I was reading Financial Samurai’s post on The Ultimate Solution For A Fair Income Tax Policy in America quite a while ago, but I still wanted to say something about it.  (Sometimes, these response posts end up disappearing in my archive for a while.)  If you haven’t had a chance to read it, or if it’s been a while and you want to refresh your memory, it’s pretty interesting (as Sam’s posts tend to be).  The Cliff Notes version is that he recommends only allowing those people who pay income taxes to vote.  If you don’t have any of your own money at stake when government starts divvying up the spoils, you’re not going to have any qualms giving out the money (and taking some yourself), or so the thinking goes.

Well, I and some other commentators had some qualms with that approach.  (Sometimes I think that Sam writes these kind of articles just to get us all riled up; not a bad strategy, if that’s what he’s doing).  The complaints included the fact that income taxes are not the only taxes being paid (there’s everything from sales taxes to Social Security taxes that lower income people pay; should they only be able to vote on issues that their taxes go to fund?  If that’s the case, expect to see lots of votes to up Social Security benefits to low or moderate income people (that is, incomes at or below that of the voter) and increasing the threshold for paying Social Security benefits.)  There are also plenty of ethical issues with disenfranchising a number of people (which is the sort of thing that’s led to protests, even wars in the past).  Short version, not something I think would be possible.

But, in the course of answering Sam’s argument, I came up with my own variation on the idea, which has some possibilities for not only keeping government spending under control, but also potentially increasing the number of people who willingly pay their taxes.

My (Brilliant) Plan

The basic idea is allow individual tax payers to direct their income taxes toward specific government programs. It won’t change the total amount owed, but at the end of the 1040 form, we add on a list of government programs, allowing the taxpayer to choose what programs he wants to support with his or her tax dollars.  (Sorry, no ‘I can spend my money smarter than the government, give me back my tax money now’ option; again, no changes in your tax bill, just in how the money is divided.)

"White House Lawn Maintenance" might be an Option, though

How would this help?  Well, I imagine that you, like me, know plenty of people who like some of what the government does, but not everything.  Heck, it’s difficult to find someone who likes everything the government does, all the time.  From people who think that the government should only defend the borders to those who want more social programs and fewer defense projects, just about everyone wants the government to spend their money differently.

That’s where being able to direct where your money goes could have a nice benefit.  Want to support the troops, and government social programs?  Direct your taxes to the military.  Want social programs to grow, but think there’s too much military spending?  Put your money toward poverty aid or other social programs.  We can even make it possible to direct your money more narrowly; the military, for one example, spends money in lots of ways, from paying soldiers to developing new weaponry.  If you want to give soldiers a nice boost in their income or want to develop ways to keep them safer in the field, you can find the appropriate government programs to do so.

The end result is a closer connection between your tax money and the government programs that it helps to fund.  If you can say to yourself, “I helped to pay those soldiers” or “My tax money helped to rebuild those roads”, it’ll help forge a better connection between your taxes and the services provided.  It could also help to get those who don’t pay taxes in protest of some government program or another to pay, if they could be ensured that their money would only go to the programs they thought were worthwhile.  (The program could also serve as a backdoor means of balancing the federal budget; if you can only put money towards government programs when the taxpayers ‘opt in’, it would make it more difficult to spend money beyond what is taken in taxes.)

Disclaimers and Notes

Before you go out and start to demand this type of tax program from the federal government (or to take to the comments and deride my utter misunderstanding of how the federal government and the tax system really works), bear in mind that this is just me, thinking out loud about government spending and taxes.  I make no claims about the efficiency of this hypothetical system, or if it would be possible to implement such a system.  I just had a thought about government spending and taxes, and wanted to share some thoughts.

Now, though, I’d like your thoughts.  What do you think of my plan?  Do you think it could work, or is it destined for failure?  Has it been tried before anywhere (again, I’m thinking out loud, and wasn’t able to find anything about this type of plan before), and how did it work out?

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Have you ever had something you were writing get overtaken by events?  You know, you’re writing about how tensions between the United States and the Soviet Union are only going to get worse, when you turn on the TV and see that, hunh, the Berlin Wall is coming down, making everything you just wrote seem completely deluded.  Sound pretty familiar?

Well, something similar happened to me this weekend; I had a post in mind about what will happen if (actually, when, at that point) an agreement to raise the US debt ceiling was NOT reached.  Low and behold, as I was putting some of the finishing touches on the article, I saw in my Alexa toolbar something about ‘Agreement on Debt Ceiling Reached’.  I put my article, which would have gone up today, off to the side, and low and behold, in just a few short days, the politicians in Washington managed to do what they hadn’t in months of squabbling up to that point.  Since my original post is all but worthless now, let me try to sum up some of the feelings of my fellow Americans in the following rant (Warning: politics ahead; you may want to escape while you still can):

Well, well, well.  After months of squabbling, bickering, accusations, and general carrying on, the United States Debt Limit has been raised.  Yes, rather than screeching to a halt (or at least, finding themselves forced to make the sort of decisions about what programs should be funded and which should not, the sort of decisions that far too many families and other organizations WITHOUT the power to raise how much they can borrow at will have had to do), the government will keep right on rolling, doing…far too many things for me to cover in a single blog post.

I think now is as good a time as any for fireworks, don't you?

I could, I suppose, discuss more about just what a debt limit increase means, both for the economy (US and global) at large and for the government itself, but I’ve already covered most of the pertinent facts when I first discussed us hitting the debt ceiling, back in May (Yes, yes, it was ONLY back in May; I know it feels like they’ve been arguing this for well over a year, but it’s only been about two and a half months since we hit the ceiling and the REAL fun began.)  With all of that said already, I have only one thing to say on the subject:

What the heck, Republicans?

You managed to get spending cuts with no tax increases (or for that matter, decreases in the number of available tax credits (that whole ‘spending in the tax code’) that Obama talked about), thus managing to tackle the rising national debt WITHOUT having to increase taxes, AND put Obama in a position to shoulder nearly all the blame for even more debt limit increases next year.  That’s a political Hat Trick if ever I’ve seen one.  Yet, YET, to judge from some of your reactions (compiled below in helpful Daily Show format), you seem to think this isn’t enough, in spite of the fact that you’ve gotten just about everything you could have hoped for (and given that you control only one house of Congress and the President is a Democrat, you shouldn’t have hoped for nearly as much as you did in the first place), you STILL seem upset:

Look, I’m a Democrat (albeit a Libertarian leaning one), so we’re probably not going to see eye to eye on most subjects, but here’s the thing: if you really want that pesky national debt gone, or at least cut down to a more manageable size, taxes SHOULD at least be on the table.  Trying to balance the national budget (and generate a surplus) on spending cuts alone will require making some serious, deep cuts to many beloved programs.  Trying to get our national budget in order on spending cuts alone is similar to a household trying to get its budget back in order only by cutting down spending, with no thoughts to earning more money: possible, but potentially harder than it needs to be.

Now, perhaps you want to do this; heck, perhaps I’m greatly misguided and most of America WANTS you to cut down federal spending to almost nothing, but my gut feeling is that there are some things on the table that, while they might be trimmed, are unlikely to be completely cut anytime soon.  (Medicare and Medicaid, for example, strike me as things you don’t want to mess with too much; the controversy surrounding Paul Ryan’s proposed budget seems to prove that.  As a side note, since I’m talking to politicians right now anyway, I should tell you that anytime I see a proposal like Ryan’s that changes a major government program ONLY for people under the age of 55 (or any age selected from the 45-65 age block), I automatically assume that (a) it’s a horrible change, (b) if it affected current seniors from the start, none of them would approve of it, and thus, (c ) leaving the current seniors out of the proposal is a shameless ploy to keep their votes, and given how seniors are frequently the voters who vote the most, win the election even as you alienate every young person.  Just something to consider, from one twenty-eight year old voter.)  If that’s the case, please bear in mind that you will need SOME tax income to fund them, and perhaps finding ways to increase that tax income would be a good thing, after all.  (I’d recommend trying to make a flatter, still somewhat progressive income tax system, with a much lower amount of deductions, preferably one where everyone making more than poverty wages paid at least SOMETHING in federal taxes.)

There, my ranting and raving is done (for now).  To all my regular readers, I promise tomorrow I’ll be back to personal finance writing, and I’ll leave the politics to the political writers.  (It’s harder than it looks, anyhow.)

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It’s official; as of Monday, the United States has hit its debt ceiling, the self-imposed limit to the level of debt that the Treasury can take on in order to fund the function of the federal government.  Yes, we have hit the current debt limit of $14.3 Trillion (an amount so large that I honestly have no ready comparisons to help put it into context), and without a law passed by Congress allowing the Treasury to borrow even more, there’s a risk of serious trouble with national finances.

To help try to sort through this (potentially) monumental event (and help to get my own thoughts in order), I thought I would go through some of the most common questions about this deficit problem, and try to answer them for my readers (and for myself).

Q: Just What Is The Debt Ceiling?

The debt ceiling is, as mentioned, the limit on the amount of debt that the Treasury Department can take on in order to fund all the spending obligations approved by Congress and the President.  As the Government Accountability Office (GAO) notes, it doesn’t stop Congress from passing legislation that increases the level of spending (or cuts the amount of tax income), nor does it keep the President from signing such legislation into law.  All it really does is determines what the Treasury is able to do in order to fund the laws that Congress enacts.

There’s no perfect parallel to your household finances (unlike the federal government, you lack the power to tax or the ability to sell IOUs to the international market at low rates).  The closest comparison I can make is maxing out your credit cards; the credit card company will no longer let you borrow money at that point, so you’re forced to find alternatives to pay what you owe.

Q: So, Does This Mean The Government Will Stop Functioning?

Short answer, No.  Longer answer: This does mean that the options that the Treasury has to finance government services is more limited, but don’t expect that the Army will bring everyone home, nor will the FBI will close up shop, Social Security checks won’t stop coming, etc.  Much as hitting your credit limit doesn’t eliminate all your money management options, there are a few possibilities that the Treasury Department has to keep the government’s doors open, including the following:

Source: The Wall Street Journal

So, good news: regardless of whether Congress and the President can come to an agreeement on the debt ceiling immediately, there is a little leeway before we run into serious trouble.  The bad news is that there’s already a date when we are expected to run into serious trouble: August 2nd, when the Treasury runs out of options for alternative sources of funds.

Q: How Do We Deal With The Debt Ceiling?

A: The easiest way is simply to raise the debt ceiling and enable more borrowing.  Similar to getting an increase in your line of credit (but potentially even easier, as Congress can simply agree to give themselves more borrowing authority), increasing the debt ceiling would enable more borrowing in order to fund the programs that Congress has already authorized.  There are arguments, particularly by Republicans, that such increases should only be granted if accompanied by significant spending cuts.  Without getting too much into the politics of the whole situation (which I might do later if and when the lines drawn in the sand become clearer), there’s a good chance this will not occur without significant political battles.

Q: What Happens If We Don’t Raise The Debt Ceiling?

Short answer: nothing good.  As we’re never gone over the debt ceiling before, it’s hard to know exactly what would happen.  A report on CNNMoney, while acknowledging that fact, mentions two (in their words, awful) possibilities for measures that might be undertaken if we can’t raise our debt limit.  The first is cutting spending and/or raising taxes by several hundred billion dollars to make up the difference between our current spending levels and our income levels (and even that level of budgetary balancing will only get us to the end of this fiscal year, in September; expect trillions in cuts or new taxes if we still haven’t raised the debt limit).  Think of the austerity measures imposed on the European Union nations that have gotten bailouts, or the type of belt-tightening you’d need to do if you no longer could rely on credit cards.

The second option is even worse: the U.S. could default on some of its debts.  It’s almost hard to articulate just how bad things would be.  It would certainly torpedo the reputation of the U.S. as a risk-free investment, causing us to spend more to borrow in the future.  It would likely cause a frenzy of selling, as investors here and abroad tried to unload their Treasuries.  Expect the stock market and the value of the U.S. dollar to be devastated.  In a word, horrible.

Q: Golly, That Sounds Bad.  What Do You Think Will Really Happen?

A: Well, as neither possibility in the event of not raising the debt ceiling sounds like the sort of thing the typical politician wants to deal with (particularly in our perpetually campaigning political culture), I feel fairly confident that an agreeement will be reached some time before it comes to that.  There will likely be some spending cuts to appease deficit-cutting Republicans, although not as many as they might like.  There might also be some decreases in tax deductions (or to use President Obama’s bizarre phrasing, ‘spending in the tax code’), or even tax increases, if the Democrats put up a fight.  Ultimately, expect a few months of infighting before a deal is reached, hopefully before the eleventh hour when the world markets start to flee in terror.

What do you think about the debt ceiling fight?  What’s the best method to resolve the current problem?  For any foreign readers, does our government look as silly to you as it feels to us U.S. citizens when it has arguments like this?

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As of the last time I checked the news (7:37:08 Friday morning), there still hasn’t been a budget agreement reached that will prevent the United States federal government from shutting down today.  While I’m certain the possibility exists for a stunning, eleventh hour agreement to be reached that keeps the government open  (if only for the next seven days, as the latest proposal from the House of Representatives would), I think it’s worth considering what will happen in cause an agreement can’t be reached.  What’s that, you say I’m cynical, thinking that the mature and reasonable elected officials in Washington D.C. will not be able to come to a reasonable conclusion, even with the eyes of the nation focused on them?  Well, perhaps, but let’s run with the concept anyway.

There’s a lot of discussion out there about how a shutdown would effect the typical Joe or Jane Citizen, detailing the government programs and agencies that would not longer be functioning (try not to smile too gleefully about the IRS being unable to conduct audits) and the problems it will cause the average person.  I’m going to take a different tact, and look at those ‘nonessential’ government workers who will be unable to work during a shutdown (or collect their paychecks during that time).

Yes, this article goes out to people like my mother, who in the event of a widespread government furlough, will find herself not working until Washington D.C. gets its act together.  It’s far from a complete guide to your furlough time, but hopefully it will help you keep your head together while you are unable to work:

1) Don’t Panic: Good advice to consider during almost any troubling situation, there’s nothing that panicking will do that will benefit you.  Yes, it’s far from fun being labeled as ‘nonessential’, particularly if you regularly have to deal with people who gladly accept your services (and frequently, the government money you dispense) but then immediately complain about the lack of service they get and size of your paycheck.  But bear in mind that there is a fair to good chance that you will end up being compensated for the missed time anyway (as government workers have in past shutdowns), and in the mean time, you can watch as the politicians try to deal with all complaints about delayed checks and lack of service that would otherwise be directed at you.

2) Try Not to Empty Your Emergency Fund: Even allowing that you will likely be compensated for your lost work time eventually, you are going to need money to live on in the meantime.  Hopefully, you’ve established a nice emergency fund and will have no problem surviving (and even thriving) while you wait to go back to work.  Even if you do have enough money to survive weeks, or perhaps months (this is Congress we’re talking about), without an agreement being struck, though, you want to keep from emptying your emergency fund.  While I’ve noted above that you will likely receive any back pay for time that you were furloughed, that depends on the generosity of Congress, and as you’ve probably guessed, you probably shouldn’t stake your survival on them.  Plus, there are already rumblings that the 2012 budget will cause as much, if not more, ‘discussion’ and consternation among lawmakers, so you should try to be prepared for that.  On the subject of being prepared…

3) Consider Using Your Downtime to Start a Side Project: Assuming this government shutdown (and thus, your furlough) stretches on for a while (that is, Congress doesn’t spend every waking minute trying to knock out some sort of plan and ends up wrapping things up by Monday), you might start to wonder how to spend this unplanned (and unpaid, at least for now) time off.  Well, why not start a side project of some sort?  From creating a blog to doing repair work on your relatives’ cars, there’s any number of things you could consider to bring in a bit more money while you have some down time.  Who knows, you might just find something you enjoy doing more than government work.

4) Don’t Be Offended: Possibly most importantly of all, don’t be offended that you are considered ‘nonessential’.  There is likely to be a far amount of dung being slung around (metaphorically, anyway) (at least, I hope it will stay metaphorical) about government workers as various politicians and commentators try to jockey and shift public perception.  I’ve known more than a few government workers in my life (including, as noted, my mother) and there’s nothing I’ve seen that makes you any less hard-working, diligent, or otherwise less deserving of respect than private workers.  Here’s hoping everyone involved in this debate keep that in mind while they try to determine an appropriate budget.

There you have it, my advice to (potentially) furloughed government employees.  Here’s hoping an agreement is reached by the close of business today, but if not… Well, perhaps we’ll see what happens when 800,000 people start side businesses all at once.  That would definitely be a sight to see.

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While reading Your Money Ratios, a book I intend to review later this week, I was particularly struck by the chapter on Social Security.  Discussions of what will happen with this popular, yet tricky, retirement program continue to animate the national stage here in the US, and even as we speak, new reforms are being rolled out that will tweak, although not completely change, the way that the Social Security system works.  Given the importance of this system to most people’s retirement, I thought I should take a closer look at it, and hopefully dispel some of the myths and rumors surrounding it.

What is Social Security?

I think that many Americans have a distorted idea of how exactly Social Security functions, in part due to all the talk of the ‘trust fund’ we’ve heard about, going back to the days of the 2000 election.  Many people (including myself, before I started to do so much personal finance reading) have the impression that Social Security works like a national 401(k): you put your money in throughout your life, the US government watches over it and invests it, and when you retire, you end up receiving your own money back, with interest.

This Blog Entry NOT Sponsored by The Social Security Administration, or any political group

That’s not the case.  (It can’t be; Ida May Fuller, the first person to start receiving Social Security benefits, did so after paying into the system for only three years, not nearly enough time to build up much of a fund for herself.)  Instead, what happens is that most of the money paid into the system by those currently working goes directly to current retirees, covering the benefits they earned while working themselves.  When the amount coming in is more than what’s needed to pay the current benefits, the rest is put into the ‘trust fund’, the accounting surplus that is left over and used to pay future beneficiaries.

This structure, with current workers’ contributions being used to pay current retirees’ benefits, has led more than a few commentators to call Social Security a Ponzi scheme, and to hypothesize that, like all other Ponzi schemes, it will eventually collapse.  This view ignores a few facts, though, including that the transfer of wealth isn’t hidden from view (or significantly different than most other social welfare programs, possible differences in funding aside) and that, with contributors consisting of every working American and contributions enforced by federal regulations and the threat of jail, it’s highly unlikely that the incoming funding will stop, which is when Ponzi schemes come to an end.  (Unless our democratically elected Congress and President vote and sign into law new regulations ending Social Security, but that’s not really the collapse of a Ponzi scheme so much as a new legislative approach.)

A more productive way to view Social Security might be as an annuity, particularly a deferred, fixed, inflation-linked annuity.  You pay into the system throughout your working life, building credit with the government, and upon retiring, you start to receive money according to how much you’ve contributed.  Live long enough, and you’ll recollect your contributions (and then some, if you’re really long lived); die shortly after retiring (or *knock on wood*, before you have the chance to retire), and you’ll find that you received much less than you contributed.  Like an annuity, it’s more of a safety net to make sure you don’t outlive your money than a get-rich investment.

What About That Trust Fund, Then?

Ah, the trust fund, confusing people into thinking that they are paying for their own benefits (rather than paying for their parents and grandparents, and in turn being paid for by their children and grandchildren) for over a decade now (if not longer).  The trust fund does serve a useful purpose, that is, ensuring that when the payments due to retirees exceed the income resulting from taxing current workers, a reserve of money exists from which to draw the difference.  In fact, the last major overhaul to the Social Security system in 1983 was designed to build up the trust fund for when the baby boomers started to retire, which it did in fact accomplish. (Which is why we’re debating how long the trust fund will last, rather than how much of a deficit the program will develop paying out claims to boomers.)

The problem is what happened to the money in the trust fund.  It’s not kept in a giant vault a la Scrooge McDuck, in savings accounts throughout the country, or even invested in the stock market (not for lack of trying on George W. Bush’s part, but that’s another story); instead, the trust fund is invested in special Treasury bonds.  In essence, the trust fund loans the money to the federal government’s general fund, where the money is spent on, well, everything the government spends money on.  There’s no perfect analogy to individuals, but the closest situation would be if you took money out of your retirement account to pay your monthly bills, with the intention of paying yourself back (with interest) when your financial situation improved.  Because of this, more than one commentator has said that the trust fund is actually filled with ‘worthless IOUs’.

That’s not quite true, though; while Treasuries, like all bonds, are IOUs (specifically, ‘I owe you X amount of money, with Y amount of interest, payable with Z amount of money every six months’ or a similar arrangement), they are far from worthless.  The general understanding is that the US government is one of the most secure, stable places in which to invest.  (Treasury bonds are widely cited as an example of ‘risk free’ investments, with a chance of default that is minuscule, at most.) Going back to our analogy, it would be like writing yourself an IOU, if you had the power to tax millions of people and throw them in jail if they failed to pay; chances are that your IOU to yourself is going to be paid, one way or another.

So, Will Social Security Survive?

Ah, the sixty-four thousand dollar question.  The short answer: yes, yes it will.  While the trust fund is expected to run out in 2041 (and depending on a number of factors, that date could be shifted earlier or later, perhaps by a rather large margin), remember that the primary source of payment for Social Security benefits are current workers.  As long as there are still young (or at least, non-retired) people working and paying taxes, there will be a source of funding for retirees.  In fact, the above linked report notes that, in its current form, the Social Security system will be able to pay at least 75% of its promised benefits through 2082, the last year for which they ran projections.  As long as you incorporate a potentially sizable dip in your promised benefits, including your expected Social Security payments in your retirement calculations can make a great deal of sense.

That said, for my own retirement planning, I try not to include any promised Social Security benefits.  I have several reasons for this.  First, you may have noticed that I highlighted ‘in its current form’; that’s because it’s possible, perhaps even likely, that our politicians will start to feel political pressure to tweak, or even completely overhaul, the system to make it more solvent, particularly as we get closer to the time when the trust fund runs out.  It is possible, however unlikely, that they will even decide to end the program entirely (I have no doubt there are some individuals currently serving in Congress who’d support this approach) or at least, bar younger people from collecting benefits.  I may personally doubt that it will come to that (and I do), but for someone like me, who’s measuring the time until he qualifies for benefits in decades, not years, a policy of not depending on Social Security benefits for retirement seems to be most appropriate.

Second, even if these more apocalyptic thoughts never come to fruition, there’s still the fact of the expected drop of 25% of benefits, perhaps more.  Even assuming that Social Security is still paying out benefits to new retirees when I am old enough to retire (which again, I believe it will be), it’s hard to know how much I can expect to get in benefits.  Somewhere between the idealistic estimates of the Social Security administration and the pessimistic predictions of bankruptcy, there is the actual amount I will receive when I reach retirement age.  (An age which, while we’re on the subject, is likely to rise, to help deal with the large number of long-lived, healthy ‘old’ people retiring and then living for half a century or more on Social Security.)  While I expect the Social Security Administration to treat me well when I hit retirement age, again it seems like a more cautious approach is to try to save enough to retire on my own, and consider any payment from Social Security as a nice bonus (and a healthy boost to my standard of living).

Speaking of retiring on my own, that brings me to the third reason I don’t include Social Security benefits in my retirement calculations: I don’t want to wait until I’m 65 (or whatever the retirement age has been set at when I reach that point) to retire.  I’m hoping for (and doing my best to plan) a retirement at sixty, fifty, heck, even forty, if I can save and invest a huge amount over the next decade.  While Social Security is a nice program, and certainly very helpful for numerous people, I hope I’m already retired well before I qualify.

There you have it, an explanation of the present (and future) of the Social Security program, why I am positive it will still be around (to some extent) when I reach retirement age (barring an act of Congress ending it, that is), and why, even with that knowledge, I don’t include Social Security in my calculations for retirement.  Here’s hoping it provided you with some helpful retirement planning information!

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Let’s say you are one of the sizable number of people who’d like the federal government of the US to decrease in size.  Maybe you’re worried about encroachment on personal and corporate liberties, maybe you think that the government has gotten too expansive for the good of the nation, maybe you simply feel that we should depend on private benefactors for more of the functions currently being performed by the government; for whatever reason (or combination thereof), you think the federal government (and possibly state and local governments, but we’re going to focus on the feds for this article) should be downsized.

Given this view, how would you alter the current tax rate?  Would you raise it or lower it?  For most of the people who want to shrink the government, the answer is clearly the latter; if you cut taxes, you can ‘starve the beast’, by depriving the government of the money it requires to grow.  It seems like a logical conclusion: if you had a child who was spending all his allowance money on loud, annoying, profane music, cutting down his allowance would end the music purchases.  No money, no misspending.

But…that’s not quite how it works with the government.  The chairman of the Cato Institute (a right leaning think tank; not a big pro-government organization, there) noted back in 2004 that “‘Starve the Beast’ Doesn’t Work”.  In a professional paper he looked at the correlation between government spending as a percentage of Gross Domestic Product (GDP) and tax rates between 1981 and 2000, and found a negative correlation (that is, as tax rates decreased, government spending increased as percentage of the total economy); lower tax rates led to MORE, not less, government.

What the Heck…?

To understand how this could happen, let’s look at a smaller scale example, two towns.  These two towns, which we’ll call Alpha and Beta (no relation to any actual towns with those names), are nearly identical.  They have similar populations in terms of both numbers and demographics, similar sizes, and similar amounts of spending (at least at the start of our thought experiment).

The one big difference between the two is how they go about paying for their spending.  The city council in Alpha is fairly old-fashioned, and insists that any spending increase be paid for by increasing taxes to derive the needed revenue.  In Beta, on the other hand, it’s common practice to provide much, if not most, of the city’s funding by issuing municipal bonds, and using a sizable portion of tax revenue to pay off the interest owed.

Now let’s say that a monorail salesman comes to each town, offering to sell a clean and efficient form of public transportation (for an admittedly sizable upfront cost).  For Alpha, doing so means increasing taxes on its citizens, immediately exposing the council members to negative attack ads and other criticism.  In Beta, the council members can pay for the monorail with another bond issue, and simply shift some more tax revenue to paying interest; there’s no need (for the time being, anyway) to increase taxes at all.  Now, which town is more likely to have a brand-new monorail a year from now?

Yup, I stole this hypothetical example from The Simpsons(R); what can I say, it's a good show.

If you answered ‘Beta’, congratulations on your reasonable understanding of human nature, politics, and economics!  Yes, people are much more likely to agree to increased spending if the pain of payment can be put off to another day (week, month, year, decade…).  As with this monorail example, so it goes with just about every type of spending.  While the city council members in Alpha will have to justify every spending increase and convince the townspeople that their taxes are well spent, Beta can play Santa Claus, giving ‘gifts’ to the citizens whenever they ask without demanding the pain of higher taxes in return.  In time, Beta’s spending will end up much higher than Alpha’s; what person doesn’t want more when they don’t have to pay for it?

What does all this have to do with the national debt?  Well, as most of you probably already realized, the United States is essentially Beta in our example.  Since we don’t increase taxes to cover our increased spending (opting to go into greater and greater debt instead), and don’t decrease spending to be in line with our tax revenue, we rely on our ability to borrow to cover our spending.  And since we don’t have to pay out of our pockets for our spending, there’s little, if any, incentive to spend less.

How to Fix Things

I probably don’t need to tell you, but borrowing endlessly is not a good idea.  At some point, your creditors start to worry, the amount of interest you need to pay to borrow more gets prohibitive, your ability to find new takers for your debt decreases and, if you don’t manage to right your financial ship in time, you end up defaulting.  (Like Orange County.  Or Russia.  Or..any number of other places that have had to default.)  If we want to repair things here, we need to take a few steps to head off that possibility, like:

1) Balance the Budget: This is definitely a biggie; as anyone who’s had any experience with budgeting can tell you, it’s hard to get into debt when you only spend what you take in (or preferably less).  (Personally, I like the idea of an automatic increase to ALL federal tax rates on all tax types (income, investment, estate, etc.) to bring the projected revenue up to the level of spending; if the thought of an automatic increase for all taxpayers if they can’t keep spending under control doesn’t motivate some smart spending reductions by our law makers, nothing will.)  Of course, just because most people agree that’s it’s important to do, doesn’t make it any easier; choose a random sampling of 100 Americans, and you’re all but certain to get at least 100 different methods of getting the budget to balance, from all spending cuts to all tax increases.This isn’t a bad thing; having a serious conversation about where to modify our budget to make it more balanced is an important task, and to make sure that everyone conversing has some ‘skin in the game’…

2) Spread the Tax Burden: You’ve probably heard that 47% of Americans don’t pay taxes.  This isn’t quite the truth (that figure only takes into account federal income taxes, not the myriad other taxes that we pay at all levels of the government), but it raises a fair point: if you aren’t paying taxes (or are getting more from the government than you pay in taxes), you don’t have much of an incentive to keep the tax burden low.  After all, it’s not really a burden to you.  Modifying the tax laws so that everyone has to pay something (even if those earning more still pay a much larger percentage), will help ensure that nobody urges spending just because it’s not on their tab.  And while we’re remaking the tax code anyway…

3) Make Taxes (and Tax Rates) More Transparent: Quick, tell me the percentage of your income that went toward taxes last year.  If you’re pretty good, you might remember your tax bracket (mine was 25%), but as I’ve discussed before, that’s not really how much you pay in federal income taxes (your real percentage that goes to the IRS is lower).  And that’s just the tip of the iceberg; it doesn’t include capital gains taxes, FICA taxes, Social Security, sales taxes, property taxes, or even state and local income taxes, just to name a few.  And without knowing how much of your income is going to fund the government, how can you decide if you’re getting a good value for your money?  There’s certainly a reasonable price that should be paid to an organization that provides everything from national armed services to Social Security benefits, but are you paying it?  A complete list of how to remake the tax system to make it more transparent is a bit beyond the scope of this (already rather long) article, but one goal for any redesigned tax system is that most everyone should be able to say, “Hello, my name is Roger, and XX% of my income goes to funding the federal government.  Wow, what a steal!/I’m being cheated!/That’s…about what I’d expect, given my income level and the services I rely on from the feds.”

There, a few simple suggestions on how to improve the tax situation in this country, and possibly decrease the size of government, to boot.  They should work much better than continuing to try to ‘Starve The Beast’.  To quote John Hodgman, “You’re Welcome”.

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(It’s Election Day in America, the most wondrous time of the year.  Unfortunately, too few politicians from either party are willing to discuss the real problems that we are going to be facing in the not too distant future.  Here is what I wish a politician would come right out and tell the American people:)

My Fellow Americans,

We have a large and steadily growing problem.  In point of fact, we have numerous problems; engagements in Iraq and Afghanistan we are still attempting to wind down, health care reform that will assuredly leave someone disappointed, and the slow economic recovery being among the most pertinent.  But a decade from now, most of these issues will be resolved, while we will still be facing the even bigger problem of our large and increasing national debt.

The Capital Building, hosting our speech today

Yes, the more we spend, and the less we bring in to the national government, the larger our debt becomes.  It’s really that simple; as a nation, we’re spending more than we take in, which is a recipe for a large and rising debt.  As recent history should tell us, we can only continue as debtors as long as our creditors (which, for the United States government includes everyone from the Social Security and Medicare trust funds to foreign government and individuals) allow us to continue in debt.  When too many creditors start to pull their money out of US Treasuries, the interest rates we’ll need to attract new money will have to rise, the government will print out even more money, and so high inflation will continue until we make a concerted effort to stop it.

Such a concerted effort, whether taken before things take a wrong turn or after, can only take a few possible forms: raising taxes or cutting government spending.  I realize that neither of these options sounds ideal; most Democrats would rather lose an arm than cut spending, and Republicans would sooner you take their right leg than take more money in taxes.  As a result, it’s unlikely that either approach on its own will be able to balance our badly out of whack national budget.  Instead, combining the two, trimming some of the fat off of the budget AND raising taxes (or equivalently, cutting down on deductions) will enable us to get our budget under control, generate a surplus (one that doesn’t require irrational exuberance brought on by the Internet) and start to pay down the national debt, while hopefully not being TOO painful for the politicians involved.

Now, it won’t be easy; trying to get politicians to reach across the aisle and work with their opposite numbers is difficult even for relatively simple matters, and this effort will be far from simple.  Even if you get a majority to agree that a combination approach is best, you still need to settle any number of smaller arguments, from the relative amounts of spending cuts and tax increases, to the particular types of spending cuts and tax increases, to how to deal with the smaller budget and larger tax burden that will be created in the wake of these decisions.

This is not a quick fix, knock-out-a-bill-over-the-weekend- and-go-have-a-drink sort of problem.  It will be a long and hard process, one which, as with any good compromise, will leave all the parties involved feeling they didn’t get all that they wanted.  Personally, I can’t claim to know what form the final agreement will take; I have my own preferences, but how well I can convince my fellow legislators to heed them I do not know.  What I DO know is that we must tackle this problem, sooner rather than later, or future generations, perhaps our children, or their children, or their childrens’ children, will reap the seeds we sow with our unbalanced budgets today.

Thank you for your patience on this Election Day, and God Bless.

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If you haven’t been completely obvious to the financial news this week (or to news in general), then you’re likely aware that on Wednesday, President Obama made an announcement about some rather sweeping changes to the nation’s financial system.  If you feel like reading up on the full list of proposals, you can read the government’s (88-page!) white paper on the subject, assuming you have the time and willingness.  If not, read on, for I shall give you a thumbnail sketch of some of the biggest points.  (With assistance from BusinessWeek)

First Proposal: Creating a Consumer Financial Protection Agency, in charge of regulating consumer financial products (credit cards, mortgages, bank accounts, etc.) with the goal of standardizing the products offered and increasing disclosure to consumers.

Pro: More disclosure from financial firms; easier comparison of financial products from diverse companies due to government standards; and an overall safer financial system.

Con: Stifled creativity on the part of financial firms when creating new products; and more difficulty for individual firms to make their products stand out.

My Take: In theory, I like the idea of a broader, overarching agency monitoring financial markets the same way that the FDA and other agencies monitor our food supplies.  In practice, I’m sure it’s going to take quite a bit of fine-tuning to adequately protect financial product consumers while allowing banks and other agencies to make a decent profit.  Given the current state of the economy and the regulatory system, I think it might be best to opt for regulation, even at the risk of over-regulation, and back off from there.

Second Proposal: Require that banks and mortgage companies that originate mortgages and other loans keep at least 5% of the assets should they securitize the loan (they’d have to ‘keep some skin in the game’).

Pro: Lenders are less likely to push risky loans when they could face financial consequences if the loan defaults; and it puts a de facto cap on the amount of leverage lenders can utilize (at twenty times the organization’s lending capital).

Con: Won’t neccessarily prevent excessive risk taking by lenders.

My Take: This proposal should do well in decreasing the number of lenders who take on great amounts of excess risk; suddenly, giving mortgages to dozens of subprime borrowers starts to seem like a bad idea if their defaults will have a direct negative influence on your bottom line.  The percent the originators are required to keep seems a bit low to me, but I suppose limiting their ability to sell loans and lend again too much would result in far fewer loans being issued, even to qualified applicants.  Five percent (and the twenty times leverage it potentially offers) seems like a good compromise.

Third Proposal: Appointing the Fed (that is, the Federal Reserve) to regulate systemic risk in the financial markets, backed by a council of other regulators chaired by the Treasury,.

Pro: Provides increased power to regulate the economy as a whole; allows the Fed to take the lead in decreasing systemic risks posed by events in the financial markets

Con: The Fed could end up being too powerful; worries that the Fed will fail to provide adequate oversight.

My Take: While it seems like a good idea to assign one organization to take point in providing regulation to the market, there are legitimate concerns about leaving that job in the hands of the Fed, especially as there is no direct Congressional oversight.  The key will be finding a compromise that minimizes the number of worried parties; the Obama proposal, for example, attempts to add more oversight to the Fed by giving some oversight of their actions to the Treasury.

Fourth Proposal: Adding increased oversight and funding requirements for derivatives trading.

Pro: Decrease the risk level in a fairly risky financial sector; add disclosure and standardization to credit default swaps and other complex derivatives.

Con: Push back from derivatives traders who are used to an environment of secrecy; difficulty in regulating the sometimes highly individualized trades.

My Take: This one is a tricky one, but necessary if we’re going to avoid a repeat of the last year.  Getting derivatives trades out into the open, ensuring that the traders have enough capital to back their trades, and understanding the level of risk involved is the only way to allow this trades to continue while preventing future financial collapses.

All of these proposals, of course, still need to be debated and approved; for the most part, though, I think they are a definite step in the right direction, and a good way to push the financial system back on track.

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