Chapter 21
Funding the Government: Taxes and Debt—Good, Bad, and Completely Lost
Whatever extent the government is involved in the economy, it needs money to operate, even if it is operating in the most limited manner. Governments only have a few sources from which to get money: (1) taxes, (2) debt, or (3) monetizing its assets (e.g., leasing out oil drilling rights on land it owns). Most large countries tap into all three resources to fund themselves. The mix of revenue generation a government chooses can impact how investments act. As technology gives more voice to more of the citizenry policies on revenue generation will likely shift and it will impact asset valuations.
Taxes are supposed to be used to raise revenue, but they have become an instrument of policy and in some cases have been used as a weapon. The complexity of the tax code in most developed countries has led the private sector to undertake financial and legal structures to avoid taxes. This is a massive waste of economic resources and implies poor revenue generation design. Scott Hodge the president of the Tax Foundation wrote that in 1955 the U.S. Internal Revenue Code stood at 409,000 words, by 2016 it was 2.4 million words. Additionally there are roughly 7.7 million words of tax regulations to go along with it. He has also cited that it takes 8.9 billion hours to comply with the United States tax code.76 Taxes are a common source of revenue for the government, but they annoy everyone and redirect resources inefficiently.
There is also an incredible amount of duplicate taxation. In the United States it is often taught that part of the rallying cry in the War of Independence was, “No taxation without representation.” Yet several hundred years after the revolt, if you commute from New Jersey or Connecticut in to New York City you get taxed by New York City and New York State and have no vote on their policies or elected officials. Sounds significantly like taxation without representation. You also are probably taxed by your hometown, county and state as well as the federal government.
There are several key types of taxation. You can divide some taxes by what is being taxed: (1) taxes on income, (2) taxes on wealth, and (3) taxes on transactions. You can also divide them by how they impact different income levels: (1) a proportional tax applies the same percentage to people of all levels of income or wealth, (2) a regressive tax applies a larger percentage to people of lower income or wealth, and (3) a progressive tax applies a higher percentage to people with higher incomes or wealth.
In the framework outlined above how do you look at sales tax? It is a tax on transactions. If a sales tax is imposed on coffee and every adult drinks one cup of espresso per day (just espresso in this example, no mocha lattes) this is a regressive tax because it accounts for a bigger portion of the earnings of people with lower incomes. In the United States, gasoline taxes are often cited as regressive. However, if a sales tax is placed on boats that cost over $500,000 that would seem to be a progressive tax, assuming lower income families do not buy these.
Taxes can have a major impact on spending but sometimes not as much as planned. There is debate over the benefits of big nationwide tax changes. A study by the New York Federal Reserve Bank77 showed that the impact on spending from tax cuts does not usually effect spending until it actually hits people’s take home pay and it is a bigger impact on spending habits when it is considered a permanent change rather than a temporary one.
Agencies of the government and other organizations try to anticipate the impact on the government’s revenue and the overall economy of any new policies and legislation through the use of dynamic scoring. This tries to show the overall impact a tax change will have on government revenues. The Tax Foundation gives the example that if a $1,000 per family tax cut is shown to lower revenue by $70 million but not increase spending, then the government will have $70 million less than it had. However, if a tax cut on corporations would lower revenue by $70 million but stimulates more capital spending, that capital spending may increase tax revenue by a total of $100 million, thus a net increase of revenue for the government.78 Kevin Hassett, when he was chief economist for the American Enterprise Institute testified that while dynamic scoring can be effective in certain cases, it misses the benefits that accrue to the economy from overall economic activity that is generated when taxes are lowered.79
Some recent research by Christine and David Romer80 on past tax cuts added some logic to the debate as they pointed out that the impact of a tax change can be heavily influenced by the reasons for the tax cut and the economic environment in which it is being done. Additionally, it is rarely one or two items that are changed in a tax bill; the legislation in this arena is usually far reaching, this occurs in an effort to get broad political support and win votes by supporting tax breaks for every politician’s pet project.
Taxes are not just used as a punishment but a reward as well. Tax incentives are frequently given in an effort to attract business to a region or change behavior, such as programs in some Scandinavian cities to reduce cars in inner cities. This has the potential to distort the competitive playing field; if the government decides to tax one product, service-type, or region differently from others (e.g., should the tax on whiskey be different than vodka or on chewing tobacco than cigars).
Big tax changes do not occur that often but minor changes happen frequently and can change the economics in some industries. It is not always easy to follow what might be happening on the tax code and trying to monitor all the rhetoric from politicians can drive anyone to the brink of reality. Monitoring some of the think tanks websites and lobbyist groups can be helpful for industry specific tax proposals. Sometimes trends start to develop and you can tell one industry or another are becoming out of favor and politicians are starting to see it as a source of revenue. For example, in the United States the courts ruled that internet retailers had to charge state sales tax, a possible blow to some of these companies and almost the same day a senator called for hearings on how to raise more federal revenue from internet companies. This is not saying that internet companies will become the next tobacco industry, but it is clearly a sign politicians may look to it for more revenue.
Taxation has lost its way; theoretically it is a source of government revenue, period. However, it has become a tool of policy, influence, and interference with free markets, often shifting the playing field for one company or another. This use as a policy tool is not questioned as often as it should be, when it gets used for policy it adds to the incredible complexity of modern tax codes. The tax sector has become an industry unto itself to deal with this maze. Just as people in the past have worried about the military industrial complex unduly influencing the United States’ military policy, one could easily theorize that the IRS-accounting-tax lawyer triad is impacting the complexity of what should be a relatively simple source of government revenue.
Tax code discussions often cause anger, debates on debt funding by the government often cause fear. Some view government borrowing as a perfectly acceptable tool to have in place at all times, others believe it should only be a temporary tool for funding. In the large developed countries and most developing countries national sovereign debt is a fact of life. Sovereign government bonds have come to serve as the benchmark “risk-free” interest rate within countries (though that is not its purpose) and therefore the yield on these bonds are used as a tool to measure risk, rates, and inflation expectations between countries and relative to corporate debt instruments.
Typically when doing comparative country analysis ratios on debt levels are one of the most important metrics. A common ratio is the debt/gross domestic product (GDP). When data is available, monitoring debt service payments to tax revenues can be a powerful analytical tool as well. It is worth noting, that when national debt ratios are analyzed it often focuses on the national debt, not all of the public government debt in the system. It is important to look at both national debt as well as all government debt when doing country analysis. Currencies need to be considered as well in lesser developed countries. The ability to issue debt in their own currency reduces risk; the level of debt issued in nonlocal currency can be a big risk factor for these countries. Debt issued in foreign currencies has been the root of some major crisis in the past.
Debt may be used to fund the government, but debt is just a loan and needs to be paid back, so big debtor countries are perpetual issuers, as tax revenue is often not able to actually repay the principle. Additionally, as it is debt it ultimately needs to be serviced by cash flow and for the government this cash flow is usually from taxes. When a government looks to increase the amount of debt they are issuing the government needs to attract capital, and that means the capital has to come from somewhere else and typically this means less capital available to the private sector. This is referred to as a crowding-out effect. Technology has not yet disintermediated the government funding process at this point. However, we would expect to see some new methods of taping capital at the national level, most likely from developing countries.
Governments such as the United States, United Kingdom, and the European Union have been giving more information generally about their funding plans and future expectations since the great recession. The amount of advanced information about their plans that government treasuries and central banks choose to give can change the level of volatility in the securities markets. In the age of social media there is pressure on these agencies to be transparent about funding plans, timing, and rates. This may not always be the best idea, as markets and business planning may become too wed to this government guidance. This may then put more pressure on the treasury or central bank to stay on their preannounced path as they fear bad economic reactions from a change in plans, even if the data is starting to signal to them that they should diverge from their prior plans. These entities may be better served to give less guidance and be allowed to be more flexible and responsive to what they see in the market rather than being wed to what they have previously said.
Governments continue to use a combination of taxes and debt funding to pay for the services it provides. How they choose to use these financing tools can change capital flows and growth rates and at times can specifically advantage or disadvantage selected regions, industries, products or services. Disruption to the traditional political process may cause an increase in the speed at which policy changes and that can increase uncertainty in your career and investment decisions.