Heading Toward the Cliff

“Hit the brakes, hit the brakes,” Publius is screaming to Ordinatio.  “I tried” Ordinatio says calmly “but the brakes don’t work because I neglected to keep up the maintenance on them.  Instead I spent the money on a new paint-job provided by my cousin”.  Publius is in the backseat of a car that is traveling toward a cliff.  The car is traveling about 25 miles per hour but is accelerating.  “Why are we accelerating?” Publius asks.  “Oh, because the gas pedal is stuck.  I neglected that maintenance also because I spent the money on these comfy leather seats installed by my best friend” Ordinatio replies.  “Can you steer away from the cliff?” Publius asks.  “Nope, that’s not an option either since I neglected to refill the steering fluid.  I spent the money on new hub-caps sold to me by my uncle” Ordinatio again replies.  “So, how are we going to avoid going over the impending cliff?”, Publius asks Ordinatio.  “Don’t you worry”, Ordinatio says.  “I am sure the car will run out of gas before we reach the cliff.  I have been down this road many times and the car always runs out of gas before going off the cliff.”  Publius has to make a decision.  Ordinatio has neglected to take care of the car and can’t be trusted to make good decisions, yet he wants Publius to trust him with Publius’ life, hoping the car runs out of gas.  Alternatively, Publius can jump out of the car.  Worst case, Publius may be in a body cast and go through excruciating pain, but at least Publius will live.  What should Publius do?  This is a no brainer.  Time for Publius to jump out of the car.

There is much talk about America’s fiscal quandary, but the above story summarizes the decision America has in front of it.  And, it is very simple.  America can (1) go through the short-term painful process of getting its financial house in order or (2) continue the current government policies that are increasing government debt levels, which can only be repaid by printing money, which then results in the collapse of the US dollar, resulting in massive price increases and thus a long-term significant reduction in the standard of living for American citizens.  In addition, because businesses make investment decisions based on long term expectations, America’s debt problem is the primary reason for the current weak economy and why the American economy fails to grow.

In the following pages, I lay out why America’s national debt is such a large problem and then propose a plan to fix America’s governmental financial health.  In developing my plan, I put aside my own personal interests and instead consider what is best for America based on the facts.  This concept of facing up to facts and not spinning the facts to serve your own personal interests is what I call Intellectual Honesty, something in short supply in America today.

AMERICA’S DEBT:  WHATS THE BIG DEAL?

Let’s review America’s debt problem.  It has two components:  the interest rate paid on the debt and absolute level of debt.  Today, the average interest rate at which the US Treasury borrows money is about 2.8%, compared to the historical norm of about 5.5%.  This is largely because (1) the Federal Reserve is keeping short term interest rates very low and (2) the US Treasury’s borrowings are heavily weighted to the short term.  At normalized interest rates and average life of the debt, the additional interest expense on the US  government’s public debt of $10.1 trillion (the commonly referenced $14.9 trillion of “debt” includes intra-governmental debt held by government entities such as the Social Security trust fund) would be about $300 billion a year.  To give this context, during the debt ceiling debates, Washington discussed cutting at most $4 trillion in spending over 10 years, or an average of $400 billion per year.  Thus, the increase in interest expense wipes out 75% of the expense cuts and means that there would be almost no actual impact on annual deficits.

Additionally, the federal government annual deficit is $1.3 trillion so debt would still increase by $1.2 trillion per year ($400 billion in annual savings less $300 billion in increased interest expense).  At current US government revenue and spending levels, in five years US government public debt would approximate $18 trillion.  At the historical average borrowing cost of 5.5%, annual interest expense on the debt will exceed $900 billion, which is over 40% of the revenues the US government takes in currently, and annual deficits will approach $2 trillion.  By comparison, current interest expense on US public debt is $266 billion and is about 7% of total government expenses.

Up until now, it was acceptable for America to run annual budget deficits because the resulting amount of total national debt was not too large relative to total economic activity.  But, now America’s debt levels have reached the tipping point where buyers of the debt should begin to question how the US government can possibly repay all this debt in the future.  In addition, past and present Presidents and Congresses, both Republican and Democrat, have promised social benefits to the American people that in no way can be honored.  Based on current estimates, the present value of unfunded obligations to Social Security, Medicare and Medicaid is about $50 trillion, 85% of which is attributed to Medicare and Medicaid.

Keynesian Economics:  Mis-diagnosing the Problem

The US economy has struggled to grow in the past few years, nor create new jobs.  President Obama’s administration and like minded economists believe that the solution is deficit funded stimulus to “jump start” the economy.  But, this is the opposite of what the US should be doing because they are misdiagnosing the problem.  It reminds me of the Seinfeld episode where George decides to do the opposite of what his instincts are and the result is that his life turns around for the better.  All the Keynesians should channel George.  The US’s problem is not lack of demand but too much debt.  The massive debt burden and unfunded entitlements are a huge risk for the US, a deterrent for investing in the US and thus the primary reason why the overall US economy is not able to grow.  And, therefore, stimulus spending has no positive long term impact on the economy, but instead makes things worse by increasing government debt.

The American Economy:  A Quasi Ponzi Scheme

US economic activity is underpinned by $1.3 trillion annual federal deficit spending, not to mention the multi hundred billion dollar annual deficits at the state and local government level.  Basically, the US economy is a quasi Ponzi scheme.  US annual GDP is about $15 trillion.  What if the federal, state and local governments actually ran balanced budgets?  That means an approximately $2 trillion reduction in expenditures, the preponderance of which go to US companies and residents.  If we assume a 1:1 relationship, meaning $1 of government spending equals $1 of GDP, then a balanced budget would result in GDP declining by about 13%.  Some people argue that government spending is highly inefficient and thus you can’t assume a 1:1 relationship.  Fine, let’s assume $1 of spending results in $0.50 of GDP; you still are talking about a 7% decline in GDP.

America’s current standard of living is out of balance with its economic productivity.  America does not produce enough to support the standard of living.  The standard of living is predicated on borrowing money from outside of the US, mostly China and Japan, and then buying things.  This is not sustainable.  Before the US can get strong again, it will have to get sober.  To use another analogy, America is like a drug addict.  As long as the US gets its daily drug fix, in this case borrowing money from foreign entities (which currently hold almost 50% of US public debt) to live beyond its means, then America feels fine.  But, just like a drug addict, the drugs are slowly killing the user and will shorten his life.  The solution is to stop taking the drugs but that will require a painful withdrawal period.  But, this withdrawal period is the sacrifice one has to make to get healthy again.  Likewise, the US will have to go through a painful economic contraction in order to get healthy again.

THE PATH FORWARD:  HOW TO GET AMERICA HEALTHY AGAIN

To solve America’s current and future economic problems requires creating an environment where people have confidence in America’s future.  And, the way to achieve this confidence is by getting America’s financial house in order, which means achieving a balanced budget and reducing the total level of debt relative to GDP (inclusive of future unfunded entitlements).  While this will likely lead to financial contraction in the short-term, it will set up American for future growth and prosperity.  Think of it like a plant.  In order for a plant to grow, from time to time you need to cut it back so that it can grow bigger and stronger.

There are two ways to balance the budget and reduce debt:  cut spending and/or increase revenue.  And, there are three ways to increase revenue:  increase tax rates, reduce tax deductions or grow the economy such that tax rates are applied to larger incomes and thus generate more taxes.

The problem with deciding whether to cut spending or increase revenue is that most Americans think about this in terms of how it impacts them, not what is best for America.  The days of “Ask not what your country can do for you, ask what you can do for your country” are long gone.  But, why is this?  I have a thesis.  And, there is no polling behind it, no surveys behind it.  It is purely from my personal experience.  Basically, nobody thinks the “system” is fair and as a result nobody is willing to sacrifice because then they feel like a sucker.  It all centers on fairness.  If the American people believe that the pain will be shared fairly, then they will be willing to give up some of their benefits or pay some more in taxes.  The American public has no respect for Washington officials.  They are perceived to serve special, narrow interests at the expense of everyone else.  So, the typical American thinks, “Why should I sacrifice when Washington bails out the banks?  Why should I sacrifice when the defense contractors continue to get rich?  Why should I sacrifice when corn farmers, which are really large corporations, get huge subsidies for ethanol which causes the cost of my food to go up?  Hell no, I am not going to sacrifice one iota”.  So, in considering policy prescriptions, it is critical to achieve fairness.  Without it, nobody will be willing to make the sacrifices necessary for American to get healthy.

The Plan:  Setting Specific Targets

Before offering detailed recommendations to solve America’s impending financial crisis, I want to provide a financial roadmap to act as a guide.  Unless we quantify the targets, it is very difficult to determine the magnitude of the policy prescriptions.

My goal is to achieve a balanced budget within five years.  Ideally I would like to achieve this faster, but the risk is that doing so could be so traumatic to the economy as to cause a depression.  Remember, getting off the crack of debt is going to be really painful and we don’t want to have a heart attack and die while getting clean.  I also considered a ten year plan but the increase in debt levels and accompanying increases in interest expense are just too high; America does not have ten years.  Upon achieving a balanced budget, the next goal is to run budget surpluses which will be used to repay government debt until debt as a % of GDP achieves 50%.  Once this 50% target is achieved, then expenses can grow at the lesser of 2% or the inflation rate.

The next question is what are appropriate revenue and expense targets?  I propose we base line off of the last time America had a balanced budget, which was 2001, to establish expense targets.  Then, we solve for the revenue targets necessary to balance the budget.  Why, you may ask, am I basing my analysis off of expense targets?  From 2001 to 2011, revenues grew by 15.7% but total expenses grew by 93.2% and expenses excluding interest expense on public debt grew by 102.4%.  During this period inflation was 28% (per the Bureau of Labor Statistics website calculator).  America’s primary issue is lack of expense control.

To be more specific, in 2001 revenues were $1.99 trillion.  2001 total expenses were $1.86 trillion and expenses excluding interest expense were $1.65 trillion.  Applying 28% for inflation, 2001 expenses excluding interest expense would be $2.11 trillion in 2011 terms.  Actual expenses excluding interest expense in 2011 were $3.33 trillion.  Thus, they were $1.22 trillion greater than inflation adjusted 2001 expenses, which is a 58% increase when population only grew about 10%.

To achieve a balanced budget, we must set specific numerical targets and then create a budget based on those financial constraints.  Regarding expenses, I propose a target for year five total expenses of $2.75 trillion, or $850 billion below current levels.  This expense target assumes $2.1 trillion for expenses excluding interest expense, which is the 2001 amount adjusted up for inflation.  The total expense target also includes $649 billion for interest expense, which is a $383 billion increase versus 2011 interest expense of $266 billion.  The reason for such a large increase in interest expense is the continuing budget deficits in the preceding four years, as well as an assumption of 5.5% for the average borrowing cost.  Revenue then must equal $2.75 trillion, which is a $450 billion increase over 2011 revenue of $2.3 trillion.  Again, most of the required increase in revenue is because of the increase in interest expense of $383 billion.  Finally, for those wondering, if revenues grow beyond $2.75 trillion annually before year five of the plan and result in a budget surplus, there will be no change to the expense targets but instead the surpluses will be used to pay down debt.  I know this is getting a little dense; at the bottom of this blog are Appendix 1 and Appendix 2 with tables that hopefully make it easier to understand.  But, it is important for you to have this numerical context as we now move on to the concepts underpinning the plan.

Government Expenses

In thinking about spending, I think back on one of the greatest movies of all time, Top Gun.  In it, one of the instructors (Stinger) tells Maverick, “Son, your ego is writing checks your body can’t cash”.  Well, America’s political class has made financial commitments that it simply can’t fulfill.  Is it in America’s self-interest to be the world’s policeman via our military?  Yes.  Can America afford it?  No.  Did America make commitments to seniors and the poor to provide Social Security, Medicare and Medicaid benefits?  Yes.  Can America afford them?  No.

The first thing that everyone needs to understand in thinking about where to cut spending is that just “cutting waste” is not realistic.  Social Security, Medicare and Medicaid currently comprise 41% of government spending.  Add defense spending and we arrive at 60% of government spending.  Interest on the debt adds roughly 7%.  Thus, we are left with 33% of spending that is not entitlement, defense or interest, which we will call discretionary spending.  Included in discretionary spending are things like veteran’s benefits, the justice department, nutrition programs for children, transportation infrastructure spending and various forms of social support, as well as agency expenses for education, housing, labor, etc. (detailed list included in the table in Appendix 2 at the end of this blog).  The annual deficit is about 40% of total spending, meaning you can eliminate all of this discretionary spending and still not balance the budget.  Additionally, some of the discretionary spending is necessary, such as transportation infrastructure, the justice department and veteran’s benefits.

Simply put, all spending needs to be cut.  This will achieve fairness since everyone will be impacted and is a mathematical requirement to achieve a balanced budget.  Here are my proposals for each of the major expense categories:

1. Defense Spending ($679 billion in 2011 versus $291 billion in 2001; 18.9% of total 2011 spending):  For Republicans to state that they are serious about cutting spending but then state that defense is off-limits is intellectually dishonest.  Bankrupting America is as much a threat to national defense as any foreign country.  So, what is the appropriate level of annual defense spending?  To answer this let’s look at the numbers (sourced from CBO data and the Peter G. Peterson Foundation (“PGPF”) website).  America currently spends $679 billion annually on defense, of which about $130 billion is for the wars in Afghanistan and Iraq.  The next 20 largest countries’ defense spending combined does not reach $679 billion, and 18 of these countries are US allies.  China spent a little over $100 billion and Russia spent about $50 billion.  Think about this.  The US and its allies spend about $1.2 trillion on defense versus $50 billion by Russia and $100 billion by China.  While it is in America’s self interest to have a strong military, the amount of spending cannot be justified.  Additionally, it is a factor leading to America’s financial demise.

I propose that within five years America’s annual defense spending be $300 billion, a $249 billion reduction from current annual spending excluding the Iraq and Afghanistan wars and a $9 billion increase compared to 2001 defense spending of $291 billion.  To achieve this, American should eliminate spending on the Iraq and Afghanistan wars, as well as incrementally cut $50 billion each year for five years.  At $300 billion, plus America’s 18 allies spending of $500 billion (assuming no change to current levels), this is still 8 times China’s current spending levels and 16 times Russia’s current spending levels.  That seems more than ample.  Additionally, the world’s economic inter-connectedness makes large wars highly unlikely.  That said, I understand that looking over the past few thousand years, mankind has always been at war and that we can’t assume just because the last 30 years have been relatively peaceful that there won’t be large world wars in the future.  But, the economic reality is that America has to take that risk because America can no longer afford to be the world’s police officer.  America cannot afford to incur the financial burden of maintaining peace and stability in all corners of the world.

2. Likewise, future Social Security, Medicare and Medicaid benefits have to be reduced.
1. Social Security ($720 billion in 2011 vs. $426 billion in 2001; 20.0% of total 2011 spending) was created in 1935, with a retirement age of 65 when life expectancy was 61 years.  Today, life expectancy is 79 and with medical advances is steadily increasing.  America should increase the ages at which citizens are eligible for Social Security.  Since American’s are living longer, Americans should expect to work longer or at least wait longer to receive Social Security benefits.  Additionally, Social Security should be means tested, such that there is a phase out of benefits based on lifetime income earned.  Benefits should be a form of backstop, not an entitlement.  Fortunately, I am in a financial position where I do not need Social Security, nor do I make decisions today expecting to receive it (I am 42 years old), and I am OK with that regardless of the fact that I paid into the system.  We need to get our financial house in order, which requires personal sacrifices.

That said, for people who are already 65 years old or are close to being 65, their Social Security benefits should not be changed.  They lived their lives based on an assumption of what they would receive from Social Security.  Instead, reductions in Social Security benefits should be phased in based on age starting with people that are say 55 (much more analysis needs to go into setting this age).

In 2010, for the first time, Social Security payouts exceeded payroll tax revenues.  And, based on America’s demographics, this trend will only get worse.  Over the next five years, Social Security is largely self-funding, but over the longer term it will become insolvent.  Thus, Social Security is not a big near term concern as it relates to achieving a balanced budget within five years, but America should phase in structural reform over the next 10 to 20 years.

2. Medicare ($483 billion in 2011 vs. $241 billion in 2001; 13.4% of total 2011 spending) and Medicaid ($275 billion in 2011 vs. $130 billion in 2001; 7.6% of total 2011 spending) are the biggest entitlement problems America faces because of their past and projected growth rates.  Since 2001, they have both grown over 100%. And, America’s population is aging.  The unfunded future expenses are forecast to be about $42 trillion.  America has to take drastic measures to reduce the consumption of healthcare.  The Affordable Care Act endeavors to hold down prices in order to reduce cost.  But, price controls never work.  Instead, the healthcare providers will increase the volume of services offered at the lower prices to achieve revenue increases.

So, how do we reduce the consumption of healthcare?  One problem with our current system is that healthcare is basically free once you pay your insurance premiums.  When was the last time you asked a doctor what a procedure would cost before you ordered it?  And why should you since someone else, your insurer, is paying the bill.  A second problem is that physicians are afraid of being sued for negligence and therefore give patients too many precautionary tests, exams, medications, etc.  Americans need to accept that the world includes risk and sometimes accidents happen.  If a doctor makes an honest mistake (meaning, there is no blatant negligence), regardless of the consequences, then the patient should not sue the doctor or the hospital.  Instead, the physician’s performance records should be public information and future patients can then decide whether or not to utilize a physician’s services.  This issue represents a larger problem in America of citizens blaming others for their problems, but this is a topic for another time and much too complicated for this paper (as well as my knowledge).  Finally, and most controversial, is the issue of end-of-life healthcare.  According to a recent study by the Lancet, 30% of total Medicare spending occurs in the last year of recipients’ lives.  This is a topic that requires honest discussion.

So, what is the solution?  Consumers of healthcare need to be incentivized to be price aware and self-ration healthcare.  One way to accomplish this is to think of healthcare insurance in terms of catastrophic coverage.  If you get a cold and want to see the doctor, you pay for that yourself.  If you have a major medical issue, then you can access insurance.  Likewise, elective procedures should not be covered by insurance.  It may seem harsh, but I think of it like a home and home insurance.  I don’t use home insurance to have my roof replaced or air conditioner replaced or my house painted.  I pay for all these services myself as normal maintenance expenses.  And, if I want to add an extension to the house, that is my personal expense also.  But, if there is a major event such as a fire, then I access insurance for reimbursement.  This system will force American’s to be price sensitive to health care, which will lead to more competitive pricing as well as less healthcare consumed.

Regarding specific expense targets, Medicare will need to decrease to $359 billion in year five of the plan, which is a 25.9% decrease compared to 2011 levels, but a $117 billion, or 48.5%, increase compared to 2001 levels.  Medicaid will need to decrease to $162 billion in year five of the plan, which is a 41.0% decrease compared to 2011 levels, but a $32 billion, or 24.9%, increase compared to 2001 levels.

3. As it relates to Discretionary Spending ($1,177 billion in 2011 vs. $559 billion in 2001; 32.7% of total spending), America should eliminate all government subsidies to corporations, eliminate all foreign aid, and restructure government agencies, including potentially eliminating some agencies entirely.  I know this seems drastic, but drastic times call for drastic measures.  We are heading toward the cliff and it’s time to distinguish between what we “want” versus what we absolutely “need”.

First, we should eliminate all government subsidies, grants, etc. that benefit the private sector or overlap with functions served by the private sector.  Let me explain.  The government should not pick winners and losers because it distorts the market and misallocates the nation’s resources.  Let the market decide what projects to fund.  There are trillions of dollars of private capital looking for investments.  If an investment makes sense, it will find funding (unless the government is actively distorting that market).  The current housing market is a perfect example.  The US government has been instituting numerous programs to try to prop up the housing market.  Yet, their actions have actually made the housing market worse in two ways.  First, by creating these artificial props, the government scares away home buyers who have no confidence in housing prices.  “What is the real price of the house without government support?” they ask themselves.  As a result, they sit on the sidelines.  And as homes sit vacant longer, their condition deteriorates, bringing down the neighborhood and the value of homes in the neighborhood.  This creates a vicious downward cycle.  Secondly, banks are hesitant to lend against homes when the value of the home is questionable given government policy distortions.  So, banks either won’t lend against a home or request equity down payments that buyers can’t provide.  What the government should want is for housing prices to collapse and reach equilibrium.  Then buyers will come out in droves and banks will lend because they will have confidence that the price, or collateral from the banks’ standpoint, is real and not manipulated by government intervention.

The government also should not pick winners and losers because it is fundamentally unfair.  It is demoralizing to the American people that industries with the most money can hire lobbyists to influence policy in their favor.  Unless the government stops providing special breaks to their supporters, there is no way the American people will accept cuts in their entitlement benefits or pay more in taxes.

The government also can’t afford the cost of all these programs which annually total in excess of $100 billion.  So, farm subsidies?  Gone.  Oil industry benefits?  See yah.  Clean tech loans, grants, etc.?  Sayonara.  Healthcare, biotech, university research grants?  Adios.  Mortgage subsidies via government agency support?  Bye, bye.

You may be saying to yourself, “What about the Internet, radar, GPS, etc. that were developed by the government.  We have to have government R&D for projects that are too expensive or forward thinking for the private sector”.  Of course, some government grants and subsidies benefit society and generate good returns on investment.  But, if you start making exceptions, then every industry will make the argument why they benefit society and should be saved.  The only way politicians can go to Iowa and say “all your farm subsidies and special benefits are being cut to zero” and live to see another day is if the politicians can say “for the benefit of America, all subsidies and special benefits are being cut to zero, so unfortunately this includes farming”.  That, the American people will accept.

Following this concept of eliminating government subsidies means a complete rethinking of the government’s interactions with America’s financial institutions.  I propose an act of congress making it illegal for any government agency to provide any form of support to any financial institution.

This means that banks will no longer borrow money from the Federal Reserve.  Why should banks be able to borrow from the Fed at near zero interest rates and then lend the money back to the Treasury by buying Treasury debt, thereby locking in a guaranteed profit?  This is fundamentally unfair.

This means that banks will no longer have access to FDIC insurance on deposits.  Why should banks be able to access insurance on deposits at rates well below what a private insurer would charge.  The FDIC is technically insolvent because its losses have way exceeded its accumulated insurance premiums.  What this means is that the FDIC has not been charging an appropriate premium for deposit insurance.  How many private insurers went bankrupt after Hurricane Katrina?  That’s right, zero.  And why?  Because they charged appropriate premiums over time and were able to build up large cushions to withstand large losses.  If banks want insurance for deposits, then they can go into the private market and buy it at market prices.  And, as a result the insurers will provide effective regulation of the banks’ activities since they will be on the hook if a bank fails.  They will place restrictions on banks activities in order to provide the insurance.  I have more faith in private insurance companies, which have a profit motive, to regulate banks’ risk-taking than government bureaucracies which have no financial incentive to properly regulate banks and who clearly failed to do so leading up to the most recent banking crisis.

This means that banks cannot receive government assistance of any form, eliminating too big to fail.  Once the market knows that banks can’t be bailed out by the government, they will be much more rigorous in their counter-party arrangements.  Banks with high leverage will find it difficult to do business with other banks or retain customers.  This will force them to reduce the riskiness of their business.  Bank counter-parties will demand transparency of on- and off-balance sheet transactions.  By eliminating the moral hazard of too big to fail, banks by definition will become less risky and less likely to cause systemic risk to the economy.

At the end of this blog there is a detailed table of Discretionary Expenses (under the line item “Other Expenses”) and the targeted amount necessary to achieve a balanced budget within five years.  To be honest, I do not know what is included in every line item that I sourced from the CBO data.  But, what I provide is a first step.  If my plan is implemented, a better understanding of the different expense items will need to occur.  But, in aggregate, expenses need to come down to $561 billion in year five of the plan, which is a reduction of $616 billion, or 52.4%, compared to 2011 levels but an increase of $2 billion, or 0.3%, compared to 2001 levels.

Government Revenues

Achieving a balanced budget requires both expense reduction and increased revenues.  Some may believe that since expense increases over the past 10 years contributed to nearly all the budget deficit, then the solution is to cut these expenses and keep revenues flat.  The problem is that in five years interest expense will increase by about $400 billion per year.  We are about to embark on a vicious cycle where increased debt leads to increased interest expense which then leads to more debt leading to more interest expense.  How will we fund this $400 in interest expense in order to get to a balanced budget?  We can either cut expenses further or increase revenues.  But, there is a point where if you cut expenses far enough, you risk social unrest.  And, that is not a risk worth taking.  This plan already cuts non-interest expenses from $3.3 trillion in 2011 to $2.1 trillion in year five of the plan.  So, in order to achieve a balanced budget, tax revenues will have to increase from $2.3 trillion in 2001 to $2.75 trillion in year five of the plan.  And,  of this $450 billion increase, $383 billion is to pay for increased interest expense.  Additionally, since expenses will be fixed, if my interest expense assumptions are too high or if the economy grows more than planned and thus tax receipts are higher than planned, then the excesses will go toward debt reduction, not expense increases.

In order to increase government revenues, America should restructure the tax code and put into place policies that encourage economic growth.

Restructuring the Tax Code

Going back to the fundamentals of the plan, for Americans to be willing to sacrifice requires them to believe that the system is fair.  America’s tax code is a fundamental deterrent to the perception of fairness.  There are two fundamental problems with the tax code:  (1) complexity which leads to high cost and the ability for those with resources to game the system and (2) lack of fairness since it picks winners and losers.

America should fundamentally restructure the tax system, including the following:

• Cut the corporate tax rate to zero.  The lost revenue of approximately $180 billion annually should be transferred to the wealthy via adjustments in personal income tax rates.  The wealthy will benefit most from this via increases in the value of their stock portfolio and thus they should bear the brunt of the lost revenues.
• ALL personal deductions should be eliminated.
• Wages, benefits, capital gains, interest income, dividends, inheritances, etc. should all be treated as taxable personal income and all taxed at the same personal income tax rates.  The government will no longer pick winners and losers via tax policy.
• There should be several progressively higher personal tax rates, with each rate increasing along with increasing income levels (like in the current system).  These personal income tax rates should be set such that they collect the same level of revenue that different income groups are currently paying (plus the $180 billion for corporate income taxes which will be allocated to the highest tax bracket).  The added $450 billion in personal income taxes needed to balance the budget should be allocated pro rata among the different tax rate groups.  Everyone should have to pay for the added interest expense of America’s increasing debt burden.

In deriving the above recommendations, I asked myself a series of questions:

Question 1:  Would America benefit from eliminating corporate income taxes and shifting the lost tax revenue to individuals via higher personal income tax rates?

For some of you, your first reaction to this is probably pretty negative.  You think I am playing favorites and benefitting the wealthy and corporate America.  But, this is not true.  Eliminating corporate income taxes benefits the working class via more job opportunities and increases in the value of public pension funds.  All the lost corporate tax revenues are being shifted to the wealthiest Americans, some of whom are the owners of these companies.  Corporate taxes should be eliminated and lost tax revenue shifted to personal income taxes for the following reasons:

1. Achieves the objective of fairness.  American companies and individuals are constantly trying to arbitrage between different tax rates applied to different corporate structures.  They form C corporations, LLCs, LLPs, LPs, MLPs, etc. in order to minimize income taxes.  By eliminating corporate taxes, you remove this gaming of the system and achieve fairness.
2. You also reduce the legal, accounting, regulatory and compliance expenses for companies and individuals (further discussed in question 4, which follows).
3. Zero corporate tax rates can encourage companies to operate in America, leading to increased employment, construction of facilities, etc.
4. Zero corporate tax rates encourage repatriation of overseas funds:  US corporations are estimated to have over $1 trillion in cash overseas that they will not transfer back to America because it will be taxed at as much as 35% by the US government.  Understand that this money was already taxed in the local country.  So, taxing it again at 35% is a non starter for companies.  By eliminating corporate tax rates, companies are more likely to repatriate their overseas cash and use it for investment or to pay dividends, which in either case results in pumping money into the US economy.
5. Zero corporate tax rates will increase the value of US publicly traded companies, which will benefit public pension funds and thus assist them with their underfunded pension plans.

Question 2:  Are the current personal income tax rates fair and do the rich, middle class and poor pay their fair share of income taxes? 

To answer this question, you have to understand how the government sources its revenue.  From the PGPF website, 45% comes from individual income taxes, 9% from corporate income taxes, 37% from payroll taxes (social security, medicare, federal unemployement insurance) and 9% from other sources (excise taxes, estate and gift taxes, customs duties, etc.).  Republicans and the Right often state that the bottom 50% of income earners do not pay any tax and that the top 10% of income earners pay 50% of taxes.  The Democrats and the Left respond that this is mis-leading since it only takes into account income taxes and ignores payroll taxes.  So, let’s look at the actual numbers.  The Urban Institute and the Brookings Institution studied payroll and income taxes paid by different income groups. The richest 1% pay 27.5% of combined income and payroll taxes, the top 20% pay 72%, and the bottom 20% pay 0.4% because they get reimbursed for some or all of their payroll taxes through the earned-income tax credit.  So, it seems pretty clear that wealthy Americans pay more than their fair share of income and payroll taxes.

Another way to look at tax fairness is to compare average tax rates.  The Wall Street Journal sourced 2008 IRS data for the following tax rates by income levels (most recent year for which data is available).  Again, it seems pretty fair.  The more you make the higher your tax rate.

Adjusted Gross Income	Average Tax Rate
$1,000,000 and up	23.3%
$500,000 to $1,000,000	24.1%
$200,000 to $500,000	19.6%
$100,000 to $200,000	12.7%
$50,000 to $100,000	8.9%
$30,000 to $50,000	7.2%

Next, for individual income taxes, who pays what (Source:  PGPF website):

Income Group	Share of Pre-tax Income	Share of Federal Taxes	Taxes Relative to Income
Top 0.1% $2,378,619+	8%	13%	+62.5%
Top 20%, $104,551+	55%	67%	+21.8%
Fourth 20%, $63,871-104,551	20%	18%	-10.0%
Middle 20%, $34,896-63,871	14%	10%	-28.6%
Second 20%, $17,873-34,896	8%	4%	-50.0%
Bottom 20%, $17,873 and below	4%	1%	-75.0%

The top 20% of income earners pay 67% of individual income taxes compared to receiving 55% of taxable income.  All other income groups pay a smaller proportion of taxes relative to their income.  Recall in my questions, I did not ask how much people are able to pay but instead what is the fair amount to pay.  President Obama often says that the rich can afford to pay more and thus should have their taxes increased.  But is this fair?  Wealthy Americans already pay significantly more in taxes relative to their income levels.

So, what then is fair?  As it relates to personal income taxes, I propose that the relative contributions remain unchanged.  Thus, the Top Quintile will still pay 67% of taxes, the Fourth Quintile 18%, the Middle Quintile 10%, and so on.  While the wealthy pay more than their fair share of taxes, they have also benefited from government support of the industries in which they work, such as banking.  So, let’s call it a push and move forward.  The annual increase in income taxes required to achieve a balanced budget within five years should be spread out pro rata among all five quintiles, thus the Top Quintile will pay 67% of the increase, the Fourth Quintile will pay 18% of the increase, etc.  The $180 billion in lost corporate income taxes should be allocated to the wealthier tax payers since they will benefit most from the increased values of the companies since they no longer pay US income tax.  Analysis will have to be done regarding the exact income levels to which this tax is allocated since I do not have access to this type of data and thus cannot make a more specific recommendation.

I am pretty sure Republicans will argue that raising taxes, especially on the wealthy, will “destroy” the economy since the wealthy are the “job creators”.  Being intellectually honest, increasing tax rates on the rich will not destroy the economy.  Wealthy Americans’ consumption will be unchanged and thus GDP will be unchanged.  All that will happen is that they will have fewer savings, which on the margin would be a negative to stock and bond prices but would have almost no impact on the actual economy via consumption.

Question 3:  Is it fair that there are different tax rates for wages, benefits, capital gains, interest income, dividends, inheritance, etc.?

Warren Buffett made news recently by claiming his tax rate is lower than his secretary’s, which is a perfect example of intellectual dishonesty.  It is a factually accurate statement but is clearly spin when the reason is explained.  Warren Buffett’s tax rate is lower not because tax rates on wages are lower for the rich than the poor and middle class.  The reason is that capital gains and dividends are taxed at different rates than wages.  Tax rates on wages are mostly irrelevant to most of the rich since they have structured their economic affairs so that their income is treated as long term capital gains and dividends, which are taxed at 15%.  This is why Warren Buffet’s income tax rate is less than his secretary’s.

Which of course raises the question whether it is fair that capital gains are taxed at 15% but wages are taxed as high as 35%?  Is labor really less noble that investing?  There are two arguments for taxing capital gains and dividend income at lower rates.  First, they result from corporate profits and since corporate profits were already taxed at 35% then taxing capital gains and dividends is a form of double taxation.  But, my plan eliminates corporate taxation.  Second, taxing capital gains at lower tax rates is supposed to encourage investment, but this argument is bunk.  A good investment is a good investment, regardless of the tax rate.  And, if the tax rate is 35% on capital gains, then all that happens is an investor is not willing to pay as much at initial investment since he would be analyzing the after-tax return on investment.  But, he will still want to make investments.  Therefore, there should be no distinction between capital gains and wages for the purposes of calculating taxable income.

At the risk of being repetitive, in order to get everyone to sacrifice, the system has to be deemed as fair.  And the ways in which the government has picked winners and losers in the tax code is a core source of unfairness.  A good example, and personal pet peeve of mine, relates to the taxation of Private Equity and Venture Capital carried interest at capital gains rates.  This is maybe the single most intellectually dishonest rule in the tax code.  PE and VC investors take others’ money and invest it.  If the investments go well, the PE and VC investors get to keep a percentage of the profits, which is called “carried interest”.  Simply put, carried interest is a success fee and should be treated as ordinary income and thus taxed like wages.  Capital gains imply putting capital at risk.  But, the PE and VC professionals incur no risk with the money they invest on behalf of others.  The argument that the PE and VC investors’ lobbyists make is that if the tax treatment is changed then investment capital will not be available to start-ups which are a key engine to increase employment.  How these people can make this argument with a straight face is beyond comprehension and an example of why America questions fairness.  Let’s look at a simple scenario.  A VC fund raises $1 billion to make investments.  The fund generates roughly 15% annual returns and after 5 years the $1 billion is worth $2 billion.  Thus, there is $1 billion of profits, and the VC fund gets to keep 20% of the profits, or $200 million dollars.  The VC fund also received an annual management fee of 2%, or $20 million annually to cover expenses.  Thus, the VC took no risk and simply invested others’ money for which it receives $200 million.  In scenario 1, the VC partners pay 15% capital gains tax on the $200 million, netting $170 million.  In scenario 2, the VC partners pay 35% ordinary income tax on the $200 million, netting $130 million.  Are the PE and VC industries really saying that if the VC partners have to pay 35% ordinary income tax rates that they are going to walk away from the industry and the $130 million?  The rules have to be fair in order to get Americans to support the difficult choices ahead, and the taxation of carried interest as capital gains is a perfect example of what is wrong with America’s tax system.  Oh, and in case you are wondering, I worked for eight years in Silicon Valley as an investment banker to the technology industry, as well as for 3 years with a global private equity fund.  Taxing carried interest as ordinary income is not in my or my friends’ personal best interests, but it is intellectually honest and in the best interest of America.

In order to achieve fairness, all income, whether wages, benefits, capital gains, interest income, dividends, inheritance, etc. should be taxed at the same rates.  The government should not decide which forms of income are better than others.  Also, this will significantly simply tax preparation, which is a topic I will discuss in the next question.

Question 4:  Are the current personal income tax deductions fair?

The government is constantly picking winners and losers, and in the process distorting the market.  Home owners get to expense interest on their mortgages and property taxes, but renters do not get to expense their rent.  The more children you have, you more your deductibles.  The government is deciding which behaviors it deems good and which by definition are not.  I work out every day.  I eat well.  I don’t drink and don’t smoke.  As a result I am in very good health and am unlikely to be a burden on society via future healthcare needs.  Why doesn’t the government give me a special tax deduction?

So, here is my proposal.  Eliminate all deductions, every last one of them.  Make tax preparation very simple.  You have income, you apply a tax rate and you make the payment.  One page.  Some will say, “But wait.  We have to encourage this one thing and that one thing.”  To this I say no.  If you make an exception for one group, then every group will want an exception.  This has to be across the board or it will not be deemed fair.  Everyone has to share the pain.

There are two key benefits to eliminating all deductions in preparing individual tax returns.  First, the government no longer decides which behavior is preferred and which is not, and thus the government stops picking winners and losers.  This will achieve greater fairness.  Second, by simplifying taxes America will be more productive.  This is a very important topic and needs further explanation.

First, there is a key economic concept to understand.  There are only two ways to increase a countries economic wealth:  (1) make things or (2) export things or services to other countries.  One way is to make something, meaning to take raw materials and apply labor and intellectual property in order to make a physical product.  Providing tax preparation services, accounting services, legal services, investment banking services do not add one bit to a countries economic wealth.  All they do is move money from the left hand to the right hand.  They are zero sum gain industries.  There is a basic level of these services required to document transactions, allocate money to businesses, prepare financial statements, etc.  So, these industries on a certain level do serve an important role in America’s economic growth.  But, America’s incredibly complex tax system encourages some of America’s smartest people to spend their time as lawyers and accountants being paid very well to understand and in some cases game the system.  In doing so, they contribute nothing to America’s economic wealth.  They should take their brilliant minds and start a software company or an energy company or do something else where they make something.  And, by simplifying the tax rules and thus making tax lawyer and tax accountant jobs obsolete, America’s economic productivity will increase.  Recognizing, though, that in the short run this will be painful as hundreds of thousands of people will lose their jobs, but this is the creative destruction America needs to grow the nation’s wealth.

Now, to be intellectually honest, I did say there were two ways to increase a countries economic wealth.  The second way is to export goods and services and thus exchange other countries’ wealth for American goods and services.  So, while legal, tax, accounting, financial, etc. services sold by American companies to American companies results in a zero sum gain, these services sold by American companies to overseas companies do result in greater American economic wealth.  But, preparing US tax returns does not involve exporting services overseas and thus does not contribute to American economic wealth.

We are finished discussing restructuring the tax code and will now move on to policies that encourage economic growth.

Encouraging Economic Growth

Cutting government spending and increasing personal income taxes at the levels that I am recommending will undoubtedly lead to a significant contraction in economic activity.  The magnitude of the contraction, though, can be moderated by America’s ability to grow the economy.  The US government needs to adopt policies to encourage economic growth.  Notice I did not say the US government needs to generate economic growth.  Instead, the US government needs to help create an environment where businesses invest in America, which leads to higher employment, higher income levels and thus higher tax receipts, getting America closer to a balanced budget.  And, when business people and investors have greater confidence in America’s fiscal situation, they will be more interested in investing in America.  Thus, a virtuous cycle will occur where success begets success.  What follows is a list of policy prescriptions for the US government to follow:

1. Reduce regulatory burdens.

Government rules and regulations are limiting economic growth.  Let me start by acknowledging that most of these rules and regulations are well intended.  They are largely meant to protect people and the environment.  But, what they fail to understand is diminishing returns.  Government rules and regulations strive for near 100% risk aversion but to get to 100% risk aversion is very, very expensive and time consuming.  This 100% risk aversion makes product offerings more expensive, as well as discourages companies to pursue new product offerings.  The approval process, the licensing process, the registration process, the risk of being sued, all of these make products more expensive or stop them from being developed.  All these rules and regulations are meant to protect consumers from risk, but what they really do is reduce the number of available products on the market or increase the price or both, which means less need for factory plants and employees (which potentially could be in America).  Or, these rules and regulations encourage companies to move their operations overseas where the rules and regulations are not as strict, thus definitely moving jobs overseas and reducing America’s economic wealth.  For example, if a company wants to build a plant in America it now takes about three years for government permitting, as well as high costs for all the reports required to be submitted.  Alternatively, a company can get permits to build plants outside of the US in a matter of months.  Given the lower on-going regulatory burden in these overseas markets, America’s federal, state and local governments are basically begging companies to open plants overseas.

Let’s make this more tangible.  The availability of certain medicines is now at risk because of the FDA.  Quoting from a Financial Times article on September 28, 2011, “Paul Bisaro, chief executive of Watson and chairman of the Generic Pharmaceutical Association, a trade body, told the Financial Times that the high costs of growing scrutiny by the Food and Drug Administration was pushing generic suppliers to stop manufacturing less profitable drugs altogether.”  The article goes on to state, “The American Society of Health System Pharmacists says the number of drug shortages that it has noted have nearly tripled since 2006, with 211 incidents in 2010 and more than 200 at present listed on its website.”

Government rules and regulations have actually impacted me personally.  I invest my own money.  In conversations with friends, they have asked me to invest their money for them.  This would seem like an opportunity to start a new business, meaning renting office space, buying equipment, hiring employees; all things that contribute to the economy.  But, each time I tell them the same thing.  The upfront regulatory burden is too high to take the risk.  I would need to take numerous exams, pay numerous fees, submit numerous forms, etc.  It just isn’t worth the hassle, and it is very expensive.  The government sets up all these hurdles to protect investors, but in my case they are reducing options to investors and preventing me from starting a business, hiring employees and contributing to the growth of the economy.

2. Encourage US and/or Canadian production of natural gas and oil.

America has to develop a realistic strategy as it relates to energy.  In setting this strategy, the following should be taken into consideration:  environmental impact, cost and availability.  And, taking all of this into account, natural gas is the best alternative and presents an opportunity to provide significant support to the US economy.

There is no magical, perfect energy solution and all alternatives have pros and cons.  Renewables such as wind, solar, bio-fuels, etc. cannot satisfy America’s energy needs.  The technologies are too young and expensive.  And they can’t fuel America’s cars.  Today, 40% of America’s corn is being used to make enough ethanol to satisfy about 2% of fuel consumption.  So, if America used 100% of its corn to make fuel, it would still need about 95% crude oil derived fuel.

At the same time, through the development of new technologies and drilling techniques, American has enough natural gas to supply energy needs for over a hundred years, and that is just based on the natural gas that has already been found.  Every day, natural gas exploration companies are finding new reservoirs.  Natural gas is also very clean.  Finally, natural gas is already a key fuel source for electricity production as well as heating homes and buildings.  Thus, natural gas satisfies all three requirements:  its cheap, its clean and its abundant in America.

The big opportunity that can act as a huge stimulus to the American economy is to use natural gas to fuel America’s vehicles.  Building out the infrastructure of pipelines and distribution will employee hundreds of thousands of people, as well as require billions of dollars of piping and equipment to move the natural gas. Much of this natural gas is being found in Ohio, Pennsylvania, New York, West Virginia and North Dakota in what are called shale deposits.  These shale deposits are a huge financial boom to these areas of American which have been very depressed since the decline of America’s industrial capacity.  Shale gas provides an opportunity to reinvigorate these areas.  North Dakota has the lowest unemployment rate of any state due to the shale boom.  Owners of the exploration companies have been very blunt in stating they can’t hire enough people and anyone willing to work hard and has the ability to learn can earn over $100,000 a year.

Fueling vehicles with natural gas also means not using oil.  And, if America is no longer dependent on oil, then it no longer has to have such an active involvement in the Middle East.  This will enable America to spend less on defense, as well as prevent America from having to support tyrants in order to guarantee the smooth flow of oil.

I mentioned before that there are pros and cons with all alternatives and natural gas is not perfect.  To access the abundant natural gas requires a technology called fracking.  Some claim that fracking risks contaminating the water table.  Fracking has been used in America for over 60 years and everything I have read points toward its safety.  Is there an occasional problem?  Of course, but that is life.  There is no risk-free energy solution and striving for zero risk is the type of mindset that is hurting the American economy.

So, what can the government do to encourage natural gas?  The answer is to get out of the way and let businesses push this forward.  The government should not give grants, should not pick winners and losers.  Which takes us back to the first issue of regulation.  It will likely take 10 to 20 years to build the infrastructure necessary to replace gasoline fueling stations with natural gas fueling stations.  In the interim, America still needs crude oil based gasoline.  And, this brings us to the current dispute over TransCanada’s proposed Keystone XL crude oil pipeline from Alberta, Canada to refineries in Oklahoma and Texas.  This project is estimated to generate $20 billion in investment and 13,000 new jobs to the US, along with 118,000 spin-off jobs.  It also will help the US to be less dependent on Middle Eastern oil.  But, the US State Department has held up approval under pressure from other federal agencies, even though this pipeline satisfies all government requirements and is no different than the other thousands of miles of pipelines traversing America.  While it is true that the crude oil comes from Alberta’s tar sands and it is a dirty process to access and process the tar sands to extract the crude oil, the ends justifies the means.  Job creation and reduced dependency on Middle Eastern oil supersede the environmental concerns.  For the energy industry to help drive economic growth in America just requires the government to take a more measured approach to regulation and understand that there are risk-reward trade-offs that should be considered.

3. Do not play favorites in company and labor disputes.

Labor has every right to organize.  They have every right to strike.  But, if unions strike, companies should have the right to fire them.  Companies should have the right to move their operations to other states or countries.  And, states should not pass laws making joining a union a prerequisite to working at a company with a union.  The government should let companies and labor negotiate terms among themselves and the government should not play favorites in the process.  The only role for the government is to make sure neither side uses violence, intimidation, etc. during the negotiations.

American companies have been moving manufacturing and jobs overseas in order to stay competitive and, let’s be honest, increase profitability.  But, that is what happens in capitalism.  And, America’s founding is premised on freedom, which means freedom to pursue selfish interests if that is what someone decides.  Ending the government’s labor favoritism will encourage American companies to manufacture in America and hire American workers, which will help enable the growth of America’s economy.

There are numerous other ways the government can encourage economic growth, such as modifying the legal system to make it harder to bring frivolous lawsuits, modifying immigration laws to encourage immigrants to come to America and contribute to the economy, restructuring the public education system to better educate young Americans, etc.  But, given the length of this paper, I will now come to a close.

ITS NOT TOO LATE

America is on a dangerous path, but it is not too late if we act now.  Concern over America’s growing debt, both current and the unfunded entitlements, and the associated increases in interest expense are debilitating to confidence.  If we wait another five or ten years to address our structural problems, it will be too late because by then the interest on the debt alone will eat up over half of all revenues.  Not to be overly dramatic, but America will face the same issues that Greece is now facing.

Addressing America’s debt problem will lead to higher confidence in America’s future which will then lead to greater investment in America and much improved economic wealth creation for all Americans.  American workers will have more job opportunities.  American companies will have greater sales opportunities.  But, in order to achieve this, we Americans will have to endure some pain.  40 years from now maybe historians will look back at us and say they were the second coming of the greatest generation.  Like those Americans that sacrificed during World War II, this era of Americans put their personal interests aside in support of what was in the best interest of the United States of America.