Bad Thinking Habit #2:
All or Nothing Thinking

Tax policy is perhaps the most important issue in the coming Presidential election: whether to keep the Bush tax cuts, let them expire, or modify them.  If no action is taken, the tax rates on capital gains and dividends will rise automatically at the end of 2008 while the others will go up at the end of 2010.  Mr. McCain and most Republicans wish to keep the lower rates, and perhaps lower some others.  Mr. Obama and most Democrats apparently wish to allow the reduced rates to expire, especially those on higher income levels.

When the latest tax cuts were enacted in 2003, their sponsors never intended them to be temporary.  A sunset provision was needed to keep the scoring within certain legal limits, but everyone understood that the intention was to renew them.  To allow the cuts to expire is a tax increase, and its merits should be judged on that basis.

Although not often mentioned, the Laffer Curve, which shows the relationship between tax rates and tax revenue, is central to the tax debate.  Republican "supply siders" are the chief advocates of keeping the low rates where they are and possibly lowering other taxes as well.  Supply siders generally believe the Laffer Curve proposition that lower tax rates generate higher tax revenue; so to raise tax rates, or let them rise automatically, would not only hurt taxpayers, but would also, by depressing the economy, actually reduce the tax revenue raised by the government.  This would be especially true of the tax on capital gains and dividends where tax payers have some control over their realization.

The other side of the tax debate believes that the supply-side position is nonsense in general and that its intellectual core, the Laffer Curve, in particular, is a proven failure.  George Bush, the father, once famously labeled the supply side position, "Voodoo Economics."

There appears to be no middle ground in this debate because each side is engaged in "all or nothing thinking."  Laffer Curve predictions either work as advertised, or they don't.  Higher tax rates either lower tax revenue or raise tax revenue.  Each side thinks the other side just doesn't get it.

This great divide might not be so great if more people actually had a look at a Laffer curve such as the one below.  Although it's not clear how steep the slope of the curve should be, it is still rather obvious that whether tax collections rise or fall depends on where we are on the curve.  The higher the existing tax rate, the less revenue is likely to be generated by even higher rates.  At some point, the peak, higher rates will start producing lower revenue.

In a world of all or nothing thinking, it is unfortunate that the Laffer Curve was originally over-hyped.  It was advertised as allowing tax rate cuts to "pay for themselves."  That didn't happen completely, to a large extent because of higher government spending, especially on the military, so the budget deficit grew.  As a result, the critics declared the Laffer Curve a failure.

In a more rational world, the fact that it happened largely, if not completely, would be classified as a success, or, at least, a partial success.  All or nothing standards rarely produce successes of any sort.

Instead of arguing whether tax cuts work (pay for themselves) or not, the question should be to what degree they pay for themselves. How much disincentive is there in the present tax structure, and how can it be reduced?  Surely, even the tax increasers don't have maximum tax revenue as their goal.

All-or-nothing thinking is responsible for other needless irrationalities in the tax debate.  For example, one side says "the rich" are the main beneficiaries of the Bush tax cuts without acknowledging that those same rich still pay most of the taxes collected.  And they never acknowledge that many on the lower end of the income scale pay no income tax at all and that number was increased by the Bush tax cuts.  The Orwellian language used in these debates rose to a new level when the government giveaways in the recent stimulus were called "rebates."  Rebates of what?

Taxes are only one area where all or nothing thinking makes debate and rational policymaking more difficult:

In energy policy, it's said there is no policy because prices have risen, or because we are importing more oil, or because oil companies make too much profit or their executives are paid too much.  There is either the preferred outcome in all respects, or there is no policy.

All or nothing thinking bedevils monetary policy as well.  In the recent credit crunch, at first the Fed just didn't get it.  It should be reducing rates for heavens' sake.  Then, when rates were reduced, the Fed was pushing on a string, and ineffective.  When inflation rose, predictably, why did the Fed let that happen?  They pushed rates too low; now look what's happened to the dollar as a result.  Nowhere in the dialog can you find discussion of trade-offs, balancing objectives, or substantial successes.  Monetary policy either works, or it doesn't.  Apparently it doesn't.  Neither, in the view of the all-or-nothing crowd, does anything else.

Holding down the tax chair at NCPA is somewhat different from what I'm used to.  During my 36 years at the Fed, and especially my 14 years as a policymaker on the FOMC, I thought of taxes primarily as half of fiscal policy, which has more to do with how tax receipts stack up against government spending than with the efficiency of the tax regime. During most of my tenure, government spending exceeded tax receipts and produced a deficit.  The perennial question was what the deficit would do to the economy. Would it spark inflation? Would it pull us out of recession?  Did it really matter?

My early training and subsequent reading led me to conclude that the economic impact of a federal budget deficit depends mostly on how it is financed–with existing money, new money, or new money plus new bank reserves, which means further monetary expansion. In other words, the impact of fiscal policy depends primarily on how it is financed, and on monetary policy. The other relevant factor is the state of the economy–how close we are to full employment of labor and other productive resources, or how much slack we have.  The financing and the condition of the economy determine the impact of a deficit, which really means that monetary policy is more important than fiscal policy.

In general, I shared the profession's preference for a balanced budget over time, with helpful deficits during economic weakness matched by helpful surpluses during more exuberant times.  This ideal almost never happened, of course, so a lower bar led us to measure the deficit as a percentage of total GDP and forgive those that didn't break through historical benchmarks.

When I came to the Dallas Fed in early 1991 and was briefed by its excellent economists, I asked our public finance specialist whether there was a good rule of thumb for good tax policy.  I don't remember her exact words, but the answer was that taxes should have broad coverage and low rates. They should distort economic activity as little as possible.  Balanced budgets over time and cycles were preferable to chronic deficits. The main evil of deficits was that they represented negative saving, which had to be offset elsewhere to finance adequate investment.

While I considered deficits to be important, I was persuaded by Milton Friedman's argument that the magnitude of government spending relative to the size of the economy was more important than how it was financed, whether by taxes or debt. In other words, the size of government was more important to economic performance, and especially to individual liberty, than the size or percentage of the deficit. I also accepted the Friedman proposition that deficits were not necessarily a bad thing if they caused the politicians to curb spending.  The problem with higher tax revenues to balance the budget was that, in practice, they would just be spent to make government bigger. They would just feed the alligator.

Some, but not much, attention was paid to whether the existing tax system was a good system and whether it should be scrapped in favor of something radically new and different.  The most common reform proposals, which sounded good to me, were versions of the flat income tax.  I recall Dick Armey coming to the bank to explain his flat tax proposal and emphasizing that taxes could be reported on a post card.  I remember thinking that it sounded like a good idea, but in the back of my mind I couldn't help thinking about the old line that, if something sounded too good to be true, it probably was.  I must now reevaluate that thought in view of the successful adoption of flat-tax systems by several eastern European governments. Who would have thunk it?

The most radical tax reform proposal during my time was conceived by two friends of mine-the national sales or national consumption tax, more recently called the Fair Tax.  In many respects, it made the most sense of all the reform proposals, but it was so radically different that I had a hard time imagining it as a practical alternative to the flat income tax. I participated in a discussion of the national sales tax with Milton Friedman, who pronounced it a good idea-the ideal solution, perhaps-but he too worried about its practicality.

That was several years ago, and I've been surprised by the growing national support for the Fair Tax.  It's still a long- shot reform, but not as long a shot as it once seemed.  In thinking about that, it occurred to me that Friedman's qualification was not very Friedman-like. He was a well-known advocate of economists limiting themselves to "positive" economics and leaving the normative aspects to practitioners, i.e., politicians. Economists should not concern themselves with practicality or the political appeal of sound economic proposals. They should give the politicians their best possible proposals and let them worry about implementation.

So, here's where I am now.  Both the flat tax and the fair tax are big improvements over the current mess. The fair tax is probably superior to the flat tax if it could be implemented. Fortunately, the world is not holding its breath waiting for me to decide.  But if you are interested in the topic, as you should be, I recommend that you learn more about the fair tax and decide for yourself.  Start with their excellent web site, http://www.fairtax.org/. I recommend it to you and ask that you not–as they use to say in my church–"harden your hearts" against it.  Please, give the fair tax a fair chance!