The Magazine

Fiscal Fitness

A political economy regimen for Republicans.

Feb 25, 2013, Vol. 18, No. 23 • By JOHN D. MUELLER and LEWIS E. LEHRMAN
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A winning agenda for a political party must simultaneously satisfy the requirements of economic effectiveness and political success. Ronald Reagan had such an agenda in the 1980s. Subsequent Republican presidential candidates have not. The opportunity now is great. Far from having a free hand after reelection, President Obama is constrained by the same economic and political realities as everyone else. This is why his first act of 2013 was to sign into law a tax code in which the top rate on labor income is about twice the rate on property income, disappointing the dominant faction of his own party.

Obama and Boehner

The four basic principles of successful American political economy may be summarized simply:

1. Current peacetime government consumption of goods and services should be funded by current taxation, not money creation—thus limiting peacetime government borrowing to an amount equal to government-owned investments of the same or lesser duration. This principle was first enunciated and implemented under President George Washington.

2. Current consumption of true public goods (such as national defense and administration of justice) should be funded with an income tax levied about equally on labor and property income. This principle was first implemented under Abraham Lincoln.

3. More narrowly targeted “quasi-public” goods, which benefit many but not all citizens, should have dedicated funding. Social benefits for specified individuals (Social Security, Medicare, and Medicaid, primarily) should be financed by payroll taxes on individuals, not by income or property taxes. This principle was first applied under Franklin D. Roosevelt at the insistence of his Treasury secretary, Henry Morgenthau.

The counterpart to this policy is that subsidies to property owners (e.g., tax-advantaged savings accounts and product, corporate, and banking subsidies) should be financed by taxes on property income (such as interest, dividends, rents, or capital gains), not payroll or income taxes.

4. Government’s size and methods should be strictly limited in order not to displace private jobs, or cause general unemployment or disinvestment in people and property. This was attempted by Ronald Reagan (with its success limited by factors we will describe).

Yet the dominant factions of both parties have violated all four principles.

1. Both have relied on government deficit spending, financed by new central bank credit and money (from the Federal Reserve and especially foreign official dollar reserves), causing chronic episodes of commodity-led inflation, international payments deficits, and uncontrolled federal budget deficits (rationalized with the slogan “Deficits don’t matter”).

2. Both parties’ dominant factions have diverted payroll-tax surpluses—labor income—to fund public goods, instead of using income taxes levied on both labor and property income. Democrats have done this to increase spending, and Republicans to give tax loopholes to favored constituents or cronies.

3. Republicans have sought to shift the burden of general government from all income to labor income, while Democrats have sought to subsidize personal social benefits (Social Security, Medicare, welfare, etc.) with the income tax and/or taxes on property income.

4. Both parties are complicit in permitting the levels of social benefits and income tax rates to mushroom to levels that crowd out new investment in people and property, causing declining productivity and prodding the U.S. birth rate to fall below replacement rate.

James Madison explained the foundation of these asymmetries in Federalist No. 10: “The most common and durable source of factions has been the various and unequal distribution of property.” And Madison distinguished property in the narrow sense, meaning “dominion .  .  . over the external things of the world,” from property in its “broader and juster meaning,” which includes anyone’s “property in the free use of his faculties,” and even religious opinions.

As the nearby chart shows, Madison’s account of factions remains a good description of U.S. national elections, as reflected in the American National Election Studies. Broadly speaking, self-identified Democrats and independent voters receive their family income disproportionately from labor (wages, salaries, fringe benefits), while self-identified Republicans received their family income disproportionately from property compensation (interest, dividends, royalties, capital gains).

While the first chart shows party identification by level and source of income, the second chart shows the evolution of party identification through the 2008 election. (The 2012 results won’t be released for at least a year, but are unlikely to have changed much.) Since the reelection of Ronald Reagan, about 50 percent of American voters have identified themselves as Democrats, about 40 percent as Republicans, and about 10 percent as independents. This means that, like Ronald Reagan, to win, a Republican presidential candidate must attract all of the Republicans, all of the independents, and some of what used to be called the “Reagan Democrats.”

The key to Reagan’s success was treating, as far as possible, labor and property income alike. That fiscal policy explains why a government that was as divided as today’s—with a Republican president and Senate and a House controlled by Democrats—achieved some of the biggest legislative victories of the 1980s: the tax reforms of 1981 and 1986 and balancing Social Security in 1983.

But every Republican presidential candidate since has lost on the economic issue, because of the principle that Jack Kemp, who devised Ronald Reagan’s tax strategy, borrowed from Arthur Laffer: “When you tax something, you get less of it.” Once the GOP shifted its ideal from taxing labor and property income equally to shifting the burden of government onto labor income, the party’s presidential candidates lost the support of independent voters and Reagan Democrats. The principles outlined by Mitt Romney were actually the closest any 2012 Republican presidential candidate came to taxing labor and property income alike. But without a specific plan, like the across-the-board 1981 Kemp-Roth tax-rate cuts or the Republican and Democratic prototypes for the Tax Reform Act of 1986, there was no legislative vehicle to deliver on Romney’s principles. Given the electoral arithmetic we have described, it is hardly surprising that President Obama defeated Governor Romney.

The following agenda would update and apply these tested American maxims of successful public finance (put here in slightly different order):

Instead of taxing income when received by workers and investors, all labor and property income should be taxed when first paid by businesses, governments, or nonprofit foundations, at a single flat rate, with no exclusions or credits (including capital gains and capital consumption allowances). A single credit for “human maintenance,” based solely on family size, would rebate income and payroll taxes up to the poverty level. (Property maintenance costs are already excluded before calculating property income.) Since existing deductions and exclusions are progressively skewed, imposing a flat rate upon a consistent measure of income would leave the distribution of the federal tax burden little changed. This is the bargain: The dominant Republican party faction gives up progressive tax loopholes, and the dominant Democratic party faction gives up progressive tax rates.

Current Social Security, Medicare, and Medicaid benefits should be balanced by current payroll taxes and premiums. But if prospective Social Security deficits continue, because of a shrinking workforce and fertility rate (from 2.5 children per woman in 1971 to 1.9 now), benefits should be made proportional not only to a worker’s past contributions but also to the number of children each worker has raised.

Unemployment insurance—which added about 2 percentage points to the unemployment rate when it was extended to as many as 99 weeks—should be restored to its original 26-week limit, which should cause a sharp fall in the unemployment rate to below 6 percent.

Automatic open-ended financing of federal deficits by the Federal Reserve and foreign central banks should be ended by defining the dollar again as a weight of gold while refunding existing official dollar and other official foreign currency reserves, much as Alexander Hamilton refunded the massive Revolutionary War debt.

We close with a prediction: President Obama will have succeeded, and any candidate of either party contending for the presidency in 2016 will succeed or fail, in precise proportion to his adherence to these classic and successful principles of American public finance.

Lewis E. Lehrman, senior partner of L.E. Lehrman & Co, and John D. Mueller, Lehrman Fellow in economics at the Ethics and Public Policy Center, are principals of the financial market consulting firm LBMC LLC.

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