Thursday, July 24, 2008 3 comments ++[ CLICK TO COMMENT ]++

Cutting Taxes Can Be Bad

One of the big differences in economics between those leaning towards the left (e.g. liberals) and those leaning towards the right (e.g. conservatives) often centers around tax cuts. I hate to paint everyone with a broad brush but conservatives often have this blind faith in tax cuts. So-called libertarians also often have the view that tax cuts are almost always good. Liberal such as myself, who are in favour of balanced budgets (I wished more on the left were), are not a fan of cutting taxes across the board.

One of the flaws with the conservative/libertarian tax cut thinking is their unrealistic expectation that tax cuts also implies government spending cuts. This is almost always false! In fact, you can consider it almost a law of politics that government spending cuts will rarely be enacted--and even if they were, they won't stick. It doesn't matter what type of government is in power. They are all unlikely to cut spending. The guilty pleasures for the left are social spending, healthcare, and education; the guilty pleasures for the right are military and corporate grants. If you don't believe this, you need look no further than the George W Bush administration over the last 8 years. George Bush is a hardcore conservative who ran a platform of fiscal conservatism (if you don't believe me, look at what prominent conservatives were saying before his first election, with respect to how much better he will be (than Clinton) when it comes to government finances.)

One of the big problems with USA right now is the fact that it is running a massive fiscal deficit. Most of this is due to the so-called 'tax cuts for the wealthy' that were enacted (the other is mostly due to military spending; some of it is also due to healthcare spending (this is due to Democrats.)) In his latest weekly letter, John Hussman talks about the disaster the tax cuts have become (that expiring tax cuts may actually be a big election issue this year.) Hussman is one of the few that I have encountered who claims that the main cause of the current account deficit is actually from government fiscal deficits.In contrast, mainstream thinking seems to pin the current account deficit on reasons such as excessive consumption, high consumer debt usage, and the attractiveness of US assets.

If you find anything I quote below interesting, I urge you to read the full article. Some of the points in the article are not quoted by me.

(source: How the War, Tax Cuts, and the Swaps Market Debased the U.S. Financial System, by John P. Hussman. July 21, 2008.)

In 2001, the U.S. initiated a series of major tax cuts amounting to about $500 billion, benefiting primarily individuals with a high marginal propensity to save, despite an already large fiscal deficit. (As an investor, my only defense to the inherent hypocrisy of criticizing this is that all of my own benefit has gone to charity). In addition, the Iraq war heaped on further direct costs of $500 billion. Nobel economist Joseph Stiglitz recently estimated the long-term total of direct and indirect costs of the war to the U.S. economy at $3 trillion.

It is widely believed that the enormous fiscal deficit created by these policies has been “stimulative.” The key question is, “stimulative to what?” Surely, not much of the answer can be found in stock valuations. Stock prices reflect the discounted present value of future cash flows. Even if the entire $500 billion was the present value of long-term cuts in dividend taxation, the “fair” present value of the U.S. stock market would increase by exactly the amount of the reduced tax burden. On a total stock market capitalization of about $15 trillion, $500 billion in tax cuts work out to a gain in value of about 3.3%. Clearly, the Bush tax cuts provided little impetus for anything but a short-term bounce in stock prices.

Even though I benefit somewhat from capital gains or dividend tax cuts, I am generally not a fan of them (I will admit up front that my job is far more important than my investments so my benefits will be different from the wealthy.) I personally would prefer if income taxes (either personal or corporate,) or gasoline tax, or tobacco tax, or a similar tax were cut. I also think it's better to do something to improve capital expenditures by corporations. For instance, instead of cutting, say, dividend tax, I think it may be preferable to let companies write off more of (or more quickly) their capital expenditures (i.e. depreciation expense.) My preference for the latter is because capital expenditures by businesses (i.e. plant, equipment, technology, etc) increases productivity and helps society in the long run.

Put simply, the massive fiscal deficit of recent years has required the U.S. to run a deep current account deficit. Moreover, our need to foist government liabilities into foreign hands has resulted in a large depreciation in the value of the U.S. dollar (if foreigners were eagerly snapping up our “stuff,” the U.S. dollar would be appreciating instead). When the domestic savings of the nation as a whole are insufficient to finance government deficits and private investment, foreign savings must be imported through the sale of securities. Our insufficient national saving has had the effect of strengthening the hand of foreign competitors, and continues to require us to sell U.S. assets into foreign hands to finance the shortfall (last week's agreed takeover of Budweiser – the Great American Beer – to a foreign company is particularly emblematic).

I'm not as nationalist as Hussman seems to be but I don't see how one can argue against his main point. By running a big fiscal deficit, you are simply strengthening others and weakening yourself.

John Hussman goes on to point out that, instead of investing in capital expenditures or something productive, we ended up with overinvestment in residential real estate.

So the policies of recent years have indeed been stimulative. But stimulative to what? Primarily to unproductive investment and poor credit. There is nothing wrong with debt that is incurred to obtain productive assets, legitimate national security, or the relief of suffering. In this instance, there is little to show but liabilities. The U.S. is now saddled with a burdensome federal debt, a deep current account deficit, reduced competitiveness, a weakened financial system, a tragic and needless loss of life on both sides of the war, and a growing indebtedness that allows major U.S. companies to be picked away by foreign hands like apples from a tree.

Sometimes bubbles aren't as bad as they seem. This is certainly true if the spending went into plants, roads, or some such thing. One of the points GaveKal had made in the past was that the tech bubble was a disaster but it left behind some useful assets such as communications networks, Internet equipment, and so forth. Unfortunately, the residential real estate bubble is going to result in nothing other than dilapated houses that no one wants to live in (check out this story of how no one wants to buy a formerly $110,000 home for $5000!)

To complete the story, we have to ask how such a destabilizing amount of high-risk lending was able to take place just because government interest rates were low. Didn't the markets make risky credit expensive enough to limit the exposure of the U.S. economy to financial strains and default?

Hussman goes on to answer this question with an explanation the side-effects of swap contracts.

So far as policy is concerned, the way toward renewed peace and prosperity is to move in the direction of fiscal discipline, increased risk-based regulation of entities that draw directly or indirectly on government assurances, credible and even-handed diplomacy, and a reaffirmation of our commitment to human rights (as Jefferson saw them, not as a grant of the State, but as an inalienable aspect of humanity itself).

Easier said than done but it's something that American needs to pursue if the situation is to be improved. Some may not agree with all that (certainly the hawks won't give up war) but balacing the books is something that is critical. It doesn't have to happen now (deficits during slowdowns/recessions are ok in my eyes) but America better start getting its government books in shape in 2 or 3 years.


3 Response to Cutting Taxes Can Be Bad

July 24, 2008 at 6:42 PM

Well...cutting taxes would definitely bad for bond insurers.

Here's a link that probably won't cheer you up: and-now-young-monoline-you-will-die.html

July 24, 2008 at 7:24 PM

AccruedInterest is one step behind me ;) That post is pretty much a read of the situation from a few days ago, with the potential ratings cut of FSA and Assured Guaranty. If FSA and AGO are cut, I think it's pretty much the end of bond insurance as we know it. I'm not sure about the structured finance side of things but muni bond insurance will almost die off completely...

As for Ambac, MBIA, et al, the future is less of a concern than the past. What can take them down is not the lack of new business in the future, but the losses on past insured products.

July 25, 2008 at 6:37 PM fitch-massive-house-price-losses-in-non-conforming-areas-to-come/

Is this kind (above) of thing going to affect Whitman's "intrinsic value" on real estate?

Meanwhile.... levenson_funds.fortune/index.htm?postversion=2008071810

I will refrain from dissing him.

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