Some Economic Reforms

Caution:- keep in mind that most of these recommendations are inter-dependent, and that they cannot generally be examined in isolation. In most cases, the provisions of multiple recommendations are intended to work together to achieve a desired result. In some case, the provisions of one recommendation are designed to correct what might otherwise be a negative consequence of some other recommendation.

Progressive versus Regressive Taxation Impacts

A "Progressive" tax structure is one where the rate of taxation increases as the taxable amount increases. A "Regressive" tax structure is one where the proportion of tax paid decreases as the taxable amount increases.

The rationale behind a progressive tax structure is that those who have the higher taxable incomes are reaping proportionally greater benefits from whatever is being funded by the tax, have more to loose if those benefits were to disappear, and therefore "should" pay proportionally more. The ethical rationale behind this "should" is based on the presumption that the taxes paid ought to be proportionate to the benefits received.  This presumption is, of course, drawn from the distributive justice principle of "fairness as equal due" -- the fair and equitable distribution of good and harm, and/or the social benefits and social costs, across the spectrum of society. It starts with the premise that all equals should be treated equally, and those who are unequal due to relevant differences, should be treated differently in a manner that is fair and proportionate to, or commensurate with, their difference.

Everyone excepts that taxation ought to be "fair".  And in this instance, the concept of fairness is understood in terms of just deserts.  The argument is based on the presumptions that

(i) those with the larger incomes, and presumably greater assets, are benefiting proportionally more from the social and economic stability, the rule of law, and other institutions and social structures maintained by the government;

(ii) that their larger incomes and greater assets are made possible by the sustainment of such a conducive environment;

(iii) that the opportunities that existed to earn such large incomes and amass such great wealth are a direct consequence of such a conducive environment; and

(iv) that these people would thus loose proportionately more than citizens less well off, should such a rewarding environment cease to exist.

One politically still popular rationale for progressive taxes that history has proven to be bankrupt, is the philosophical position that the wealth of the wealthiest "ought" to be expropriated by the government and redistributed to the poorest in the society. This argument is based on the ethical principle that the needs of the many morally justify the forcible expropriation of the wealth of the few - i.e. that needing something is more ethically worthy than earning something. The collapse of the Communist economies has vividly demonstrated that this ethical reasoning is critically flawed.

The rationale behind a regressive tax structure is simplicity. Openly regressive tax structures are almost always either a flat percentage of the taxable amount, or a fixed single amount. The fixed single amount is often especially attractive politically, since it can be marketed fairly easily on an egalitarian "per capita user-fee" basis. The most common current examples of regressive taxes are sales and value-added taxes (single percentage of taxable amount), payroll taxes (fixed amount per employee), unemployment insurance, and social security taxes (fixed percentage up to a specified limit, and a flat amount there after). There is quite likely an additional "hidden" rationale behind the kinds of regressive taxes that have been implemented. They usually impact hardest those in the society with the least political leverage. And because that population is also the largest numerically, the regressive taxes reap larger total dollar amounts than would be politically acceptable via a progressive structure.

The current popularity of a "Flat Tax" approach to income tax reform is based on its supposed simplicity when compared with the overly-complex status-quo. Whatever "fairness" arguments that are presented are founded on the dubious suggestion that however regressive a flat-tax approach would be, it would be more progressive than the current system that lets many of the wealthy off "Scot-free". At least that is the public claim. As in all political campaign pronouncements, the reality is quite a bit different. Even in those relatively rare cases where the wealthy have managed to pay little or no "Income Tax", they are still subject to the same "User-Fees" and "Sales-Taxes" as the rest of us. And since the wealthy have, by definition, more income to dispose of in the first place, they inevitably wind up paying a greater total amount of such taxes (per capita) that do the non-wealthy. Thus while the reality is that for some of the wealthy the taxation system is not as progressive as might have been intended, it is not true that they pay no taxes at all. A 5% sales tax on a $2 million yacht pays considerably more than the same sales tax on a $2 bottle of water.  

Moreover, given the inherent complexities of defining what "income" would be subject to such a flat tax, it is questionable whether a significant portion of the plethora of existing loop-holes would be closed. Even the proponents of the flat-tax approach, recognise that it would be regressive and that regressive taxes are somehow less desirable than progressive ones. Although few, even among the experts, acknowledge the readily available evidence that supports that attitude.

Statistics from England since the 1750's, and the U.S. from the 1950's suggest that the average economic growth rate of the economy varies inversely with the degree to which government revenues are funded by regressive tax structures. In general, there is a strong correlation between progressive taxation and high economic growth. (And of course, between regressive taxation and low economic growth). This correlation also shows up when current year data (2004 was the latest available from the UN at the time of this writing) is compared across nations. Economists have not come to any general agreement on why this correlation should hold, which may explain the lack of public discussion of this evidence. But there is no disagreement about the strength and implications of the correlation.

1) Excise (Import / Export) Taxes

 

2) Corporate Taxes

Corporate taxes should be completely eliminated. Corporate taxes, whether income, sales, or value-added, have two effects - both detrimental to the interests of the consumers.   The first is to distort the corporate treatment of liabilities.   Current tax law means that interest on borrowed funds is tax exempt, while dividends paid to share-holders are double taxed.   Once because they are after-tax corporate expenditures, and second because they are treated as income by the individuals who receive them.   The imbalance in the treatment of capital gains means that it often "pays" a corporation and its shareholders to retain earnings and buy back their common stock, rather than pay dividends.   Massive conglomerates are therefore intelligent options from a tax perspective.   Borrow billions, and retain corporate earnings to buy up the shares of other companies.  

In order to promote the disintegration of giant monopolistic conglomerates, instead of sending a tax-slip to each shareholder just for the dividends paid out, each corporation would divide the entire corporate income by shareholder, and let each shareholder report as income their portion of the earnings-per-share. Corporate income would naturally include the appropriate share of the earnings-per-share of any stock held. This would remove any tax-based incentive for vertical or horizontal amalgamation of companies.

Eliminating corporate taxes in this way would have some significant advantages over both a corporate profit tax, and a sales or value-added tax. Eliminating corporate taxes would -

3) Commercial Competition Policy

Where excise taxes do cause increased costs to the consumer, and net economic disadvantage, is where the local market does not demonstrate price competition. When the local market is non-existent (the only source of supply is off-shore), excise taxes will raise consumer costs with no compensating economic benefit. When the local market is monopolistic or oligopolistic, competing suppliers will compete in all fields except price. As a result, there is no economic incentive pushing efficiency, innovation, and entrepreneurship. The consumer costs of the product will remain above the economic advantages of the manufacturing wages required to build the product. As long as there is price competition, the economic incentives will push the consumer cost of the product below the economic advantages of the manufacturing wages required to build the product. So there is a clear economic advantage to be reaped by fostering and enforcing an economic environment conducive to price competition. To achieve this, the following policies are recommended:-

 

4) Personal Income Taxes

Personal Income Tax brackets need to be completely re-configured. In addition, all payroll taxes (such as Social Security and Unemployment taxes) that are currently imposed most heavily on the lower income brackets should be eliminated. Each decade, statistics from the previous 10 years should be employed to re-align the tax-bracket boundaries. (Using the same frequency as the census would make a certain amount of logical sense.) The bottom 10% of taxable incomes should pay no income taxes.

5) The Money Supply

At the moment, the way the banking system in the United States is currently configured, the control of the amount of money in circulation, the control of interest rates, and thus the control of the national (and indeed the international) economy is totally vested in a small group of technocrats - seven appointed bureaucrats and five private bankers. These gentlemen are not elected, not subject to public review of their actions, and not responsive (except at their own whim) to the political will of the electorate or any elected representatives. The Board of Directors of the Federal Reserve System has the legally authorised power to frustrate, circumvent, and nullify any economic aims and actions of the elected members of Congress.

Money and Banking are considered "complex and esoteric" subjects by both politicians and the press. Explaining and discussing issues in this field is not suitable for "20 second sound bites". As a result, our political representatives and members of the press avoid discussing them, avoid learning about them, and avoid educating the public on their significance to our daily lives. If the Federal Reserve should choose to initiate a recession by raising interest rates, or initiate inflation by expanding the money supply, there is no public discussion about alternatives or consequences.

Even though the politicians in Congress have the authority necessary to over-see the activities of the Federal Reserve, they are loath to do so. The Congress enjoys the political rewards of authorising the spending of monies. They do not choose to accept the responsibility for the economic consequences of their fiscal policies. If they were to start exercising their authority to oversee what the Federal Reserve is actually doing, they would have to accept the political responsibility for the FED's actions - whether it be economic growth or recession, unemployment, higher interest rates, or inflation. It is politically expedient to have an "independent" Federal Reserve Board to blame.

Some Elementary Economic Facts of Life

A universally accepted principle of economics is that the amount of money in circulation must approximately equal the amount of goods and services that are being demanded. If too much money is put into circulation, you get "demand-pull" inflation (too much money chasing too few goods). If too little money is put into circulation, you get a "demand-lag" recession (insufficient demand to sufficiently employ the labour force). Another universally accepted principle of economics is that the rate of new capital investment in the economy varies inversely with the interest rate. High interest rates stifle new capital investment, even if economic demand is high - resulting in "Stagflation" (demand-pull inflation concurrent with low economic growth). Low interest rates promote higher capital investment, if (a big if) there is sufficient demand to justify that investment.

What is less understood, are the political consequences of these economic alternatives. Consider inflation. Who benefits and who gets hurt? The victims of inflation are not those commonly believed. During periods of inflation, wages and prices generally keep pace. There may be some lag, but by and large, wages and prices remain relatively stable in real terms (after inflation is factored out). Most pensions and other forms of government assistance to the poor are indexed to the cost of living, so they too do not suffer. The people who suffer, are those with financial assets. And those with financial assets are a small minority of the population. The latest statistics (1996) suggest that 64% of Americans have less than $10,000 in financial assets. The beneficiaries of inflation are all those who own real assets (land and houses, for the most part), and those who are in debt. When you borrow money, you borrow in current year dollars, and repay the loan in inflated future year dollars. Inflation therefore tends to shift wealth from the wealthier (who own and lend the financial assets) to the poorer (who borrow and spend). Manufacturing too, frequently benefits from inflation - and that includes the manufacturing workers. During periods of inflation, the currency is devaluing against real assets. This generally translates into a devaluation of the currency against other currencies. Which means that a nation's exports become cheaper and more saleable. The victims of inflation, therefore, are the owners of assets and the lenders of money. They are numerically the minority, but the political influence of their wealth is significant.

The way to "correct" inflation, and restore monetary stability, is to reduce the aggregate levels of demand. There are a number of ways of doing this. Most of the levers are under the control of the Congress through its fiscal policies and credit management laws. The Federal Reserve System has control over only one - interest rates. By raising interest rates, the costs of borrowing goes up and the amount of borrowed money goes down. Most of the economy depends on borrowed money to smooth its functioning - very little is exchanged on a "Cash on Delivery" basis. Many sectors of the economy are very sensitive to the costs of borrowed money. Housing starts and car purchases, as highly visible examples, will decline dramatically as interest rates go up. The effect ripples through the economy, slowing things down. Manufacturers produce less, and lay off people. Businesses can't sell enough to cover their debts, and go out of business. Higher interest rates also generally attract foreign capital into the nation's currency, biding up the exchange rate. As a consequence, the export prices of the nations exports go up, export demand falls. Manufacturers produce less, and lay off workers. Unemployment rises. Demand falls. Excess supplies of manufacturing capacity, labour, and commodities results in downward pressures on prices. Inflation is stopped. Who benefits and who gets hurt? Anyone who owes money gets hurt as the costs of borrowing goes up. Anyone who depends on borrowed money gets hurt - and most businesses fund their operations with short-term borrowing. Anyone who lends money benefits as the rewards of lending go up. Owners of real assets (land and houses, mostly) get hurt as the prices fall to reflect the rising costs of mortgages and the falling prices of commodities. Owners of financial assets benefit as the return on investment goes up. High interest rates therefore tend to shift wealth from the poorer (who borrow) to the wealthier (who lend).

None of these trade-offs are discussed by either politicians or the press. The public is largely ignorant of the alternative and consequences. Congress has chosen to abdicate its responsibility for making these kinds of trade-offs. It has delegated responsibility for managing the economy to the Federal Reserve System. And the political constituency of the Federal Reserve System, the people with whom they talk and to whom they listen, are the people who own and lend money.

How the Banks Work

Suppose you come along, and deposit $10,000 of cash in my bank. Now it's a small bank in a small town (and you are just one of many depositors), so I can draw upon the experience of 300 years of banking experience to know that it is not likely that you or any combination of my depositors will walk in and require that $10,000 in cash. I can lend out that $10,000 to a other people, and earn interest on the loans. I can get away with this, because most financial transactions that will be done with the borrowed money, will not be done using cash, but will be done using checks (or other electronic forms of money). The people to whom I lend that $10,000 will take only a small portion of their borrowed money in cash. I will only need enough cash on hand to provide the needs of those who want to hold on to some cash. And experience shows that this portion will be small, and the period that people hold on to cash is relatively short. Pretty soon, one of the other people in town will come in to deposit that cash because they have received it in payment for some sale.

The early "bankers" of the 1600's were actually goldsmiths. And the "cash" they were dealing with was gold. The banking function was discovered when they began to print "gold receipts" as receipts for the gold bullion that they kept in their safes for their depositors. They quickly learned that they could print "gold receipts" for more gold than they actually had on deposit. They discovered that few people actually wanted to actually carry around their bullion. It was much more convenient for people to carry and exchange these "gold receipts". Thus began the "fractional reserve" method of banking.

What it means today, is that my bank can lend out much more than just the $10,000 that you deposited. As long as I retain in my safe sufficient cash to satisfy any of my depositors who might come in and ask for some cash, there is no practical limit on the dollar volume of new loans I can create. As a banker, I can create new money out of thin air. Since the loans earn interest, and the deposit pays little or none, I have a nice little money making machine. There are some risks, or course. Borrowers can default on their loans. And depositors can come in and demand more cash than I have on hand at the moment. But the niceties of modern American banking legislation easily minimises these risks.

In order to put some constraints on the potential for excesses, the banking laws stipulate that I must maintain "reserves" (ie. "cash on hand") of a minimum of 8% of my outstanding loans. Which means that, based on your $10,000 deposit, I could write loans for (and of course earn interest on) $125,000. Should I need it, I can always borrow additional cash from my friendly local Federal Reserve Bank. In fact, should I wish to write even more loans, I can always borrow the cash to cover the reserve requirements as well (a practice call "managed liabilities" in modern parlance). To make things even easier, the banking laws permit many financial instruments besides cash currency to be classified in the category "reserves". Just about any commercial debt instrument will qualify. As will Treasury bills and bonds, and bank deposits held at any of the Federal Reserve Banks. I can, therefore, not only earn interest on the outstanding loans I can issue, I can also earn interest on the "reserves" I must retain.

To minimise any threat of a sudden influx of depositors demanding their deposits back, the banking laws have established the Federal Deposit Insurance Corporation. This institution guarantees the availability of all deposits up to $100,000 - even if my bank collapses for other reasons. Modern corporate liability laws are so structured that even if my bank should fail, I myself will not be financially liable for any uninsured deposits. And if my bank becomes large enough, the Federal Reserve Board will not permit it to fail. The FRB will adjust interest rates, and economic conditions, so that my debtors will not default.

Combine the Economic Facts of Life that make it clear that owners of assets and lenders of money are hurt by inflation but benefit from high interest rates, with the working principles of banking operations, and it becomes obvious that Bankers are the most vociferous proponents of -

These policies result in an economically regressive transfer of wealth from the poorer to the richer, and an allocation of economic pain and dislocation disproportionately on those least able to bear it. So it is only natural that the banking community strongly opposes any modification of the current banking regulations, any oversight of the Federal Reserve Board, or any reduction in the secrecy and "mysticism" with which the Federal Reserve Board carries out its functions.

Creation of Money

The United States Government is just like any retail banking customer when it gets paid (takes in taxes), spends money, or borrows money. The only effective difference is that the US government is not very likely to default on its loans, so it tends to pay a lower than average interest in its borrowings.

The book-keeper for the United States Government is the United States Treasury Department. But unlike most other national government book-keepers, the Treasury Department does not manage the economy or the money supply. Congress has delegated these functions to the Federal Reserve Board.

When the FRB wants to increase the money supply (or lower interest rates, which is effectively the same thing since you can't do one without the other), it purchases "Stuff" on the open market. It does this through the "Open Market Desk" at the New York Federal Reserve Bank. To pay for what it buys, it issues a check (or rather arranges an electronic funds transfer). The money gets deposited, like any other deposit, in any of the thousands of banks throughout the system. The banking system, making use of the fractional reserve rules, then lends out $12.50 for every dollar that the FRB pays out.

Where did the FRB get the money it pays out to buy that "Stuff"? It creates it out of thin air. There is nothing to back it up. The US currency is no longer based on gold, or on any commodity standard. There is no theoretical limit to the amount of money that the FRB can create in this way. The only practical limit is the consequence to the economy of issuing too much money - inflation. The accounting books balance at the end of the day, because the purchased "Stuff" is held on the accounts as an "Asset" to correspond to the "Liability" created by the outstanding check. The "control" (such as it is) on excesses of the FRB in the creation of money, is that the FRB has no direct incentive to buy "Stuff". The FRB itself is not a profit making enterprise. Any income earned on the "Stuff" it buys is returned as income to the US Treasury.

Two economic factors govern how much money the economy requires (without having too much or too little). One is the "velocity of money". This is a technical term indicating how rapidly money changes hands over time. In 1987 (the last statistic for which I have data), the velocity was approximately 6. This means that a Gross Domestic Product of $1 trillion will require about $167 billion in money. The velocity of money changes over time, as people change their individual attitude about maintaining their own "cash on hand". The other factor is the growth of the Gross Domestic Product. As it grows, the economy will need more money. As a consequence of these factors, the FRB very rarely has to actually decrease the money supply. Instead, it merely has to regulate the rate at which it permits the supply to grow.

But if it does choose to contract the money supply, it does so by the reverse of its normal process. It sells "Stuff" on the open market. When it receives payment for what it has sold, it decreases the account against which it normally issues payment checks, and simultaneously decreases the asset balance. If necessary (it has never been) it has the authority to borrow US Treasury Bills from the US Treasury, in order to sell them on the open market.

The "Stuff" that the FRB trades in is legally any interest bearing debt instrument. As the debt instrument is paid off by the issuer, the monies received by the FRB decrease the account against which the payment checks were drawn, and simultaneously decrease the asset balance. To simplify the accounting process, the FRB almost exclusively deals in very short term instruments. And because any income earned on the "Stuff" it buys is returned as US Treasury, the FRB almost exclusively deals in short-term (30 to 90 day) US Treasury bills. (The other main component of "Stuff" is short term loans to the small list of large banks authorised to deal directly with the Federal Reserve.)

Recommendations

(A) The history of the Fed since its inception in 1913 demonstrates that the bankers who are running the show, will run it for the benefit of the banks involved, and not the electorate to whom they are not responsible. Whenever there has been a run on any senior bank, the Fed has created sufficient liquidity in the money market to protect the banks - regardless of the economic consequences. Whenever inflation has become a significant banking concern, it has raised interest rates and initiated recessions - regardless of the consequences to the population. The first and most important banking reform required is, therefore, to restore political control over the economy. To that end, the Federal Reserve Board must be made a subsiduary department of the United States Treasury. The Secretary of the Treasury, the President's Budget Director, and the Chairmen of the House and Senate Banking Committees must become voting members of the Federal Reserve Board. The presidents of the twelve Federal Reserve Banks must be shifted from the Federal Reserve Board, to the Federal Reserve Advisory Committee. The political processes must no longer be permitted to circumvent their responsibility for the economic prosperity of the nation.

(B) To create money, the US Treasury should spend the money into existence. Currently, to spend money it doesn't have, the US Treasury sells a US Treasury Bill and uses the money thus borrowed from the open market to fund its operations. The Federal Reserve then creates money out of thin air to buy it back from the open market. Eliminate the middleman. Allow the Treasury to create the money out of thin air. Each time it writes a check to cover operations, it would create a "United States Share" as an offsetting entry in the books (technically it would fall under the "Shareholder's equity" entry on the balance sheet.)

(c) The reserve requirement should be raised to 33%. (I would prefer to raise it to 100%, but the banks need a meaningful source of income, or the customer service fees will quickly become extortionate.) A 33% reserve ratio will allow a bank to loan out 2 dollars for every dollar of "United States Shares" it holds as reserves. By decreasing the "fractional reserve" multiple from 12.5 to 2, the amount of money that the US Treasury would have to create to meet the demands of the economy would be six times what Federal Reserve now creates. This means that the government would be able to spend six times the amount it presently can without having to borrow (and pay interest on the debt).

6) Banking Regulations

Far too much of the banking system's portfolio of outstanding loans are to Third World governments, commodity and real estate speculators, and buyers of non-productive financial instruments. Bankers have been seduced by the higher interest payments that these risky and non-productive ventures are willing to pay. The whole idea of creating new money, however, is to foster the creation of new wealth in the form of increased output. The banks need to redirect their loan portfolios away from non-productive borrowers and towards capital investment projects and direct consumption activities (if the demand is there, some entrepreneur will create the supply). To that end, a series of new Banking system regulations are required:

7) International Debt Relief

"The developing world owes approximately $1.3 trillion to the governments and banks of the industrialised nations and to international financial institutions. Each year, the repayment of capital and interest amounts to approximately $150 billion - roughly three times as much as the developing world receives in aid. As it is impossible to meet these interest charges in full, the amount unpaid is added to the amount of debt owed .... When all transactions are taken into account - the net effect is that the developing world is now transferring $40 to $50 billion a year to the industrialised world." --
                          (The State of the World's Children, 1992, Summary, New York: Oxford University Press, pp 8-11)

The current demand on the economies of the developing world to generate positive trade balances in order to pay the interest on their debt, has meant rapid and uncontrolled industrialisation in order to produce products not for local consumption, but for American consumption.

The solution to this problem is as simple and as complex as the recommendations here provided for the US Economy: -

8) Currency Speculation

There is no part of the financial economy in greater need of being slowed down than the currency traders. It is estimated that currency transactions now exceed $1 trillion a day. There is no productive justification for that volume. It exceeds the combined annual Gross Domestic Products of many countries. And it exceeds by several times the combined value of international trade. The vast majority of it is pure and simple speculation. As numerous writers have pointed out (one example is Soros), the volume is large enough, and the speed of movement fast enough, that the speculators can easily overwhelm even the largest government. It is another case where economic power over a nation is vested in a small band of unelected private investors who are responsive only to their own interests and whims, and not to any electorate or elected representatives. Their power needs to be curtailed.

9) Labour Monopoly Regulation

In all of the modern industrial "western" world, all corporate and government monopolies and many near monopolies are tightly regulated by the government. They are closely watched, and their prices and profits are controlled. Any price increases require government approval, and generally require thorough economic justification. There is one notable exception, however. All major labour unions exert monopolistic control over the labour market of their respective sectors. Yet their monopolistic pricing power is totally uncontrolled by any regulators.

When costs grow faster than productivity, the result is "cost-push" inflation. For most manufacturing enterprises, and all service enterprises, labour costs form the large majority of production costs. So when labour costs grow faster than general productivity, the result is "cost-push" inflation. Examining the US statistics since 1949 shows that although the average manufacturing wage has grown dramatically in nominal terms, when adjusted for inflation it has grown no faster than, and in lock-step with, the growth in average manufacturing labour productivity.

Therefore, all labour-union collective agreement wage increases should be constrained by law so that the average wage increase for all workers covered by collective agreements rises no more than the previous year's increase in overall average labour productivity.

10) Campaign Finance Reform

Not strictly an economic reform, this one really should have been first on the list. Reform of the manner in which political candidates finance their election campaigns is a necessary pre-requisite to the achievement of any of the foregoing reforms. As things stand now, the vested interests that would be negatively impacted by the above reforms have sufficient funds to buy outright the entire Congress - several times over. There is no possibility at all of these reforms being enacted as long as the electorate's representatives in Congress are filtered through the sieve of campaign financing by special interests.

 

11) Miscellaneous Changes

This is a collection of miscellaneous changes to various legislation to complete the set of economic reforms initiated by the major items listed above.

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