Blind Leading the Blind, I: Taxation

In Astrid Lindgren's now classic Pippi Långstrump (Longstocking to non-Swedish speakers), Pippilotta Viktualia Rullgardina Krusmynta Efraimsdotter Långstrump — "Pippi" to her friends — while on a walk with her friends Tommy and Annika finds a large rusty tin can. Being Pippi, she immediately puts the can on over her head, then trips and falls because she can't see where she is going.

Pippi's first words on being helped up are how fortunate she has been in having the can on her head to prevent serious injury as a result of the fall. Annika points out that Pippi wouldn't have fallen if she hadn't put the can over her head in the first place. Pippi ignores this obviously silly comment.

The world's strongest nine-year-old girl is fictional, and can be excused for carrying out such antics. We, however, live in the real world. When Benjamin Bernanke announces that action by the Federal Reserve "prevented 'total meltdown'" following the 2008 financial crisis, and staved off "a more severe recession" ("Fed Prevented 'Total Meltdown,' Bernanke Says," Wall Street Journal, 03/28/12, A5), we are entitled to do a little more than point out the incongruity of the claim that the Federal Reserve saved the country from a situation it was largely responsible for creating in the first place.

Shades of J. P. Morgan being credited with saving the world during the Panic of 1907 . . . a panic he caused by denying an emergency loan to the Knickerbocker Bank and Trust when that institution got into trouble speculating in the stock market. Morgan's goal was to force a rival out of business. The Federal Reserve was established in part to prevent such antics from ever again taking place by breaking up the concentrated control over money and credit enjoyed by Morgan's integrated financial empire.

As the original language in the enabling legislation stated, the Federal Reserve was instituted to break up Morgan's virtual monopoly over money and credit. The idea was to "provide for the establishment of federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes." (Ch. 6, 38 Stat. 251, December 23, 1913, 12 U.S.C. ch. 3)

We haven't been able to find this language in the current amended version of the Federal Reserve Act of 1913. We don't know whether that's because it's been removed, or the Federal Reserve just doesn't want it spread around how far it's departed from its original purpose.

The "why" doesn't really matter. What's important here is that, contrary to its stated purpose of providing adequate liquidity for private sector needs and overseeing the financial system, the Federal Reserve has since 1916 been instrumental in diverting credit away from productive uses and into non-productive uses, and, following the repeal of Glass-Steagall and the removal of internal controls to the financial system, in encouraging the formation of financial institutions "too big to fail." Either move alone would have been sufficient to put the economy into deep trouble. Together they virtually ensured disaster.

Worse, the basic problem has not been corrected, only covered up with some very expensive whitewash. The rot is spreading even faster than before. In order to correct the underlying problem, two steps have become absolutely essential in the short run, and a third in the mid- to long-run if the correction is to be maintained. All three need to be instituted at the earliest possible date to avoid the looming meltdown that Bernanke has only delayed, not prevented. These are:

Reform of the tax system. No, not abolish the income tax, but return it to its original purpose of raising revenue so that government can carry out its legitimate functions. When instituted in 1913, a 1% tax was levied on all incomes, across the board. A progressive rate was added for incomes above $20,000. There was a $3,000 exemption for single adults, and $4,000 for married couples.

In today's terms, the $3,000 exemption translates into more than $66,000, while the $4,000 exemption is the equivalent of more than $88,000. Considering that $750 per year was an exceptionally high rate of pay in 1913 (Henry Ford paid a generous base wage of $2.34 per day for a six-day week) most people didn't pay income taxes.

We advocate eliminating virtually all deductions at the personal level, but increasing the exemption to $30,000 per non-dependent and $20,000 per dependent. True, this is not as generous as the original exemption, but government is a lot more expensive today, and there's a rather large debt to pay off. Under these assumptions, a "typical" family of two adults and two children would pay no income tax until aggregate income exceeds $100,000. At that point a single rate would be levied on all income, whether from wages, dividends, gambling, inheritance — whatever.

Capital gains should probably be inflation indexed. For the sake of expedience (and to prevent tax collectors from being lynched), capital gains realized from appreciation of the currency as it shifts from debt to asset backing (below) should be ignored. Try explaining to an outraged voter that taxes are due because he or she sold a house for less than the purchase price due to a rise in the value of the dollar!

A critical tax reform is to make dividends tax deductible at the corporate level, but treat them as ordinary income at the personal level. This would encourage corporations to pay out earnings instead of accumulating cash or leveraging to finance growth, and to finance growth by issuing new equity shares carrying an automatic "full payout" feature as well as the vote.

By adding a lifetime tax deferral of, say, $1 million for the purchase of qualified income-generating assets, ordinary people could accumulate dividend-paying equity shares using "pre-tax" dollars. Allowing everyone to purchase qualified shares on credit (below) and pay for the shares with the dividends on the shares would provide both a source of capital financing for corporations and a means for currently propertyless citizens to build wealth and participate in economic growth based on the production of marketable goods and services in the private sector, not illusory growth through non-productive government spending and other inflationary measures.

Tomorrow we will look at the banking and income system. If we don't have cans over our heads, we might even see something.

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