A great deal of attention is currently being paid to the fiscal cliff and a grand bargain. If the past is any indicator, under either event taxes will go up substantially but spending will not go down very much. That ought to be bad news for the stock market which normally is an advance indicator of overall economic activity. However, the market since the election in November 2012 has not tanked to the extent that it did in 2008. The question is why?
The answer is complicated, but important. First, look at the state of the economy. Real GDP is growing at a rate substantially below that of previous recoveries. The Bureau of Economic Analysis reports the US GDP grew during the second quarter at an annual rate of 1.5%, the third quarter it grew 2.7% and the expectations for the fourth quarter, according to a survey of forecasters reported on December 4, 2012 by the Wall Street Journal are below 1%. By contrast, the expansion of GDP during the recovery of 1980-1981 was at an annual rate of 4.4%.
There is a large amount of money on the sideline. The total currency and demand deposits in October 2012 amounted to $2.4 trillion, of which $1.6 trillion was in cash. Reserves on the balance sheet of the Federal Reserve as of the end of November 2012 were in excess of 2.8 trillion. These are unprecedentedly high levels. Thus, trillions of dollars are poised to be lent or invested. It is decision time in the economy. The implication of which, is that changes in government fiscal and monetary policies will exert a powerful influences on the disposition of the money. Indeed, they may already be affecting economic decisions.
Both the fiscal cliff and the grand bargain involve taxing high income earners for benefits provided to others. That is not a stable equilibrium. Indeed, it reflects a fundamental misunderstanding about the function of government. At the basic level, government provides services to those who pay the tax price. Without any indication that those paying the higher tax price are receiving a corresponding increase in the value of government services, there is no justification for the tax increase.
In other words, those smart enough to command high incomes, are also smart enough to avoid paying the higher tax price. In more normal times, those in the tax avoidance industry intensify their efforts and are compensated handsomely for their efforts. The magnitude of the tax avoidance is much greater than the overt evasion. However, the latter is not trivial. The IRS estimate of tax evasion for 2006 is on the order of $450 billion, which includes $105 billion in late payments.
Thus, there is already in existence a large institution of tax avoidance which could easily morph into systematic tax evasion. One example is barter using the increasing resources of the Internet. Barter web sites now exist but seem to be small and targeted on ordinary consumer goods. The IRS has already recognized one form of barter that has to be reported. The IRS warns that a plumber doing repair services to a dentist in exchange for dental services, must be reported. Indeed, there is a form (1099-B) that must be filed by both parties. The important characteristic of barter is that is is difficult to detect. There is no W-2 like form filed in advance by one of the parties. That means that there is great potential for a large and successful expansion of barter exchanges that are difficult to detect. However, it is not clear that there is a lot of money at stake.
High income earners might not participate in barter to a large extent. However, taxpayers who have high incomes might simply reduce their investments and take the funds and, for example, buy villas in the Caribbean. They would cease to be entrepreneurs intent on stimulating the economy to the same extent as they would without the extra future taxes and regulations. One is reminded of the strike by capitalists in Ayn Rand’s Atlas Shrugged.
These would be hedges against not only tax increases in a grand bargain, but also the other taxes that are threatened, like the carbon tax and inflation. The latter can be expected when the Federal Reserve relaxes the very high reserve requirements for member banks and releases the pent up increases in the money supply.
The hedging has already begun. Several companies have moved up dividends into 2012. The Wall Street Journal on November 29, 2012 indicated that 173 companies had already announced special dividends. Costco is a notorious example, as pointed out in a November 30, 2012 editorial in the Wall Street Journal. It’s Obama reelection supporter and former CEO Jim Sinegal who, along with other directors, was the primary beneficiary from Costco’s declaring a special dividend in 2012. Clearly Political preferences do not interfere with doing business for dividend recipients.
These defensive actions will reduce tax receipts to a substantial extent. And it might even destroy the voluntary tax reporting system that now exists in the United States. Italy has a different tax system, often called “voluntary.” According to the Economist of December 1, 2012, the Italian “authorities believe that more than 4 million households, around one fifth of the country’s total, submit dodgy tax returns.” A similar problem exists in Greece where widespread tax evasion is estimated to cost the cash-strapped country as much as €28 billion ($35.88 billion) a year, according to a study by Margarita Tsoutsoura of the University of Chicago’s Booth School of Business.
In the United States, there is already massive evasion of the immigration and drug laws. Investors and businesses are working out plan B for 2013 and beyond. This might be the reason the markets have not tanked like they did in 2008. One possible part of plan B is that enforcement of Federal tax regimes my become more difficult by an order of magnitude. Indeed, a total collapse may be possible. Would this be a catastrophe? A lesson from the 18th century may suggest an answer.
In an insightful study of the deregulation of mercantilist trade restrictions in 18th Century England, Robert Ekelund and Robert Tollison, Politicized Economies (College Station: Texas A&M Press, 1997) argue that a reversion to free trade did not come about through rescinding the mercantilist laws. It came about through a widespread disregard of those laws. The process was helped by the rising power of the Parliament that became a countervailing influence to the sovereign. This reduced the rents that the king could charge for favors and made enforcement very difficult. That might happen in the present day with respect to the complex set of tax laws. There might not be enough enforcement resources to stop such a de facto tax overhaul. Of course, there would be other adverse side effects like default. But eventually there would be a net gain as the tax regime is ignored.
Following the demise of the mercantilist system in the 1700s came a century of prosperity in England. It also gave rise to the Scottish enlightenment led by David Hume and Adam Smith. An extra bonus was the independence of the American colonies. All in all, these were not bad outcomes and gives hope for a similar solution to our current tax predicament.