Spendable dollars, taxes, and borrowing

In a roundup of candidate's positions on fixing Social Security, CNNMoney via Yahoo reports "Huckabee: In conjunction with his desire to move toward a consumption tax system in which you would pay taxes on your purchases but not on your income or investments, Huckabee would favor eliminating Social Security taxes. And it's been reported that he supports the idea of workers using individual investment accounts, although no details are offered about how they would be funded."

This is an interesting thought, and it raises the issue of how spendable dollars affect borrowing.

In California, for instance, taxpayers can pay as much as 62%*, ** of income in income taxes alone. That means that one dollar of income equals 28 cents of spendable money. Put another way, $1 of property tax, sales tax, vehicle registration tax or the like, or $1 of general spending will require a taxpayer to earn almost $4 in income.

(* 74% if one of the universal healthcare proposals pass, ** 11% state + 35% federal + 16% social security/medicare/self-employment tax=62%)

A lower-wage taxpayer might pay 5% state, 25% federal, and 8% Social Security income taxes, for a total of 38% off the top. That would leave the taxpayer with 62 spendable cents per dollar earned, requiring roughly $1.60 in income per dollar of rent, sales tax, or whatever the taxpayer wants or needs to pay.

To update the old saying, a penny saved is anywhere from 1 1/2 cents to 4 cents earned.

Now, if a taxpayer borrows $1 from a credit card, he gets one full spendable dollar. He'll have to earn at least $1.60 to pay that dollar back, more if he owes interest charges. This is a big part of the reason that people get into trouble with credit cards. They are easier to spend than wage income, because they go so much further, but they are much, much harder to repay than we realize, because earned income doesn't go very far at all. And when a borrower erases debts under bankruptcy, the earned equivalent value is often more than twice the actual dollar value.

Taxes do have an impact on behavior. One of the very large and very ignored factors contributing to the real estate runup was the change in tax law regarding capital gains on housing. If a house could earn you $40k in a year, that is more money than most people could earn in a full year of full-time employment, but it also provided $26k spendable dollars after 10% state income tax and 15% federal long-term capital gains tax (after holding the property for a year). A middle-class employee in California would have paid 10% state, 35% federal, and 8% Social Security tax on equivalent wage income, or 28% more taxes than the house flipper owed. $40k in housing appreciation would replace the equivalent net spendable dollars as $55k in wage income. Two houses at $80k profits would replace $110k in wage income - suddenly the risks look less, well, risky. If the flipper holds the house for two years to qualify for 0% Federal taxes, he reduces his tax burden by 38% compared to earning wages - and note that it rarely takes 52 weeks of 40 hour days to flip a house. I haven't sold a house since the tax law change, but I am under the impression that the appreciation is excluded from income - so it would not affect the tax rate on other earnings. You can't do that with a second job, investment income, or any other income stream available to the average taxpayer.

The net result of all that house-flipping is just now hitting front-page news, and we all know it's ugly. Many of us have been reading the financial news and realize that Americans are spending more than they earn - a negative savings rate. The result of that particular tidbit is increasing American debt (both personal and government debt) and devestation to the value of the dollar (from $1.35 Euros in 2002, to .67 Euros today, almost half its value of 5 years ago). The same way that capital gains exclusions from real estate wrought havoc on the housing market, high income tax rates incentivize increased borrowing.

So if Huckabee's plan passed, the tax burden would hit at the point of consumption, rather than when the money is earned. This may sound strange, because it is so far outside our current experience. But ignore, for a moment, whether his proposal is a good idea or not. Just think about what behavior it rewards and what behavior it penalizes - the polar opposite of today's situation.

Under a consumption tax, earning, investing, and saving would be tax neutral. These are all activities that contribute to the long-term well-being of our nation. Spending would be penalized - and borrowing would be penalized as a result. While consumer spending has fueled recent economic growth, we are begining to see that it was a house of cards that could destroy our economy. Consumer spending has resulted in an enormous trade imbalance with China and other foreign nations, enormous mountains of trash from buying poorly-made products as well as from impulse purchases that ended up being unwanted. Our savings rate has gone from positive to negative, leaving the majority of individual consumers - as well as the government - without adequate reserves to weather a crisis. Jobs have been created, but those jobs are now being terminated as the spending machine slows.

Spending without consideration creates unstable growth. When every dollar is dear, consumers spend more thoughtfully, more slowly. We have a crime situation where middle-class and poor teenagers steal to keep up with their peers - many of whom are enjoying the fruits of their parents' slow descent into bankruptcy. Savers have been penalized over the past 5 years by an erosion of the value of their savings ($1 saved 5 years ago would buy $1.35 Euros worth of gasoline, but today that dollar has earned 28 cents in interest, for a total of $1.28 which will buy .87 Euros worth of gasoline). Workers are being penalized as their jobs are outsourced and terminated. Companies are being penalized for investing in additional capacity, because tightening in the credit markets is bringing consumption to a crawl. Surging bankruptcies can't be far behind, as surging foreclosures are already swooning the economy.

Slow, thoughtful spending creates sustainable growth. Savings provides a cushion for continued consumption in an economic downturn, fueling a recovery. Buying as much house, or car, or stuff, as one can afford means less displacement in individual lives and less displacement in the overall economy. Living within one's means is the opposite of having a spending orgy for 5 years and then cutting back drastically just to pay the mortgage.

Since taxes incentivize behavior, high income taxes contribute to the problem. They will not contribute to the solution.