Archive for May, 2010

Optimum Rate of Tax

Sunday, May 23rd, 2010

By Ford Peterson © 2010

Did you know that there was an optimum amount of tax?  It’s true.  There is a point where too little is being done as a community, and another point where the overhead becomes a drag on the economy.  As a portion of Personal Income, the federal government collects about 21%[1] and MN collects another 16%[2] for a total of 37% of Personal Income.  Is this too much?  Too little?  There is a way to determine the optimum.  The notion of Optimum Tax Rate is inseparably entwined with the population’s ability to Save.

A Call for Bigger Government

The DFL caucus is universally calling for more revenue.  With the economy on the ropes, loading additional burdens on people seems, at a minimum, counter-productive.  More than likely, additional burdens could even be destructive.   Calls to “Tax the Rich” are commonplace today, followed by cheers of hooray from the little people.  Guess what folks.  The “Rich” own Minnesota.  They own the engines of commerce, the banks that hold the mortgages, and the politicians hired to run the place.  Gouge the ‘rich’ and they extract more rent from everybody to compensate.  More than likely an aggressively progressive tax system would incentivize the rich to move away and avoid Minnesota (Oops!  Cook the Golden Goose and she stops laying golden eggs!).  Many argue that government is already too big.  Yet the seemingly endless line of people in need indicates to compassionate people that government is not big enough.  What does this have to do with tax rates and saving rates?  Let me explain…

Balanced Budget Multiplier

A balanced budget happens when revenues are sufficient to offset spending.  On a macroeconomic scale, the population as a whole is roughly indifferent to a balanced budget.  I liken it to scooping water out of one side of the pail and dumping it into the other.  The money circulates around and life is good.  There are two counter-balancing variables in this equation.  Consider the multiplier (over simplified but here goes) to be spending over revenues.  A balanced budget is 1:1 spending to revenue.  There are numerator (spending) effects and denominator (revenue) effects.  Understanding how this relationship is affected under various conditions allows us to answer the question: “Can we afford higher taxes?”  When 20% is extracted, and 20% is spent, we have a balanced budget.  When 60% is extracted, and 60% is spent, we still have a balanced budget.  Obviously the size determines who gets to consume the income.  Is it spent by the individuals that generated the revenue, or by society as a whole?  The overall size of the budget matters.  When is it optimum?  The equation is optimized when the budget includes saving.

Surplus Vs Deficit

Economists have long understood, and politicians have learned to amplify, a budget deficit will accelerate the circulation of money because the government is spending more than it is extracting.  Surplus of course means just the opposite.  When spending increases to exceed the extraction, money circulates quicker.  A budget deficit is therefore analogous to going on a spending spree with your credit card, or fueling consumption by liquidating your savings.  I don’t mean investing it, I mean consuming.  The federal government has the added luxury of being able to print money, which induces inflationary effects well beyond the scope of my thesis.  However, the state does not have the luxury of printing and is therefore limited to either: 1) borrowing; or 2) spending reserves; or 3) taxing.  Whether the government borrows the money or prints the money, as long as they spend more than they extract there is a positive budget multiplier in play (spending over revenue).  A ratio less than 1 is negative on the economy.  A ratio greater than 1 has a positive influence.  Although very difficult to measure accurately, the multiplier effect is universally known to exist.

So why not spin-up the economy by running only deficits?  Eureka!  That’s exactly what has been happening at the federal level for many years.  The natural limit on this multiplier is that we live in a world with limited resources.  The state’s limited cash reserves can quickly be depleted.  Politician’s can only borrow so much before credit ratings deteriorate and cost of borrowing becomes prohibitive or credit disappears.  Since the state cannot print money, it must therefore choose to eventually extract it from the people.  With the state, the Surplus / Deficit issue is all about timing.  Minnesota’s annual cycle arbitrarily runs from July through June.  Over time, consumption must be funded and credit lines must be paid.  Oh yes, silly me.  There is also the often used political trickery referred to as “kicking the can down the road.”  Can this be done forever?  Forever is a long time.  But I digress…

Forced Consumption Versus Saving

The government is not the only entity involved with the economy.  Each individual and business can run a deficit or surplus.  On the aggregate, individuals with more revenue than expenses can ‘save’ the money to spend later.   Businesses can build cash reserves (equity) using the very same principle.  And when they save, they are not consuming.  Increased consumption fueled by liquidating savings, or through additional borrowing, creates a positive economic multiplier.  And failing to consume revenue is a negative economic multiplier.  This creates a political paradox.  It is good for my personal economy when I save, but it’s bad for the entire economy when anybody saves.  Yet saving for future need is paramount to the sound management of resources.

The government resolves the paradox by choosing a rate of tax.  By spinning more money through the treasury, the ability to save is limited.  The government can force you to consume by extracting the money and consuming it for you.  Sounds evil doesn’t it?  In large measure, they spend it on each of us in the form of infrastructure and presumably ‘necessary’ services.  Everybody wants roads, bridges, sound banking, personal safety, courts, police, fire, schools, welfare, etc.  If the proxy spending sounds evil, get over it and figure out how you want to pay for the shared consumption, or help figure out what we can do without.

Over time, the winners and losers fine-tune the tax code to conform to the political winds blowing—lobbying to get somebody else to pay.  Eventually it gets tweaked again, loopholes disappear, and inequity gets evened out.  Ultimately, in an otherwise benevolent and democratic society, the rate of tax settles around ‘from each according to his ability, to each according to his need.’  This of course is a quote right out of a text on Marxism[3].  That’s scary!  Please don’t shoot the messenger.  Redistribution is a well understood procedure, promulgated by your government.  But again I digress…

Ability to Save is the Barometer

So the rate of tax is too high when saving becomes too low.  What is too low?  We each view the room from our respective corner.  A biased opinion would suggest that all the money I can save is good for me, and any money you save is bad for me.  Obviously this is the extreme position at the microeconomic level.  In my unbiased opinion, any macroeconomic budget that includes some saving is more reasonable than a budget with zero or negative saving.  Bad things can and do happen to good people, and to the nation, or to the states within.  Saving for that rainy day is imperative to prudent management of money.  The same is true of individuals, business, and government.

What is Saving?

Good question.  Economists consider saving to be the act of setting income aside to conserve it for future consumption.  Investing is something you do after you have saved it.  So don’t confuse investing with saving.  Saving is simply NOT consuming it today.

Why don’t economists consider the family residence in the ‘saving’ equation?  In some respects paying for the family residence is an act of setting money aside, but it’s different because buying a house is not necessarily consumption.  If everybody built a brand new house, and nobody recycled old houses, then building a house would look more like consumption.  Remember, the definition of ‘saving’ is setting income aside to conserve it for future consumption.  The home does not fit this definition.  Increasing home prices would have suggested some windfall saving in addition to the mortgage payment—especially in an environment where people pull the equity every 3-4 years and consume it.  Decreasing values have the opposite effect.  In any event, including a personal residence as saving doesn’t fit the measure we are looking to use as a guidepost to striking a balance regarding: “How high a rate is too high?”

It is interesting to note that the United States used to measure savings in the form of M3, an empirical measurement of the components of savings.  In November 2005 the practice of disclosing it was discontinued.[4] Rest assured the minions in charge of our currency are tracking it.  They simply don’t want the people to be concerned about policy or practice.  Today the people can only estimate the rate of saving.  It is believed that the rate of saving in America is now zero.[5] The implication is that we are officially over-taxed making this a perfect time to cut spending and the rate of tax.

Individual or Shared Responsibility

The implication of saving seems obvious.  To be clear, if you have no savings, your needs will eventually overtake your ability to provide for yourself.  In America we have a complex maze of social safety nets funded by individual responsibility (insurance, saving, etc.), private charity (homeless shelters, etc.), and government institutions (Social Security, Medicare, Medicaid, welfare, etc.).  Pressure from an aging population coupled with abuses imposed by foreign invaders has brought these social structures to the brink of failure.[6]  Individual willingness to consume to the point of zero saving implies a willingness to consider complete reliance on government to provide in a time of need.  People stopped saving after government convinced them that society will provide.  Of course this notion is not correct, or in any event unsustainable.  We need to change the equation.  Lower the tax and increase the expectation that personal responsibility will be rewarded.

Timing of Save Versus Tax

In an effort to de-politicize currency issues, the United States has delegated the responsibility of managing our currency to the Federal Reserve, the Chairman of which is appointed by the President.  Artificially establishing the rate of interest has been used as the lever to suppress an over-cooked economy, or stimulate an economy in need of vitality.  The lever has been effective at securing a relatively constant rate of inflation.  But the mechanism is broken.  Interest rates are at zero.  Being in possession of savings has been rendered valueless!  This traditional method imposes a significant burden on those accumulating savings to provide for retirement, etc.  We are also watching in dumbfounded amazement as Billions are being paid as bonuses to bankers standing in the money stream of access to free money.  A more fair method would impose a variable tax on the people, accumulating reserves during the good times and providing stimulus during bad.  We all watched in horror as the price of oil skyrocketed, and witnessed the negative implication of this added “tax” on the people.  doubly offensive was the realization that the additional tax burden was being paid as profit to nations who hate our very existence.  Perhaps a high but variable rate of tax on oil is the answer?  It would work, but how do you de-politicize this function?


In this age of hyper-capitalism[7], a tax is imposed based on needs.  Those with more income and means are taxed higher than those without.  Don’t shoot the messenger; let’s deal with the dilemma of balancing needs and surplus.  Increasing community supported infrastructure may be warranted when the population is in an economic surplus, measured by its ability to save.  In an absence of surplus, extracting less revenue will stimulate the economy.  In the current zero saving environment, spending must first be reduced to equal the extraction.  The tax must then be reduced even further to bring the economy back into equilibrium without adding to the already skyrocketing debt.  The only reasonable answer is to reduce the size of the government budgets, reduce the burden we have asked government to impose on society.  And do so by reducing the Treasury’s public consumption. 

The Chinese people have been saving at record rates and are fortunately buying our national debt[8].  Eventually, the foreign governments structured with policies that encourage saving may realize they too will need to force consumption on their people and raise the tax to do so.  When they raise the rate of tax in those countries, the saving rate in those countries will correspondingly slow, just as it has for those of us in the United States.

Be an informed voter in this November’s elections.  The size of government will be determined by those you elect to represent you.  Be informed.  Demand position papers.  Hold their feet to the fire when they deviate from their elected path.  Don’t be misled by disingenuous rhetoric like “Tax the Rich.”[9]

The opinions expressed are those of the author.  No politicians were injured in the delivery of this message.  You are free to copy and quote giving proper attribution to the author.


[1]  Table 17-1 on pp 245.  18% of GDP equates to approximately 21% based on personal income, a more meaningful measure of available spending.

[2]  See the graph on page 1.  The average of years 2006 through 2011 is 16.05%.  It varies up and down between 15.5% and 16.5%.





[7] Hyper-capitalism is defined here to describe where one party to a transaction is indifferent to the social consequences.  Sale of tobacco, abusive banking practices, legal gaming, etc., are good examples.