One More Thought on Inflation and Commodities

Speaking of inflation, some alarmists are concerned about a “bubble” in oil prices, citing the recent run-up. Well, it all depends on your point of view.

If you look at it from a U.S. dollar perspective, it does look like oil has been rallying strongly:

Source:Bloomberg WTI price

Look at the same data from a currency perspective of a commodity producing nation and you get quite a different picture in, say, Australia:

In Aussie dollars, oil prices are flat and can be justified because a large part of their costs are denominated in its own (strong) currency.

What we have is not a bull market in commodities so much as a bear market in the dollar.

We also see why hard assets are a good hedge not just against inflation but against currency weakness as well.

The Great Debate: Inflation vs. Deflation

The Great Debate

I would like to return to a subject we have touched on in the past: the inflation vs. deflation debate. Few things matter more in the world of investing than getting this call right, and the fact is some very smart people have come to very different conclusions while looking at the same data. So what's really behind this debate?

What spooks everyone, of course, is the tremendous increase in money supply, which you can see below:

Source: IMF, Bloomberg

In and of itself, though, more money does not cause more inflation. The monetarists - who, again, I love and respect - got this part wrong. More money in circulation only tends to result in inflation when people are actually doing something with it, which is otherwise known as the velocity of money.

To understand why, consider first how money is created. Popular imagination has it that the Treasury prints money, but that's not how it happens. The Treasury has little to do with it. What actually happens is that the Federal Reserve "monetizes" debt, which is to say they go out and buy government debt from banks at market prices. The debt goes back on the Fed balance sheet and the cash goes to the banks.

The key piece then becomes, what do the banks do with the cash? Normally, they lend it out and the money then has a "multiplier effect" through the economy since banks can loan $10 for every dollar in reserves. But that's not happening now. Banks are licking their wounds and hoarding cash to rebuild their balance sheets. As a result, the money is not yet "out there" chasing goods and services. Furthermore, the money is already out in the real economy is being hoarded to repair business and personal balance sheets. Are you spending as much money as two years ago? Didn't think so.

So, the deflation vs. inflation debate is really just an argument over when (and how much) the velocity of money recovers. In the graph below, you can see how much it has declined lately. This is why there's no inflation right now.

Source: OECD, Bloomberg

But we need to pull the onion back one layer further. What will cause velocity to come back? It turns out that velocity is highly correlated with employment, which is quite logical. People don't spend when they're out of work. Here's the history:

The correlation here is 0.75, which is really high for anything in economics land.

So, inflation won't kick in until employment starts to recover. When will this be? Don't know, although much of the policy coming out of Washington is totally anti job creation. It's a fair bet that employment doesn't come roaring back, which means inflation is not an immediate threat.

But, Scott, you have been ranting about the inflationary threat for months now. What gives?

Inflation is a huge threat, it just won't happen in the next few months, and maybe not for a year or two. Employment (and therefore velocity) tends to be mean reverting. It will return, and when it does, the Fed will almost certainly find it has overshot the mark. It has to overshoot the mark because the alternative - deflation, depression - is far worse. And then there's the fact that the government owes $12 trillion that it would very much like to inflate its way out of.

My friend Mike Kelly said it best: it's like you get to a party late and everyone else is already a couple of drinks deep, so you decide to play catch-up. Pretty soon everyone else is looking at you like you have three heads and your wife is giving you the hook. You overshot the mark. (I'm told this happens to, you know, other people.)

Anyway, it's last call and the Fed has its face in the punchbowl.

The Fed, Later That Same Evening

(Wonkish aside: I am not a proponent of the so-called Phillips Curve, which states that there is a long-run relationship between employment and inflation. The relationship simply doesn't exist over time. Having said that, because of the extraordinary amount of money being pumped into the system, employment in this particular cycle will be the trigger that causes velocity, which will be a key trigger that causes inflation. The other triggers, as I've covered in previous letters, are emerging market demand for raw materials and a socialist-driven supply drought.)

Prediction Markets Revisited

Those of you who have been receiving this letter for years know that prediction markets are one of my pet subjects. The recipient list has grown a great deal of late, though, so I thought it might be a good time to revisit the whole concept. (Apologies to those of you for whom this is familiar turf.) Prediction markets are a wonderful source of non-biased information, which is something that's increasingly difficult to find.

A prediction market is a real money market where you can bet on just about anything that has a binary outcome, i.e. it will happen or it won't happen. For instance, "A magnitude 9.0 earthquake will occur anywhere on earth before December 31," or "Where the Wild Things Are will win the Oscar for Best Picture." Contracts trade between $0 and $10. At expiration, winning bettors collect $10, while losers forfeit their entire bet. So let's say a contract trades at $4, a bettor who believes the event will occur puts up $4 to make a profit of $6, while an investor who thinks the opposite can short the contract, putting up $6 to make $4. We can directly infer that the "market" believes there to be a 40% probability of the event occurring.

Let use a real example. Currently, "Democrats to win White House in 2012" is trading at 65%, meaning things look pretty good for the Dems, at least right now. If you think the odds are higher than 65%, you simply put up $6.50, and after the election you get your $6.50 back, as well as another $3.50, assuming you were correct. It might seem like this is a long time to wait for a payoff, but these contracts trade continuously, so one can play shorter term trends. Here you can see the "Dems to win White House" contract over time:

(Interestingly, another contract allows one to bet on who the Democrat nominee will be, and Obama's odds are only 82% (is Hillary in the wings?). We can then infer that Obama's odds of being the next president are 53% [0.65 * 0.82].)

Now, what is so cool about all this, exactly? It isn't, at least for me, the appeal of having yet another way to gamble money. Rather, it is because these markets represent great information flow about future events, some of which we care a great deal about. Yes, some are (entertainingly) frivolous, but many are quite important. For instance, what could be more relevant right now than getting a handle on whether health care reform will pass? Yes, there are polls, but prediction markets have proved far more accurate, because they are anonymous and use real money.

Prediction markets are rooted in the "wisdom of crowds" concept (see James Surowiecki's excellent book by the same name), which holds that the aggregated wisdom of a group of random people is frequently more accurate than the smartest single member of the group. Surowiecki's opening example comes from an early 20th country fair in England where fairgoers, for a sixpence, participated in a contest to guess the weight of an ox. The guesses had a high degree of variance, but the average guess was, ultimately, only one pound away from the actual weight. This was considerably more accurate than the guesses of some butchers who were present.

When I was teaching my Yale class, each year I would perform much the same experiment. I would pass around a glass jar filled with change and ask the students to guess the total dollar amount. As with the ox, many individual guesses were comically off, but once again the average was amazingly accurate.

The best site for prediction markets is intrade.com. I just checked, and here is where just a few of the markets are trading:

Event Probability

Healthcare passes (before year end) 10% (wow)

Healthcare passes (before July) 12%

“Cap and Trade” passes (before Dec. ’10) 41%

Romney wins Republican nomination 25%

Pawlenty wins nomination 22%

Palin wins nomination 22%

Palin announces her own TV show (before Dec. ’09) 13%

Republicans recapture the House 30%

Highest marginal tax rate will be > 38% (2010) 21%

The Dow will close above 10,000 this year 54%

The Dow will trade below 6500 this year 16%

U.S. debt subjected to credit warning (before Dec. ’10) 25%

Iran conducts a nuclear test (before Dec. ’10) 16%

Obama sends > 10,000 to Afghanistan 85%

Higgs Boson particle to be observed (Dec. ’10) 11%

Verizon to sell iphone (Dec. ’09) 10%

Freedom Tower to open (Dec. 2013) 45%

BofA repays TARP money (Dec. ’10) 35%

Roman Polanski extradited (Dec. ’10) 70%

There are many, many more. Intrade even lets you suggest contracts. The Roman Polanski one was mine.

Another robust prediction market involves movie grosses, which can be found at hsx.com. This one is slightly different in that no real money is involved (it’s an onshore concern), but nonetheless, it has a record of remarkable accuracy in an area that is notoriously unpredictable. You can see how this would be of great interest to Hollywood insiders. Essentially, bets are made using play money on how much a movie will gross. If a movie "stock” trades at $90, it means that the market believes the movie will gross $90 million.

Here, for instance, we see the movie stock for Avatar, James Cameron’s first film since Titanic. It trades at about $180, and it is interesting to observe its history. There was a long period of hype for this movie that built up expectations to a very high level, and this was reflected in the stock. But then the trailer apparently didn’t live up to the hype, so the stock traded down. $20 says James Cameron checks the price at least once a week.

Another interesting site is longbet.org, which is an “arena for long term competitive predictions.” Basically, people make very long term bets, with the proceeds going to charity. Bets are hotly debated by posters. Here’s the marquee bet:

Featured Bet - Long Bets

Duration 10 years (02008-02017)

“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

Predictor:
Warren Buffett

Challenger:
Protégé Partners, LLC

Stakes: $1,000,000
(Will go to Girls Incorporated of Omaha if Buffett wins,
or Friends of Absolute Return for Kids, Inc if Protégé Partners, LLC wins.)

Bring it on! Warren Buffet and a fund-of-funds firm in a $1 million smackdown. So far Buffet is getting his clock cleaned with the S&P down 24% while hedge funds are down 5%.

Entrepreneurs will find many more uses for prediction markets in the future, particularly for use in large corporations as a way to collect uncolored information from employees, suppliers, and customers, who would otherwise have an incentive to shade their projections on such things as sales. This is already happening to a small degree, but I believe it will grow.

The guessing game with the ox was chronicled by a famous British scientist/statistician named Francis Galton, who had wandered into the fair that day in 1905. Galton was a knighted polymath best known for his work in genetics (he was Charles Darwin’s cousin, as it happened) and statistics. Born prominently, Galton was also a noted elitist who coined the term “eugenics.” He believed that certain people were just meant to run things. He asked for the betting slips on the ox because he thought an analysis of the data would illustrate his point, which was that the masses are basically stupid and should stay out of the way. He viewed the results with some dismay. A collection of country rubes smarter than the experts? It wasn’t what he wanted to find, but to his credit he didn't bury his findings.

Which leads me to my last point, and the other reason why I love prediction markets: they are inherently anti-elitist. They are populist by definition. Who doesn’t tire of the pontificators and the pundits, of the nattering nabobs (to borrow from Safire, by way of Agnew)? We are carpet bombed 24/7 by know-it-all philodoxes, and more than telling us what to think, more and more they are telling us what to do. That’s where I get off the bus.

Prediction markets cut through all the b.s.

Gotta Love Trees

No matter what’s happening in the world, trees grow. We love that 60% of the return on timber comes from biological growth, making it both uncorrelated to most other investments as well as unique in the commodity world. We also love that timber is an excellent inflation hedge:

Note the huge returns for timber in the 70s, when the U.S. government printed money with abandon. Hey wait, that sounds exactly like…now. Trees, which are limited by existing acreage and take many years to grow, are by nature limited in supply. When the supply of money increases, trees become scarce relative to dollars, and therefore must rise in price. It’s not very complicated. (One other interesting thing in the graph above is that timber prices seem to anticipate inflation by a year or two.)

I have discussed parts of our inflation thesis in previous letters. We covered how I like the monetarists but that they only worry about the supply of money while they should additionally worry about the supply of goods, and that socialist economies are very much detrimental to the supply of goods. I also discussed how I’m not buying what the Keynesians are selling, which is that too much economic growth is the root of inflation. This month, I’d like to add one more thought, which is that most economists’ views of inflation are too parochial. To predict inflationary trends, a global perspective is now necessary. For instance, over the last 15 years or so, most overestimated inflation because they didn’t properly understand how deflationary the globalization of the labor market would be. China, in particular, has suppressed global inflation through a combination of abundant, inexpensive labor and ample manufacturing capacity. Now, however, I fear what the underestimating is happening in the other direction.

To understand why, consider that much of the current debate about inflation vs. deflation in the U.S.A. has been about domestic indicators such as unemployment and capacity utilization. Conventional economics says that if lots of factories (or people) are sitting idle, then new production should be easy to bring online, and inflation will be negligible. This thinking overlooks a key difference in this economic cycle vs. prior ones: the U.S.A. and the developed world matter much less than they did in the past.

As an illustration of this trend, the graph below shows how the demand for finished steel - one of the key inputs into most infrastructure projects and industrial and consumer goods – has flat lined in the developed world over the past decade. All of the growth has come from developing markets, especially China. The same holds for just about any other commodity you’d care to pick.

In a nutshell, you can’t analyze squat these days (little academic lingo there) without considering what China and India are doing. China, most of all, is becoming a massive net consumer of commodities. And the thing about commodities – as I suggested about trees – is that you can’t gin up the supply quickly. Oil, metals, timber…the supply is highly inflexible. Thus, as China continues to grow, it will put enormous pressure on commodity prices, which flow through to the price of absolutely everything right here at home. We got a sneak preview of this from 2005-2008.

So you see, the fact that a bunch of factories in the U.S. are underutilized is of little consequence. More parochial concerns such as a wanton monetary policy and socialist/bureaucratic bottlenecks will simply add fuel to this simmering fire.

One other thought. Here is the past volume of searches on Google for the words “inflation protection:”

The top graph represents the prevalence of the search term relative to all other search terms. Before the Lehman meltdown, there weren’t enough searches to even register, but things changed in a hurry.

The words “deflation protection” don’t register at all.

(Google Trends, by the way, is a very interesting tool, and I almost feel like one could build a quant model off it, something I plan to give more thought to in the future.)

The Rising R-Squared of Politics and Markets

I always preface this endeavor by saying that predicting the stock market is a fool's errand, but who can resist sometimes? So, at the risk of looking stupid, my view is that we are witnessing one of the great bear market rallies of all time.

A year ago, when we were all collectively peering into the abyss, I predicted a 20-25% rally starting in late January or February. Seemed like a bold call at the time. I got the rally right but wildly underestimated the magnitude, which is now over 50%. My prediction was predicated on the sheer amount of cash that was being accumulated, with one the largest chunks coming in January in the form of hedge fund redemptions. I figured some of it was bound to start trickling back into an oversold market, and it did. But there were other factors that really juiced this rally.

First, of course, the government has turned on the monetary spigot like no time in history. No one wants to risk deflation, so there's nothing subtle about this. Official rates have been lowered to near zero. The government is also artificially lowering rates in private credit markets through its TALF program (in which Belstar participates). And of course, those printing presses are humming.

Second, the government has passed the largest fiscal stimulus bill in our history. The effect of this is debatable because very little of the money has actually been spent, but it's possible it was a short-term psychological prop to the market. (Note: the use of proceeds in these measures is highly dubious. More on this below.)

And then there's politics. It may seem like I've been dwelling on this a lot lately, and it may also seem like I have "taken sides." But markets are affected by politics, so you can't very well have an opinion on one without having an opinion on the other. Market commentators who studiously try to avoid saying anything political ignore the elephant in the room. Or the donkey.

The new laws being contemplated in Washington today such as cap and trade and healthcare will have a profound influence on the American economy, and more specifically on corporate profits. They are game changers. If you try to analyze what's going on in markets without considering the political landscape, your views are meaningless. Ah, for the days when all we had to worry about were P/E ratios. So, agree with me or not, you will get my honest opinion.

So, let's take a look at the market this year, viewed through a political lens:



Here's my take. When Obama was elected, there also came large gains for Democrats in Congress. This was something the implications of which many didn't fully ponder, at least not until November 5th, 2008. The market traded off initially, rallied somewhat in December, but then tanked hard through early March. It was during this period that the full scope and ambition of the Obama agenda crystallized for many. With a strong Democrat majority and a completely cowed Republican minority, it appeared there were no limits on Mr. Obama's power. This very clearly had negative implications for industries such energy, insurance, utilities, drugs, healthcare, agriculture, and others. Is it any surprise the market tanked? The S&P was down 29% by March 9th.

Then something interesting happened. In early March it became apparent that "cap and trade," which amounted to an enormous tax on energy (cum a serious dose of social engineering), was not a slam dunk. Democrat House members from energy and agriculture states got an earful from their constituents and balked, and while the measure passed, it was by a mere 7 votes, and passage in the Senate suddenly appeared unlikely. This was a surprise to many, and the first falter of the legislative juggernaut. The rally's inception coincides almost perfectly with the appearance of the first meaningful opposition to the president's agenda.
Next, in middle/late March, another key initiative faltered, the so-called "card check" bill, which was a sop to big labor, and decidedly anti-business. The market gathered momentum.

Then, just as the rally appeared to be waning in mid-summer, the town hall meetings started, the ones where droves materialized to vent their opposition to Obamacare. Again, no one saw this coming. Republican lawmakers - too busy rummaging around for their spines - had been ready to roll over, and passage seemed likely. But as the reality changed, the market once again picked up steam.

Below you can see the Intrade.com odds of healthcare legislation passing this year. Note that the odds peaked in mid July, just about when the town hall protests started, and just about when the market began its latest surge. Coincidence? Hmm.


Which brings us to today. The political aspect of the rally is somewhat perverse: the market rallies because something bad is less likely to happen rather than something good will happen. Corporate profits won't stink as bad as we thought, huzzah!

Moving beyond politics, the liquidity argument has been stretched a bit thin. Obviously a lot of that cash has been spent. Although cash levels are still reasonably high, I would argue that they will stay high relative to pre-meltdown history.

Monetary stimulus has definitely helped, but it runs the risk of going too far and causing hyper-inflation, as I've discussed in previous letters. Also, the TALF program will expire next year. Will credit spreads blow out when not artificially constrained by the Fed? Very possible.

As for fiscal stimulus, all this does is borrow from the future to ease our pain today. It is the policy equivalent of being a 12-year old. The amount of debt we are accumulating is unconscionable. The one area where I might have been sympathetic to fiscal stimulus is with national infrastructure, roads, bridges, electrical grids, etc. The fact is, much of this needs repair or modernization, so what better time than now when people need work? Also, this money shouldn't be considered spending, per se, but rather investment. Economies need infrastructure, so there's a return on that investment. Sadly, the stimulus bills we have passed have little to do with this. Mostly, they give money away to pet projects and special interests. My personal fave is $150 million for "volcano research." That'll get the wheels of commerce rolling!

We are left with a rally that seems mostly artificial. The fact is that we are still deleveraging, so consumer and corporate spending will remain low. Tax rates are rising fast, particularly at state and local levels (although the Feds will catch up soon). Housing and autos have been briefly propped up by still more government programs, but "cash for clunkers" is over and housing tax credits will have to end as well. The sheer growth of government guarantees the future misallocation of resources coupled with a higher level of economic uncertainty hence higher risk and higher volatility We have taken about five shots of whiskey for a quick buzz, but the hangover awaits. It's difficult to imagine any other scenario.

Many, including I, have noted that the stock market rallied 48% in 1930, post crash, and went on to new lows. I wonder if this is an analog for today. Personally, I don't think new lows are in store, but we could be at the high end of a trading range that lasts years.

I should say, by the way, that I am by nature an optimist, so all this negativity doesn't come naturally. (It makes me feel sophisticated, though - have you ever noticed how pessimists are held in higher intellectual esteem, even though they are wrong most of the time?) I should, however, throw out two or three bright spots. First, emerging markets are quite healthy, and consumer-led demand from the newly minted global bourgeoisie will help our own economy, particularly the export sector. Second, the next great game-changing technology is just around the corner. Don't know what it is, but since technological progress is speeding up, it will be here soon. Will it be enough? Don't know that either. Third, the fact that I, a preternatural bull, am bearish is a very bullish sign!

Are We Socialist Yet?

To answer this, we have to define what socialism is. There’s often confusion surrounding this, of course. An article in my local paper this week upbraided a previous week’s writer who had decried our country’s “headlong rush into socialism.” The article said this was ridiculous, because Obama isn’t trying to turn the U.S. into the old Soviet Union. While this may be debatable (I say, only half joking), who said anything about the Soviet Union? The Soviet system was what we refer to as communist. Importantly, communism is little more than a logical extension of socialism, with even more power in the hands of the state. But what the letter writer was really objecting to is what he sees as our country’s adoption of European style socialism, with its protected working class, socialized medicine, high tax rates, etc.

Have we become Finland, or France? Again, it seems we need a definition here. Philosophically, socialism is about a large and powerful state, which necessarily comes at the expense of personal liberties. A government can’t spend money without taking it from someone first.

But still, this is a vague definition, and I like to quantify things. I started my thought process with tax rates, but quickly realized this would be difficult to calculate. After all, how many forms of taxation are there in our country? Hundreds? Thousands? One easily forgets all the small taxes built into things like the monthly cable bill. My colleague Daniel Grasman, a European who knows his socialism, suggested I look at total government expenditures as a percentage of the overall economy. Bingo! All taxes find their way into spending, so this method captures everything.

On the next page is the data for OECD countries going back to 1991.

General government total outlays as a % of GDP

A little hard to see, I know, but that archetypal socialist country, Sweden, tops our list, along with France and the other Scandinavian nations. No surprises here. Note, though, that the Scandinavian countries have been inching away from socialism while we have been inching towards it. The gap between Sweden and the U.S. in 1991 was 23.6%. By 2010, it is projected to be 15.1%. And the U.S. numbers don’t even include an assumption for nationalized health care.

By my way of thinking, every country on this list is socialist, including the U.S. Some are just worse than others. To appreciate this, let’s look at a longer term view of the U.S, because this has been creeping up on us for a long time:



The trend is as clear as it is unsustainable. As Margaret Thatcher once famously said, “The problem with socialism is that you eventually run out of other people’s money.” Well, yes, but the problems run deeper than that, including the creation of a culture of dependency, something that runs counter to America’s long standing tradition of self-reliance.

But these numbers don’t capture the whole picture. Socialism is about power focused in the state, and power is not always manifested through money. The state can pass laws compelling citizens to do things. For instance, in Southampton, Long Island, the town board has passed a law saying that henceforth all pools must be heated with solar panels. An 800 square foot pool will require 500 square feet in solar panels. Where to put them? The town board won’t solve that problem for you, but they feel good about themselves because they are saving the planet. A small liberty – the right to heat your pool – is lost. These things add up.

An even more threatening example? The “cap and trade” bill passed recently by the House mandates that your house must undergo an “environmental audit” if you wish to sell it. In other words, a federal bureaucrat will be able to hold up your house sale indefinitely if you don’t have the right kind of light bulbs. To make the policing of this possible, the bill plans to increase the staff of the EPA from 10,000 to 45,000 people. Yikes!

There has been an interesting backlash of late in town halls and letters to editors, and I have a theory about this. The graph on the previous page tells an interesting story. It says that statism has been very effective at advancing its interests over the decades, but it has done so incrementally. This was clever because, like the frog that doesn’t know it’s in boiling water until it’s too late, the logical foes of statism have largely ignored statism’s steady advance. Why? Because, I think, these logical foes are busy with their lives. They have jobs and families, and would frankly not like to take time out from these pursuits to do things like read twelve hundred page bills.

This is quite contrary to the “activist,” whose very life is often organized around advancing an agenda. I noticed this dynamic first in college. The activists seemed to have few other pursuits. Many of us certainly opposed them philosophically, but this opposition was about our fifth priority behind things like sports, socializing, sleep, and yes, even studies. Where activism was concerned, we may have had them outnumbered, but we were at a complete disadvantage.

This dynamic persists in the real world. The activists go into politics, or work for advocacy groups, while the rest of us just…work. Take ACORN, which seems to be able to muster a crowd of people on virtually any weekday. Who are these people and how did they manage to get the day off? They didn’t, because this is what they do.

An ACORN Protest – How Do They Have the Time?

So, for decades now, these folks have successfully, incrementally, advanced the power of the state. Over the last seven months, though, they have decided to reach for the brass ring. They want everything on their wish list, and they want it now, and this has turned out to be a large strategic error. It was so much, so fast – one trillion dollar bill after another – that the “silent majority,” as they are often called, said to themselves, “hey, maybe we should actually pay attention to this.” A tipping point had been reached, and an angry backlash began. The honeymoon for Mr. Obama is definitely over:

I believe the huge dip in the stock market last winter was largely attributable to the prospect that Mr. Obama would be able to get his entire agenda through, and people were suddenly getting clarity as to what that agenda really was. The huge rally since began almost to the day that it became apparent that cap and trade would likely never get through the Senate, and the rally gained steam as health care floundered. Stay tuned, though, this isn’t over.

Some Musings on Taxation

Question: What is Hauser's Law? Answer: The Most Simple, Important Economic Concept You've Never Heard Of

In 1993, an economist named Kurt Hauser discovered an amazing fact: the federal government, no matter how much it raised or lowered the top income tax rate, always collects about 19.5% of GDP in tax receipts:


This is almost unbelievable. Look at the 1950s, when marginal rates were 90%. The government collected about 19.5% of GDP. Look at the 1980s, when the highest rate got down to 28%. The government collected about 19.5% of GDP.

Some critics say this is misleading because it measures total tax revenue (including corporate revenue, etc.), and not simply revenue from individuals. Fair enough. Take out everything else and here’s what it looks like:

Case closed, I’d say. Note the amazing constancy even during the huge cuts in the 80s. (I remember a former economics advisor of mine, James Tobin, testifying before Congress that the tax cuts would lead to huge drops in revenue and result in recession. This, from a Nobel Prize winner.)

My colleague, Simina Farcasiu, points out that the data above probably understate the case since GDP is likely understated during high tax regimes, i.e. when tax rates are high, the underground economy is larger, so tax receipts during high tax periods are even lower as a percentage of "total" GDP (legit + underground).

The conclusion is clear enough: marginal rates should be lower since this will stimulate economic activity and the government will collect more actual dollars as GDP expands. Not that it’s always desirable to give politicians more to spend, but the point is the economy will be healthier, and therefore society at large.

What's interesting to me is that when people are asked what they consider to be a fair rate of taxation, the most common reply is 20%. It seems that this is also what society, collectively, has decided to pay, regardless of the tax rate.

But wait, you say, willingness has nothing to do with it. The law is the law! True, and not true. First, high income earners are quite dexterous at finding legal ways to avoid taxes. One way is to live more of your life on pre-tax income. Say you run a small or medium size business. Right now you're thinking quite creatively about what sort of expenses can be run through your company. Don't have a dental plan? You will soon. Not expensing at least part of your car lease? You will soon. These are things most business owners won't obsess about in a low tax environment, but they are obsessing about it now, and the taxes haven't even hit yet. Oh, and these same folks are pondering just not working as hard, which is another legal way to avoid taxes. And, of course, there will be those who have no compunction about crossing legal lines.

All this, of course, should remind you of the Laffer Curve:

Hauser's Law can be taken as empirical proof of the Laffer Curve's efficacy. And really, no one can argue with Laffer's basic logic. At a 0% tax rate, the government collects nothing. At a 100% marginal rate, presumably no one will work, or more likely all labor will be off the books, so again, the government collects nothing.

What is difficult to tell is how the curve is shaped, and where the peak of the curve is. I used to live in Hong Kong where there was a 15% flat tax, and tax collection was quite robust. Indeed, the Hong Kong government would run a huge surplus every year.

Some interesting experiments were conducted by three Canadian economists to understand whether there was any psychological underpinnings to the Laffer Curve. It turns out there are very strong ones:

"The fact that tax responsiveness of work is substantially greater when the tax rates are set by another subject in flesh and blood than by nature is taken as evidence that workers respond strongly and emotionally to unfair taxation, which is consistent with the history of tax revolts. To be more specific, taxpayers want to punish the tax setters who intentionally violated the social norm of fair taxation."*

In other words, when tax payers feel like they are getting shafted, they take it personally, and they react. "I'll show them," is the attitude, which is a sentiment I am hearing over and over, and, for the most part, which is amazing because most of the coming tax hikes haven’t even taken effect. This sentiment is most prevalent among the well off, which makes some sense, since the top 5% of taxpayers already pay 60% of federal taxes (source: IRS). Now our president says almost daily that everything he wants to do can be financed by these very same people. He even seems pleased at the prospect.

{*A Micro-foundation for the Laffer Curve In a Real Effort Experiment (Levy-Garboua, Masclet, and Montmarquette, 2006)}

It will never happen. He may try, but the revenue won't materialize, because those 5% are already enraged, and they also happen to be the best equipped to avoid taxes if they want to. As I suggested, many are small business owners who can live more of their lives pre-tax, and many have the resources to say, "Screw you, I'm retiring." They'll move to Florida (no state income tax) and buy munis.

And then there will be the resurgence of the grey market economy. I heard about a contractor on Long Island the other day who now will quote two prices for jobs: one cash under the table, the other above board. He had never done this before. What set him off after all these years? Was it...

35% Personal Federal Tax
8.8% Personal State Tax (NY)
6.2% Social Security Payroll Tax
2.4% Medicare Payroll Tax

No, it was none of these things. It was a new 3% payroll tax to pay for the hugely inefficient Metropolitan Transit Authority in New York City. Even though his business is 100 miles from the city, he has to pay the tax because the Long Island Railroad (part of the MTA) has a single branch that services his town, something that he never uses. For this guy, it was the tipping point, which jibes with the Canadian study. (Interestingly, this guy's employees are also highly incentivized to go along with the scheme since they, too, will avoid taxes by being paid off the books.) If taxpayers feel they are getting jerked around, they will sometimes radically alter their behavior, and may have little compunction about crossing legal lines.

Any and every tax proposal that has ever come out of Washington uses something called “static scoring,” which assumes that people never vary their behavior. This is wildly unrealistic. I can tell you that conversations about tax-minimization are being had everywhere right now, from little shops to big corporations. Look for corporate perks like a car and driver to make a big comeback.

Next month we will ponder the question: are we a socialist country?