CFO: Direct vs Indirect Taxes

Interesting story from CFO.com, reporting on findings from a KPMG survey of multinational corporations. Apparently indirect taxes (e.g., VAT or value added taxes) are becoming more important as the burden of direct taxation (e.g., corporate income taxes) falls globally. The report raises two important points.

 
First, it reveals the inescapable reality of economic tradeoffs. While taxes on corporate investment and output are falling globally, corporations are having to wrestle with new and complex kinds of tax administration. Under VAT and similar systems (think state and local sales taxes in the U.S. for example), they are essentially tax collecting agents of the government. As Milton Friedman was fond of saying, there’s no such thing as a free lunch. Apparently the axiom holds true in corporate taxation.

Second, it confirms that the global trend towards lower direct tax burdens on productive activity is still intact. We continue to believe that this fact is the single most important aspect of the global political economy for U.S. policymakers to grasp. It means that on a relative basis, the U.S. is becoming a less competitive destination for capital investment, simply by standing still on tax policy. And given the current political winds here, there’s a possibility that this divergence will be exacerbated by heavier regulatory, tax, and trade burdens in coming years. Should that happen, we would look for some political upheaval in 2012, either in Congressional control or the Presidency; it will depend upon where the most compelling challengers show up.

On a related note, Rep. Paul Ryan of Wisconsin recently penned an encouraging op-ed in the Wall Street Journal on his recent entitlement reform proposals. Ryan is one of the boldest members of Congress regarding tax reform, though he’s clearly swimming against the tide at the moment. Perhaps he’ll gains some momentum once our current policy directions are found wanting by the U.S. electorate:

…The current federal tax code is complex, burdensome and discourages economic growth. It cannot be fixed with incremental changes; it needs a complete overhaul.

…The rates in the simplified code are 10% on income up to $100,000 for joint filers ($50,000 for single filers); and 25% on taxable income above these amounts. There is also a generous standard deduction and personal exemption totaling $39,000 for a family of four. The alternative minimum tax is eliminated. And to promote long-term investment in economic growth, taxes on capital gains, dividends and estates are also eliminated.

On the business side, the bill gets rid of our uncompetitive corporate tax – currently the second highest in the industrialized world – and replaces it with a business consumption tax of 8.5%, which is half the average industrialized world rate.

The roadmap I’m offering is a real plan, with real proposals, real numbers to back them, and real legislation to implement it. Based on the analysis of government actuaries, it is projected to make Social Security and Medicare permanently solvent, lift the growing debt burden on future generations, and hold Federal taxes to 18.5% of GDP…

We have some concerns about the plan. For example, while it might be true at times, it’s far from proven that elimination of the estate tax would lead to a higher rate of economic growth. More important, his plan continues much of the disparity that exist between tax rates on different types and levels of income. For example, it would incentivize many who are subject to the 25% marginal income tax rate to incorporate, if possible (and clever tax professionals will find a way), in order to take advantage of an 8.5% corporate tax rate. And everyone subject to income taxes would be incentivized to earn as much income as possible in the form of dividends and capital gains. Employer benefits would also remain a more attractive form of compensation at the margin.

Still, as tax and entitlement reforms go, we agree with the underlying philosophy and direction. His proposal to target a federal tax burden of 18.5% of GDP is especially interesting. Assuming that our political system is reasonably efficient (as political systems go), why not target a long term historic tax burden? Better yet, and even more efficient, why not let the electorate set the appropriate percentage every year, and require Congress to budget accordingly? Then seek to make the collection as efficient as possible in order to consume fewer resources than the current tax system’s administration,  compliance, and enforcement currently do. Taxpayers as a whole would be slightly richer in terms of time and money.

Rep. Ryan: Repeal Humphrey-Hawkins

GOP Representative Paul Ryan of Wisconsin penned an interesting op-ed for the Wall Street Journal yesterday: "Blame Congress for Inflation". He is writing legislation that would repeal the  Humphrey-Hawkins Full Employment Act of 1978, which imposed the prevailing ‘dual mandate’ on the Federal Reserve–to ensure long term price stability (or said another way, to ensure the long term value of the dollar) AND short-term economic growth (a/k/a to support ‘full employment’). Unfortunately, those two goals are not always compatible, and the latter is almost always the more politically expedient objective, especially in the eyes of Congress. Ryan wrote:

Price stability is a basic necessity of long-term prosperity. And, with monetary policy under its jurisdiction, the Fed is the only institution capable of stabilizing prices.

That last assertion is not entirely correct–the European Central Bank and The Bank of Japan also play a critical role in setting the price of globally traded goods, and thus have an impact on other nation’s price levels, including our own–but it’s closer than most politicians ever get. It’s also a courageous issue for a legislator to stick their neck out on. His proposal should probably be viewed as a competitive response to the fact that, after almost 100 years, the U.S. dollar and Federal Reserve face meaningful competition for the first time, in the form of the Euro and the European Central Bank. Notably, the ECB is committed solely to price stability.

Ryan then touches, fleetingly, on the critical aspect of price stability that continues to be overlooked by most commentators–taxes:

…negative outcomes are not the intention of Fed policy. Mr. Bernanke has been dealt a bad hand – a slowing economy and upward pressure on prices – and he is trying to win on both ends. But Congress, too, is accountable in this…Congress is already threatening the economic climate by dangling the prospect of huge tax increases ($683 billion in the House-passed budget) and sharply higher spending. There is no sign that Congress will change its tune on fiscal affairs – but passing the Price Stability Act is a chance at a bipartisan commitment to sound money.

The state of the real domestic economy, and the non-monetary policy measures that impact it, should not be overlooked when considering the appropriate objective for monetary policy. For example, when the Bank of England was the steward of the world’s monetary standard from roughly 1821 to 1913, its primary objective was price (i.e., monetary) stability. That did indeed support long term investment and risk taking, globally. But it also prevented the Bank from supporting the domestic economy of England in hard times by lowering the cost of credit. Whatever factors were impacting the domestic economy–technological innovation, demographics, social upheaval, or most commonly, political errors like higher taxes, regulations, and tariffs–the Bank of England was required to look the other way, keeping its eye only on global price stability. To preserve such an arrangement, political bodies with the power to tax, regulate, and set trade policy had to be more economically savvy and behave in ways that were sensitive to the situation of the domestic economy, and its competitive state relative to other parts of the world. The current Congress demonstrates little of this awareness, which means that Ryan’s proposal would not come without tradeoffs.

Like many other commentators advocating a stronger dollar, Ryan is on the right track. But by not hitting the issue of America’s declining economic competitiveness (and the looming problem of higher taxes, trade barriers, and entitlement burdens) just as hard, he is advocating a prescription that may or may not be better than a bout of mild stagflation. Our political history clearly demonstrates that, when meaningful political relief for the real economy is not forthcoming, the U.S. electorate will accept policies that eventually inflate a good deal of its economic burdens away…whatever the rest of the world may think.

The rise of the Euro and the ECB is making this approach to economic affairs less and less feasible, which means it’s time for Congress to get back to policy making that enhances the expected long-term performance of the U.S. economy. It has done so in the past, in the 1960s, the late 1970s to the mid 1980s, and the late 1990s. In all of these periods, the Federal Reserve was freed up to focus on price stability. Without a return to pro-growth policies from Congress, Ryan’s bill is almost sure to fail.