Deflation, Taxes, And Economics

Came across quite a few interesting economic articles tonight. First, I came across this article from Morgan Stanley which poses the question: are non-traditional economic remedies needed? Then I came across this article in which the CATO institute discusses some of the problems of the EU's tax harmonization plan. So given the current state of the global economy, where do we go from here?

If you know the answer, there's a Mr. Greenspan in Washington who would love to hear from you right about now.

I think that the Morgan Stanley article has come pretty close where we currently are. This is an unusual time in our history. Traditional economic theories aren't working as expected. But we've also come to a crossroads of sorts. Supply side economics has been a resounding success - too good in fact. We've now hit a point where supply is outstripping demand by so much, that without some kind of radical stimulus, we may have forced a deflationary environment on ourselves.

There is a general agreement that the current tax system needs reform. And right now, right on the cusp of an economic train wreck, may be our best opportunity to effect major tax reform while simultaneously helping to encourage demand in the marketplace.

What I think we should seriously look into doing is in Q4 (October, November, December) abolish the personal income tax and end tax withholding from paychecks. At the same time, announce that in January a new consumption based tax will go into effect.

What you would be achieving is that you would be giving everyone an across the board raise by terminating the withholding of taxes. At the same time, you would be encouraging them to spend the money before January when prices would be rising (assuming static models, which are almost always wrong, but very useful in this case) with the imposition of the new national sales tax.

The idea is to stimulate demand. The psychological effect of the "tax holiday" in Q4 might be enough to get the economy pointed back in the right direction. Of course, it might also fail.

But is this really an unconventional technique? Not when you boil it down to its basics. It is simply a variation on deficit spending.

To finance the whole scheme, using the most recent numbers from the St. Louis Federal Reserve Bank it would cost somewhere around $200-$250 billion in additional deficit spending. That is a huge addition to the federal deficit to risk on a scheme that might very well fail.

But even in failure, there would still be some success.

We would have a new personal consumption tax, which would be more fair. We would have an opportunity to correct the lunacy in the corporate tax rates, where companies are encouraged to either stay very small, or grow very big, very quick. We need to make the corporate rates more fair so that we can encourage the growth of smaller businesses, which is where most of our economic and job growth comes from.

Remember the EU's attempt to avoid "tax competition?" They are essentially admitting that they have already lost this battle. In order to get supply and demand in balance in Europe, they have chosen to accept high unemployment and confiscatory personal income tax rates to support a welfare state. That is not what we want. We want full employment, low taxes, and growth.

If we can rationalize our tax structure, especially on the corporate side, we could reignite that growth. As we "win" the tax battles vs. Europe, we will get more companies growing here. More growing companies means more employment. More employment leads to higher wages and the higher wages will eventually lead to the increased demand.

What we lack right now is the demand to build a business in the US. Ultimately, that has to change if we are going to continue to be successful.

Kind of a long full circle argument for the benefits of supply side economics, huh? And while we are in our current predicament because supply side economics worked too well and outstripped demand, that is still the best long term strategy for the economy. We just need to figure out how to get through the short-term blip.

The great fear of many economists right now is the idea of "pushing the string." And it is a real problem, especially given the economy's lack of response to previous stimulus attempts. But the idea of a "tax holiday" and switch over to a consumption based tax structure would have one great difference between it and traditional government deficit spending plans: it would be the people, not the government, deciding where the deficit spending went. The people are ultimately the demand side of the equation in the economy. In this case, deficit spending wouldn't be pushing the string, but would be giving the people a chance to pull on it for a change.

Maybe the idea would work, maybe it wouldn't. Unfortunately it would take a political miracle to pull it off which means that we almost certainly will not get to find out how effective it would have been. The best that I'm really hoping for is that we move a little closer to the consumption based tax idea.

But then again, unusual situations call for unusual action.