Basic Economics

by Sowell, Thomas

  Taxes cannot be passed on to consumers when a particular tax falls on businesses or products produced in a particular place, if consumers have the option of buying the same product produced in other places not subject to the same tax. As noted in Chapter 6, if the government of South Africa imposes a tax of $10 an ounce on gold, South African gold cannot be sold in the world market for $10 an ounce more than gold produced in other countries where that tax does not apply, since gold is gold as far as consumers are concerned, regardless of where it was produced. The price of gold produced and sold within South Africa could rise by $10 an ounce if the South African government forbad the importation of gold from countries without such a tax. Even in the absence of a ban on the importation of gold, the price of gold could rise somewhat within South Africa if there were transportation costs of, say, $2 an ounce for gold produced in the nearest other gold-producing countries. But, in that case, only $2 an ounce of the tax could be passed on to the South African consumers as a price increase, and South African gold producers would have to absorb the other $8 in tax increases themselves, as well as absorbing the entire $10 for gold that they sell outside South Africa.

  Whatever the product and whatever the tax, where the actual burden of that tax falls in practice depends on many economic factors, not just on who is compelled by law to deliver the money to the government.

  Inflation can change the incidence of taxation in other ways. Under what is called “progressive taxation,” people with higher incomes pay not only a higher amount of taxes but also a higher percentage of their incomes. During periods of substantial inflation, people of modest means find their dollar incomes rising as the cost of living rises, even if on net balance they are unable to purchase any more real goods and services than before. But, because tax laws are written in terms of money, citizens with only average levels of income can end up paying a higher percentage of their incomes in taxes when their money incomes rise to levels once reached by affluent or wealthy people. In short, the combination of inflation and progressive income taxation laws means rising tax rates for a given real income, even when the tax laws remain unchanged. Conversely, a period of deflation means falling tax rates on a given real income.

  Where income is in the form of capital gains, the effect of inflation is accentuated because of the years that can elapse between the time when an investment is made and the time when that investment begins to pay a return—or is expected to pay a return, since expectations are by no means always fulfilled. If an investment of a million dollars is made by a business and the price level doubles over the years, that investment will become worth two million dollars even if it has failed to earn anything. Because tax laws are based on value expressed in money, that business will now have to pay taxes on the additional million dollars, even though the real value of the investment has failed to grow in the years since it was made.

  Whatever the losses sustained by such businesses, the larger and more fundamental question is the effect of inflation on the economy as a whole. Since financial markets make investments—or decline to make investments—on the basis of the anticipated returns, during a period of sustained inflation and substantial tax rates on capital gains, these markets are less willing to make investments at rates of return that would otherwise cause them to invest, because the effective tax rates on real capital gains are higher and taxes may be collected even where there is no real capital gain at all. Declining levels of investment mean declining economic activity in general and declining job opportunities. According to a business economist:

  From the late 1960s to the early 1980s, effective tax rates on capital averaged more than 100%. Perhaps it is no coincidence that real equity values [stock prices adjusted for inflation] collapsed by nearly two-thirds from 1968 to 1982. This period saw sputtering productivity, rising inflation, high unemployment, and an American economy in general decline.{674}

  Local Taxation

  Taxation of course occurs at both the national and the local levels. In the United States, local property taxes supply much of the revenue used by local governments. Like other governmental units, local governments tend to want to maximize the revenues they receive, which in turn enables local officials to maximize the favorable publicity they receive from spending money in ways that will increase their chances of re-election. At the same time, raising tax rates produces adverse political reactions, which can reduce these officials’ re-election prospects.

  Among the ways used by local officials to escape this dilemma has been one also used by national officials: Issue bonds to pay for much of current spending, thereby producing immediate benefits to dispense and thereby gain votes, while in effect taxing future taxpayers who will have to pay the bondholders when the bonds reach their maturity dates. Since future taxpayers include many who are too young to vote currently—including some who are yet unborn—current deficit spending maximizes the current political benefits to current officials while minimizing effects from current taxpayers and voters.

  One of the things that makes deficit spending especially attractive to local politicians is that many municipal and state bonds are tax-exempt. That makes such bonds especially valuable to people with high incomes, when the federal taxes on such incomes are very high. Among the repercussions of this are that large sums of money are often available to finance local projects with tax-exempt bonds, regardless of whether these projects would meet any criterion based on weighing costs against benefits. What the high-income purchaser of these bonds is paying for is exemption of income from federal taxation. Unlike purchasers of bonds or stocks in the private economy, the purchaser of tax-exempt local government securities has no vested interest in whether the particular things financed by these securities achieve whatever their object is. Even if these debt-financed expenditures turn out to be a complete failure in achieving whatever they were supposed to achieve, the taxpayers are nevertheless forced to pay the bondholders.

  From the standpoint of the allocation of scarce resources which have alternative uses in the economy, the net result is that these politically chosen projects are able to receive more resources than they would in a private free market, including resources that would be more valuable elsewhere. From the standpoint of government revenue, what is gained by the local government is being able to readily sell its bonds that pay a lower interest rate than private securities whose purchasers have to pay taxes on that interest. What is gained financially by the local government may be a fraction of what is lost financially by the federal government that is unable to tax the income on these local bonds. Finally, what is lost by the local taxpayers—albeit in the future—is having to pay higher taxes because of the ease of financing politically chosen projects with tax-exempt bonds.

  Another way of raising local tax revenues without raising local tax rates is to replace low-valued property with higher-valued property, since the latter yields more tax revenue at a given tax rate. This replacement can be achieved by condemning as “blighted” the housing and businesses in low-income or even moderate-income neighborhoods, acquiring the property through the power of eminent domain and then transferring it to other private enterprises that will build upscale shopping malls, hotels, or casinos, for example, which will generate more tax revenue than the existing homeowners and business owners were paying.

  The outraged homeowners and business owners, who often receive less in compensation than the market value of their demolished property, are usually a sufficiently small percentage of the voting population that local officials can gain votes on net balance—if they calculate accurately. It is often possible to convince others in the media and in the public that it is these dispossessed tenants, homeowners, and business owners who are “selfish” in opposing “progress” for the whole community.

  This apparent progress can be illustrated with pictures taken before and after local “redevelopment,” showing newer and more upscale neighborhoods replacing the old. But much of this local progress may be part of a zero-s
um process nationally, when things that would have been built in one place are built in another place because confiscated property costs less to the new owners than it would have cost elsewhere in a free market. But the new owners’ financial gain is the original owners’ financial loss. Even if the original owners were compensated at the full market value of their properties, this may still be less than the property was worth to them, since they obviously had not sold their property before it was taken from them through the power of eminent domain. In this case, there is not simply a zero-sum process but a negative-sum process, in which what is gained by some is exceeded by what is lost by others.

  The 2005 U.S. Supreme Court decision in Kelo v. New London expanded the powers of governments to take property under the powers of eminent domain for “public purposes,” extending beyond the Constitution’s authorization of taking private property for “public use” such as building reservoirs, bridges, or highways. This decision confirmed the power already being exercised to transfer private property from one user to another, even if the latter were simply building amusement parks or other recreational facilities.

  What this means economically, in terms of the allocation of scarce resources which have alternative uses, is that the alternative uses no longer have to be of higher value than the original uses, since the alternative users no longer have to bid the property away from the original owners. Instead, those who want the property can rely on government officials to simply take it, exercising the power of eminent domain, and then sell it to them for less than they would have had to pay the existing property owners to get the latter to transfer the property to them voluntarily.

  Government Bonds

  Selling government bonds is simply borrowing money to be repaid from future tax revenues. Government bonds can also be a source of confusion under their other name, “the national debt.” These bonds, like all bonds, are indeed a debt but the economic significance of a given amount of debt can vary greatly according to the circumstances. That is as true for the government as it is for an individual.

  What would be a huge debt for a factory worker may be insignificant for a millionaire who can easily pay it off at his convenience. Similarly, a national debt that would be crushing when a nation’s income is low may be quite manageable when national income is much higher. Thus, although the U.S. national debt held by the public reached a record high in 2004, it was only 37 percent of the country’s Gross Domestic Product at that time, while a much smaller debt, decades earlier, was a higher percentage of the GDP back in 1945, when the U.S. national debt was more than 100 percent of the GDP that year.{675}

  Like other statistical aggregates, the national debt tends to grow over time as population and the national income grow, and as inflation causes a given number of dollars to represent smaller amounts of real wealth or real liabilities. This presents political opportunities for critics of whatever party is in power to denounce their running up record-breaking debts to be paid by future generations. Depending on the specific circumstances of a particular country at a particular time, this may be a reason for serious concern or the criticisms may be simply political theater.

  National debts must be compared not only to national output or national income but also to the alternatives facing a given nation at a given time. For example, the federal debt of the United States in 1945 was $258 billion, at a time when the national income was $182 billion.{676} In other words, the national debt was 41 percent higher than the national income, as a result of paying the enormous costs of fighting World War II. The costs of not fighting the Nazis or imperial Japan were considered to be so much worse that the national debt seemed secondary at the time.

  Even in peacetime, if a nation’s highways and bridges are crumbling from a lack of maintenance and repair, that does not appear in national debt statistics, but neglected infrastructure is a burden being passed on to the next generation, just as surely as a national debt would be. If the costs of repairs are worth the benefits, then issuing government bonds to raise the money needed to restore this infrastructure makes sense—and the burden on future generations may be no greater than if the bonds had never been issued, though it takes the form of money owed rather than the form of crumbling and perhaps dangerous infrastructure that may become even more costly to repair in the next generation, due to continued neglect.

  Either wartime or peacetime expenditures by the government can be paid for out of tax revenues or out of money received from selling government bonds. Which method makes more economic sense depends in part on whether the money is being spent for a current flow of goods and services, such as electricity or paper for government agencies or food for the military forces, or is instead being spent for adding to an accumulated stock of capital, such as hydroelectric dams or national highways to be used in future years for future generations.

  Going into debt to create long-term investments makes as much sense for the government as a private individual’s borrowing more than his annual income to buy a house. By the same token, people who borrow more than their annual income to pay for lavish entertainment this year are simply living beyond their means and probably heading for big financial trouble. The same principle applies to government expenditures for current benefits, with the costs being passed on to future generations.

  What must also be taken into account when assessing a national debt is to whom it is owed. When a government sells all of its bonds to its own citizens, that is very different from selling all or a substantial part of its bonds to people in other countries. The difference is that an internal debt is held by the same population that is responsible for paying the taxes to redeem the principal and pay the interest. “We owe it to ourselves” is a phrase sometimes used to describe this situation. But, when a significant share of the bonds issued by the U.S. government is bought by people in China or Japan, then the bond-holders and the taxpayers are no longer the same population. Future generations of Chinese and Japanese will be able to collect wealth from future generations of Americans. As of 2011, nearly half the federal debt of the United States—46 percent—was held by foreigners.{677}

  Even when a national debt is held entirely by citizens of the country that issued the bonds, different individuals hold different shares of the bonds and pay different shares of the taxes. Much also depends on how members of future generations acquire the bonds issued to the current generation. If the next generation simply inherits the bonds bought by the current generation, then they inherit both the debt and the wealth required to pay off the debt, so that there is no net burden passed on from one generation to the next. If, however, the older generation sells its bonds to the younger generation—either directly from individual to individual or by cashing in the bonds, which the government pays for by issuing new bonds to new people—then the burden of the debt may be liquidated, as far as the older generation is concerned, and passed on to the next generation.

  Financial arrangements and their complications should not obscure what is happening in terms of real goods and services. When the United States fought World War II, running up a huge national debt did not mean that the Americans alive at that time got something for nothing on credit. The tanks, bombers, and other military equipment and supplies used to fight the war came out of the American economy at that time—at the expense of consumer goods that would otherwise have been produced by American industry. These costs were not paid for by borrowing from people in other countries. American consumers simply consumed a smaller share of American output.

  Financially, the war was paid for by a mixture of raising taxes and selling bonds. But, whatever the particular mixture, that did not relieve that generation from having to sacrifice their standard of living to fight the war. The burden of paying for World War II could be passed on to a later generation only in the sense that the World War II generation could in later years be reimbursed for their sacrifice by the sale of the bonds they had bought during the war. In reality, however, wartime inflation meant that t
he real purchasing power of the bonds when they were cashed in was not as much as the purchasing power that had been sacrificed to buy the bonds during the war. The World War II generation was permanently stuck with the losses this entailed.

  In general, the government’s choice of acquiring money through the collection of taxes or the sale of government bonds does not relieve the current population of its economic burden unless the government sells the bonds to foreigners. Even in that case, however, this merely postpones the burden. The choice may be more significant politically to the government itself, as it may encounter less resistance when it does not raise taxes to cover all current spending but relies on bond sales to supplement its tax revenues. This convenience for the government is a temptation to use bond sales to cover current expenses instead of reserving such sales to cover spending on long-term projects. There are obvious political benefits available to those currently in power by spending money to provide benefits to current voters and passing the costs on to those currently too young to vote, including those who are not yet born.

  Although government bonds get paid off when they reach their maturity dates, usually new bonds are issued and sold, so that the national debt is turned over rather than being paid off, though at particular periods of history some countries have paid off their national debts, either partially or completely. This does not mean that selling government bonds is without costs or risks. The cost to the government includes the interest that must be paid on the national debt. The more important cost to the economy is the government’s absorption of investment funds that could otherwise have gone into the private sector, where they would have added to the country’s capital equipment.

  When the national debt reaches a size where investors begin to worry about whether it can continue to be turned over as government bonds mature, without raising interest rates to attract the needed buyers, that can lead to expectations that higher interest rates will inhibit future investment—an expectation that can immediately inhibit current investment. Rising interest rates for government bonds tend to affect other interest rates, which also rise, due to competition for investment funds in the financial markets—and that in turn tends to reduce credit and the aggregate demand on which continuing prosperity depends.