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.
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).