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We Are the 98 Percent

Monday, January 7, 2013

The only way to finance a big European-style state is to have it paid for by massive taxation of everyone, mostly the middle class. Right now, we are avoiding honest debate on this fact.

The central issue of our time is the debate over the size and scope of government. Two unpleasant but undeniable mathematical truths limit the feasible policy choices. The recent sound and fury of the fiscal cliff follies in the end signified nothing because the resolution was in fact just a denial of both truths.

The first truth is that the current tax rates cannot support the promises made to middle-class Americans. The most unaffordable items in fiscal projections are Social Security for everyone and government-sponsored health care for the middle class. You cannot preserve these even with Draconian slashing of military, infrastructure, welfare, education, and other expenditures.

The second truth is that you cannot pay for the Life of Julia, or any vision of a cradle-to-grave welfare state, without massive and increasingly regressive middle-class taxes. The poor don't have the money to pay for a European-style welfare state, and the rich, rich as they are, don't have anywhere near enough.

Not only that, it's easy to tax middle-class assets and transactions — things like payrolls, sales, and real estate — but soaking the rich means taxing investments. Investments are complicated and can be restructured to minimize taxes. Also, investments are the lifeblood of economic growth. Raising significantly more taxes from the rich also requires higher marginal tax rates — and their rates are already quite high. High marginal rates distort the economy and yield less revenue than anticipated because they increase the rewards for legal and illegal tax avoidance.

That's not to say it's impossible to get more money from the rich, but it's tricky and past attempts have typically been less effective than forecast and often counterproductive. Moreover, even under the most optimistic assumptions, taxes on the rich — or taxes on businesses, financial transactions, or anything else aimed at the rich (and often hitting others) — will still not cover a large fraction of the costs of a European-style welfare state. Ask the Europeans — they’ve tried it all and failed. 

Even under the most optimistic assumptions, taxes on the rich will still not cover a large fraction of the costs of a European-style welfare state.

To be in our political center today, you have to deny both these truths and pretend that if we sharpen our pencils and make a bunch of wildly optimistic assumptions, we can close a few tax loopholes, cut some waste from spending, and maybe nudge upper-income tax rates up a little, and continue merrily on the same big-and-growing-bigger government path without unfortunate consequences. This is a “balanced approach,” as it ignores both mathematical truths equally, but the denial of clear reality means this approach is doomed to fail.

Surprisingly, many progressive pundits are moving away from their traditional complaint that America’s tax code is too regressive, favoring the rich. They are starting to tell us, albeit only after an election mainly contested on these issues, the truth: to fund the European-style social welfare state which they advocate, we must tax everyone more.

For example, Ezra Klein, blogging for the Washington Post on December 7th, writes, “The need for tax receipts to grow underscores the necessity of finding an efficient way to collect them. Experts say that should include tax reform and new tax sources that take the pressure off the income tax, such as a value added tax or a carbon tax.”

Klein is mild compared to Eduardo Porter, who writes in the New York Times on November 27th, “Many Americans may find this hard to believe, but the United States already has one of the most progressive tax systems in the developed world” and “Taxes on American households do more to redistribute resources and reduce inequality than the tax codes of most other rich nations.” Mr. Porter, it is shocking to see you argue in the New York Times that the United States is a progressive paragon!  Those in the Occupy Wall Street movement must be surprised to learn that you, one of their standard-bearers, think the United States already does considerably more redistribution than Western Europe!

These pundits know the math. To achieve anything like the European-style entitlement state they advocate, we need to tax everyone a lot more, not just the 1 percent. Despite all the drum circles protesting the inequitable distribution of resources, the wealthy just don’t have enough. The middle class and even the poor must step up to carry more of the burden if this is our desired endgame.

In his November 27th op-ed, Porter also writes “The experience of many other developed countries suggests that paying for a government that could help the poor and the middle class cope in our brave new globalized world will require more money from the middle class itself,” and “Big-government social democracies, by contrast, rely on flatter taxes to finance their public spending.”

What we cannot have is the Life of Julia at no additional burden to 99 out of 100 of us.

In a similar vein, Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities and a former economist for Vice President Biden, writes, "It's perfectly reasonable for the White House to begin collecting more revenue from folks who have done by far the best in pretax terms." But wait a moment for it — he then adds, "But ultimately we can't raise the revenue we need only on the top 2 percent."

Note the use of “2 percent,” a number the president himself has begun using more often. It is a small but telling evolution from decrying the “1 percent.” One wonders if the Occupy Wall Street protestors have corrected their signs to read “We are the 98 percent”? Are those in the 98th percentile already saying “They came for the 1 percent and I said nothing…”? According to the more honest progressive pundits above, it will not be long until the 50th percentile is saying it too.

If we take the logic of a Porter or Klein or Bernstein seriously — and we should — their prescription for taxes is nearly the opposite of the president’s public stance. Let’s say what Porter and others are saying but in plain English (or, failing that, let’s just underline a lot).

If we are to redistribute like Europe, we must tax like Europe. The middle class must pay more taxes and they must pay a larger share of the tax burden. The president, in contrast, is vowing to raise taxes on only the rich. One wonders if President Obama would have won the election if he had warned voters that “to pay for Obamacare, stimulus spending, increased regulatory oversight, and the rest of the big government wish list I believe important, we need to raise the level and share of taxes paid by the middle class”? One also wonders why more progressive pundits were not as clear about their goals and the necessities pre-election as they are starting to be now.

The choice the country faces is simple. We can have big government and the Life of Julia (at least for a while, but that is another essay), with everyone paying through the nose and the middle-class share of taxes rising not falling, or we can return to the American tradition of limited government, with everyone paying a smaller burden to the state, with relatively limited services for, and relatively light taxes on, the middle class. What we cannot have is the Life of Julia at no additional burden to 99 out of 100 of us. Nobody, Left or Right, really thinks that math works, no matter what they may say in public.

Surprisingly, many progressive pundits are moving away from their traditional complaint that America’s tax code is too regressive, favoring the rich.

So what happens if we continue down the current path, with perhaps some small amount of revenue raised from some additional taxes on the rich? Remember, the only way to finance a big European-style state is to have it paid for by massive taxation of everyone, mostly the middle class. Right now we are avoiding honest debate on this fact, perhaps because those desirous of this change know the middle class would rebel if it saw the future bill it will have to pay. Instead, large government benefits are being continued and increased, and still new ones introduced, with little accurate discussion of who will ultimately pay.

What happens historically when benefits are bestowed without a bill also coming due is that we get hooked on them. Then, even when they become disasters not worth their cost, people are terrified to change them, as giving something up is indeed quite frightening.

Of course, as a byproduct of this growth in the state, many of us believe we also suffer a terrific erosion of liberty, free-enterprise, and individual responsibility and initiative.

Finally, after we become fully addicted to the latest increase in big government, the bill will ultimately be presented to everyone including, and in all likelihood over-emphasizing, the middle class and the poor. The people who were promised they would be untouched will see the largest proportional hikes. That’s exactly what has happened in Europe. We have seen this movie before, but this time we don’t need subtitles.

In other words, if we told everyone the ultimate destination right now, the country would likely reject it. But if built up in this piecemeal manner with benefits up front and the bill presented later, it can become reality.

The way to boil the frog of freedom is slowly.

We may, with open eyes, choose the reassuring security of big government with a far larger safety and subsidy net and far higher taxes for all — by no means just the “rich” but in fact more so on the middle class — and likely the sclerotic growth and dependency of Europe. Or we may choose the opposite. But we deserve an honest debate about this critical issue. A debate missing from the last election.

Cliff Asness is managing and founding principal of AQR Capital Management. He is a trustee of the American Enterprise Institute.

Author's note: I'd like to thank Aaron Brown, John Cochrane, Ken French, John Liew, and Mike Mendelson for some very helpful suggestions. Comments may be directed to comments@stumblingontruth.com.

FURTHER READING: Asness also writes “The Health Care Myths We Must Confront.” Steve Conover discusses “The Unfairness of the Buffett Tax.” Aparna Mathur explains “How Taxing the Rich Harms the Middle Class,” and Marc A. Thiessen asks “Why Not Let Taxes Rise on the Middle Class?” Sita Nataraj Slavov contributes “Too Large to be Left Out.”

Image by Dianna Ingram / Bergman Group

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