Saturday, December 29, 2007

The burden of spending

Over the 12 months to October 2007, home prices in the 20 largest metropolitan areas declined by 6.1 percent. And they have fallen every month since January. With less equity to borrow from, homeowners could cut their spending. As a second whammy, a large volume of adjustable rate mortgages are scheduled to reset to higher interest rates between 2008 and 2012. The burden of higher monthly payments could force households to reduce their expenditures too.

Economic growth and consumer debt are inextricably connected in the U.S. And it’s been that way for so long that it’s easy to forget why and what that implies.

Spending has outpaced personal income since the mid 1980s. Households saved ten percent of disposable income in 1985, five percent in the mid 1990s, and then nothing in 2005. (See chart 1, maroon series, scale on the left axis.)

Chart 1 (click to enlarge)

Low interest rates motivated the consumption ramp-up. Loose monetary policy played its part, but it would be incorrect to blame it all on the Fed. The massive accumulation of wealth by developing countries lowered the opportunity cost of spending, as Alan Greenspan has explained.

Interest rates motivated it, but the borrowing spree was made possible by innovations in the financial sector that increased the supply of debt. The introduction of the FICO score in the early 1990s improved the assessment of a borrower’s creditworthiness – or at least lenders believe so. By pegging interest rates to an index, instead of offering fixed rates, lenders transferred some financial risk to borrowers. Securitization of debt balances shifted some more of that risk off the lenders’ balance sheets.

The problem with a growth path based on borrowing and spending is that it has a natural end. An individual’s debt limit is determined by her creditworthiness, income capacity and collateral. That limit may be high relative to current income, and it may even be unknown to the borrower — after all, it’s up to the lender to draw the line. But once debt balances reach that limit, spending can grow only as fast as income (minus debt payments). Consumption is pinned to the vagaries of income. At the aggregate level, that means that economic growth is more vulnerable to unemployment and to the swings of the stock and real estate markets.

For instance, back in 2001 unemployment was rising, investment fell sharply, and share prices crashed. But overall the economy held up better than expected. Why? One explanation lies in real estate wealth. That year house prices rose by nine percent and consumers borrowed against home equity.

As a gauge of the current level of indebtedness, households now spend almost 15 percent of their disposable income on interest payments, including mortgages. (See chart 1, blue series, scale on the right axis.) If you include repayment of principal, the fraction of debt payments is much larger. Debt repayments are linked to interest rates, and hence subject to unforeseeable increases. Hence the worry about mortgage resets.

The main variables that determine spending and access to debt are outside the policymaker’s control. The cost of borrowing depends on the world level and distribution of savings. Lenders will continue to improve their assessment and management of risk, thus reducing the cost of credit. And central banks are capable of controlling inflation, but not of preventing asset bubbles or stimulating long-run growth.

But don’t despair: tax policy can mend our spending ways. First of all, do no harm. Tax laws can distort the cost of borrowing. The Tax Reform Act of 1986 partially addressed this issue by getting rid of the deduction for interest paid on consumer debt (credit card and uncollateralized loans). The deduction for mortgage interest should go next. I concede that there’s a (weak) case for subsidizing home ownership. But these days a house is much more than a place to live: it’s a piggy bank to draw from. There is no reason why the government should subsidize that.

Second, replace the personal income tax with a tax on consumption. A basic tenet of economics is that if you tax something you get less of it. An income tax punishes work. Instead, the government could levy a tax on the difference between income and contributions to savings. The new tax could be progressive, rather than flat, and could include personal deductions, just like the current personal income tax.

The main obstacle to those tax policies is political. The mortgage interest deduction is popular, and a consumption tax is still regarded as an oddity. No presidential candidate who actually cares about being elected would make such proposals. Perhaps in 2012, if the then incumbent president can afford it. Changing the nature of American economic growth is a cause worthy of spending political capital on.

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Anonymous said...

Don't you mean EXCLUDING mortgage interest? Otherwise, how could debt service be equal to zero as a percentage of disposable income at 2 points on your chart.

Anonymous said...

Warren Buffet agrees with you, calling for a progressive consumption tax. And, Mr. Huckabee's FairTax fills the bill.

Economist Dale Jorgensen, Harvard University, was commissioned to find out what portion of current prices were represented by costs for complying with the federal income tax code (i.e., embedded tax costs). He concluded that 22% (average) of every retail dollar, spent by consumers, constituted a price-embedded tax. Thus, in addition to individual income tax and FICA withholding, individuals are unwittingly paying these unseen, embedded business tax costs with every purchase of a new product, or service.

Under FairTax, prices would fall, due to removal of embedded business tax-related costs. Concurrently, wages may rise due to a mix of factors, including reversion of withheld pay (or some portion thereof) to employees, advancement opportunities due to business expansion resulting from retained earnings, and/or increased demand for labor accompanying increased competition (from that expansion). Where profits (or wages) appear lucrative, competition will move into the market space, driving out excesses (immediately present after FairTax is enacted), arriving at new "market-adjusted" prices.

For FairTax to constitute 23% of new transaction cost (i.e., "market-adjusted" price plus FairTax), a mark-up of 29.9% (tax exclusive rate) on the new "market-adjusted" price is necessary. (Before balking, consider what we're paying now if income tax rates are converted to tax-exclusive sales tax rates on net income instead of percentage of gross income. The following figures can be compared to the 29.9% FairTax mark-up: Fifteen pct bracket = 17.6%, twenty-five pct bracket = 33.3%, twenty-eight pct bracket = 38.9% (! really), and thirty-five pct bracket = 53.8% (! that's how bad it is).

In order to make FairTax a progressive consumption tax (such as that recently called for by Warren Buffett), all citizen-families are simply sent a monthly consumption [tax] allowance, called a "prebate." This prebate is intended to reimburse taxes on necessities for every citizen family without need for record-keeping or reporting. Moreover, the direct payment bypasses the creation of a tax code specifying exempted products and services around which a lobbyist industry could grow. The amount is variable, based on family size, and is equal to the FairTax rate on poverty-level spending, as defined by the Dept. of Commerce. At present, a family of one would receive ~$200/month, a family of four, ~$500/month. Thus, the "effective" FairTax rate paid by citizens, will *never* equal the full 23%. Of course, U.S. visitors (legal, and illegal) will pay the full FairTax when they purchase anything new, at retail (used are not taxed again). Under FairTax, working families will have their whole paychecks (minus any state or local income tax withholding) plus their monthly family prebate.

Additionally, citizens will no longer have to spend the average 50 hours per year preparing their federal tax returns. Having more monthly income may result in using credit less, and saving more. Larger savings will make it easier to purchase a home, at a lower interest rate and monthly payment. (Thus, mortgage deductions are no longer applicable when income is not the basis for taxation).

But is FairTax actually "fairer"? To provide substantive answers, Prof.'s Kotlikoff and Rapson (10/06) have concluded,

"...the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.

"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."

Further, per Jokischa and Kotlikoff (2005) ...

"...once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."

The current income-based tax system is also more expensive to run, because of the manner in which the tax code is gamed by politicians and lobbyists. Politicians realize great power, and attract constituencies for support, by granting tax favors (i.e., credits, deductions, exemptions) through lobbyists. Fully, fifty-three percent of Washington lobbyists are there because of the tax code! The tax code is continually changing, making it more complex - more difficult to understand. And, the salaries and costs of tax lawyers and lobbyists end up in higher prices of the products and services we buy. Additionally, the time and money required to keep records, file returns, report for audits, retain accounting and legal help, pay IRS penalties and interest, is time and money lost for other productive, or recreational, activities. Depriving us of the use of withheld wages increases our expenses through zero-interest withholding, inflation, return preparation time, and interest paid on credit cards and loans that otherwise may not have been necessary. Summed up, the cost of tax compliance, nationally, has been estimated to range anywhere from $265 billion to twice that amount, depending on the extent to which tax-avoidance consultation is sought and utilized. These expenses constitute a substantial hidden tax which is incomprehensible to the average working American. And the FairTax gets rid of all of it for most Americans, and most of it for business owners.

We, as FairTax advocates, believe that government should serve We, the People, with a fair tax system that will not enable politicians to pit poor against rich (creating barriers to achieve wealth, adding tax penalty to the sacrifices made for personal success). Nor do we want politicians to continue using business as a tool to hide taxes from consumers, often villifying business, which discourages entrepreneuship, personal achievement, economic growth. Liberty and happiness depends on restoring the fruits of labor to those who produce them. We believe that the tax function should align with economic growth, not against it, that government should be paid for in the same manner as working Americans - when, and because, something is sold!

As things stand at present, the system primarily benefits politicans who cater to special interests through lobbyists who game the tax code. The politician seeks to capture them as constituent voting blocks, dependent on continued syphoning of taxpayer dollars to their members' benefit. This is increasingly repugnant to the average working American who often finds it difficult to meet the needs of his, or her, own family in an environment where federal and state business income taxes substantially contribute to trade inequities resulting in the loss of American jobs! Thus, the Sovereign are continually degraded by features of Congress's income tax policy. The most rapidly-growing needs-based "special interest" group has become the Citizens! You see? Congress has nearly all the power; and We, the People, have become We, the Serfs, robbed and enslaved. Getting the federal government's hands out of our family paychecks is the single most important reason to replace the income tax with a consumption tax, the FairTax.

Many of us have joined in order to build a national movement to free ourselves, our family pocketbooks, and our businesses from confiscation of income, and punishment of productivity. And this we say to our federal representatives,

"Either scrap the code and enact the FairTax, or we intend on replacing you with someone who will."

(May reproduce in whole or part. - Ian)

Francisco said...

In response to anonymous on 12/30/07: the scale for debt service is on the right axis, not the left.

Sorry it took me a while to respond: I've been away from the internet for a few days.

Thanks for stopping by.

Francisco said...

In response to Ian (1/2/2008)
Thanks a lot for leaving such a long and thoughtful comment.

My post didn't endorse FairTax, just an expenditure tax: "a tax on the difference between income and contributions to savings."

I believe one can simplify the tax code, stimulate saving, and have a progressive tax system, without resorting to FairTax.

To be honest, I don't know how the tax I propose would fare against FairTax, but your comments are illuminating. I'll continue to study FairTax and maybe write a post about it in the future.

Thanks! Please come back to EconWeekly.


Anonymous said...

It is a very interesting blog for the non studied people in economics. I´ll read as frequently as I can in case of any of these issues afects to Spain.
From Spain, a frustrated econocmist wrote!