class is not income inequality or fairness. We are stupid! We make dumb decisions with our money and how we save. You hear this all the time if you listen to Dave Ramsey. Here is a quote from a John Goodman post, Why There is Wealth Inequality.

The greatest inequality of wealth holdings is among the elderly and the primary reason for that inequality is the different saving rates of people when they are young. Here is Noah Smith:

If you do the math, you discover that in the long run, income levels and initial wealth…are not the main determinants of wealth. They are dwarfed by…savings rates and rates of return. The most potent way to get more wealth to the poor and middle-class is to get these people to save more of their income, and to invest in assets with higher average rates of return.

Pointer from Arnold Kling.

Unfortunately the key idea we get from Keynesian economics is that increased spending is good for the economy and deficits are not important. Although I am skeptical that this plan ever worked, we can see that since 2000 this plan has definitely not worked. Here is the chart I created a couple months ago to show that relationship. For those unfamiliar with Mitchell’s Golden Rule, “the private sector should grow faster than the government”. I still prefer the stronger form which states the private sector should grow faster than the growth in government debt if we want to grow out of our mess. As a country if our economic policies are working, the green line would be lower than both the red and blue lines. If we look at the country as an individual investor, we need a greater return on our investment and this dependence on debt is not working!

The Fiscal Cliff Deal: The Good, The Bad, and The Ugly

By a 257-167 vote the House passed the fiscal cliff deal on Tuesday. For our family the vote is a good since:

  1. Both my wife and I have mothers who are older than eighty and have estates greater than 1 million but less than 5 million.
  2. All of the other tax increases except for the resumption of normal Social Security taxes do not affect us.

The bad news is that we are reminded that even in the face of disaster, our politicians cannot vote for spending cuts. I guess we have to run the economy into the ditch to get meaningful spending cuts. After reviewing a lot of economic history, my best guess is that we have been on a down hills slide since 2000 due to our debt load. Historically the three most powerful macroeconomic stimuli that increases consumer spending have been increases in defense spending, tax cuts, and increased consumer debt. If we cannot over-stimulate the economy with all three of these at work like we had during the Bush years, we are doomed to plan B, spending cuts and debt reduction. The 2009 stimulus spending package is a grim reminder that this time it is not different. We probably went over the magic debt to GDP number that Reinhart and Rogoff  talk about in their book, This Time Is Different: Eight Centuries of Financial Folly in 2000 but it was obscured by the consumer spending tricks of the last decade.

Too bad that these consumer spending tricks no longer work. Now we are left with the ugly option.  We know from history that there is a good way and a bad way to balance the budget. As the editorial in the Wall Street Journal, The Right Way to Balance the Budget, pointed out, the " the typical unsuccessful consolidation consisted of 53% tax increases and 47% spending cuts" while the "typical successful fiscal consolidation consisted, on average, of 85% spending cuts." Here is a summary of the bill that passed. History predicts that this bill with its preference for tax increases over spending cuts will be unsuccessful at balancing the budget or improving the economy. Fixing the spending problem was left for another day.

The Senate early this morning passed H.R. 8 by a vote of 89-8 to avert the fiscal cliff.  The bill now moves to the House.  Highlights of the bill include:

  • Raise the marginal tax rate to 39.6% on income over $450,000 (joint) and $400,000 (single).
  • Raise the tax rate on dividends and long term capital gains to 20% on taxpayers with income over $450,000 (joint) and $400,000 (single).  The top rate would remain 15% for taxpayers with lower incomes.
  • Estate and gift tax:  $5 million exemption (inflation-adjusted) and 40% rate.
  • Permanent and retroactive patch for the AMT.
  • Return of the exemption and itemized deduction phase-outs on taxpayers with income over $300,000 (joint) and $250,000 (single).
  • One-year extension of 50% bonus depreciation.
  • Extension of various tax extenders.

Revenue estimates from the Congressional Budget Office and Joint Committee on Taxation score the bill as adding $3.9 billion to the deficit over ten years compared to existing (January 1, 2013) law.  The White House has released this fact sheet and statement from President Obama.

TaxProf Blog: CBO on Fiscal Cliff Deal: $1 in Spending Cuts ($15 Billion) for Every $41 in Tax Increases ($620 Billion)

Switzerland’s “Debt Brake” Is a Role Model for Spending Control and Fiscal Restraint « International Liberty

I agree with Dan Mitchell on many issues. I just found this piece he wrote about Switzerland’s “Debt Brake” in April of 2012. I originally read about the “Debt Brake” in his opinion editorial in the Wall Street Journal. As Dan mentions it is not really a debt brake but a spending restraint and it is only as good as our legislators are willing to let it work. Although it is unlikely that this type of spending restraint will be part of the fiscal cliff negotiations Part I, it make be part of the Part II or Part III negotiations. Ultimately our politicians would have to embrace the fact that our major entitlement programs, Social Security, Medicare, and Medicaid, have become “pay as you go” programs. Here is his chart that shows the problem with spending growing faster than the tax revenues or population.

Obviously spending growth is a fundamental economic problem for the United States and our legislators are willing to copy good ideas from other countries. Representative Brady with his MAP act and Senator Corker with his CAP Act  think a similar debt brake policy in the United States would be a good solution to control the growth of federal spending. Here is what Dan said about the “Debt Brake”.

Switzerland’s debt brake limits spending growth to average revenue increases over a multiyear period (as calculated by the Swiss Federal Department of Finance). This feature appeals to Keynesians, who like deficit spending when the economy stumbles and tax revenues dip. But it appeals to proponents of good fiscal policy, because politicians aren’t able to boost spending when the economy is doing well and the Treasury is flush with cash. Equally important, it is very difficult for politicians to increase the spending cap by raising taxes. Maximum rates for most national taxes in Switzerland are constitutionally set (such as by an 11.5% income tax, an 8% value-added tax and an 8.5% corporate tax). The rates can only be changed by a double-majority referendum, which means a majority of voters in a majority of cantons would have to agree.

He goes on to make the point that this policy becomes a de facto spending cap and that it has been a good policy for avoiding the fiscal crisis problems affecting the rest of Europe.

Switzerland’s spending cap has helped the country avoid the fiscal crisis affecting so many other European nations. Annual central government spending today is less than 20% of gross domestic product, and total spending by all levels of government is about 34% of GDP. That’s a decline from 36% when the debt brake took effect. This may not sound impressive, but it’s remarkable considering how the burden of government has jumped in most other developed nations. In the U.S., total government spending has jumped to 41% of GDP from 36% during the same time period.

He concludes with:

To conclude, we know the right policy. It is spending restraint. We also know a policy that will achieve spending restraint. A binding spending cap. The problem, as I note in my oped, is that “politicians don’t want any type of constraint on their ability to buy votes with other people’s money.”

Overcoming that obstacle is the real challenge.

Switzerland’s “Debt Brake” Is a Role Model for Spending Control and Fiscal Restraint « International Liberty