In my last piece, The Laffer Curve and Austrian Economics, I argued that the “Laffer Maxima” moves depending on where the economy is in the boom-bust credit cycle. I used an example of a marginal restaurant business in the bust phase, which fails when the income tax rate on the people who live nearby rises by 100 basis points.

In that piece, I did not intend to address the impact of taxes on the “middle class” vs. taxes on “the rich”.  A reader raised the question however, and thus motivated me to write this piece.

As I implied in that piece, the middle class are obliged to cut their spending dollar for dollar with any increase in any tax that they must pay.  I stated that this is because their budget is zero-sum, especially in the bust phase.  This leads to an important point: a dollar of tax increase here must necessarily decrease spending by a dollar. And this is just the primary impact. When this decrease forces the marginal business under, the secondary and tertiary impacts may be far in excess of one dollar.

In my example, the marginal restaurant had 8 employees, and a mortgage on some fixtures and tenant improvements.  Ignoring the impacts to the vendors of tomato sauce and mozzarella cheese, the default on perhaps $100,000 in debt is very significant.  And so is putting 8 people out of work.

In the bust phase, the destruction wrought by this tax that most people would consider to be “small”, is anything but small. And of course this process occurs all over the country.

It’s worth noting (though I do not intend to go into detail in this piece) that part of the problem is that the middle class has very little savings.  They live almost entirely on their cash flow, which is inelastic.

But what happens when taxes are increased on “the rich”? Is it not “fair” to redistribute wealth to even out the gaps between the “rich” and the rest of us? What happens if we increase taxes on the “rich”?

One cannot look at the economy on the basis of consumption only. It is important to understand capital accumulation and decumulation.

If a business sells $100,000 worth of product, and it cost $50,000 to make and sell, then they have a $50,000 profit. This is still true, even if they buy a $50,000 manufacturing machine. The business should treat the machine as capital which depreciates over its expected lifetime.

Likewise, if a business is neglecting its tooling, not investing in research and development, and deferring maintenance, it may seem to generate a “profit”.  But this is illusory. In an accurate assessment, it is consuming its capital. If it cannot allocate some of its “profits” towards capital, it is in reality consuming itself. It will eventually go out of business.

And this is important to understand when it comes to assessing taxes on “the rich”.  While there are some “rich” people who earn staggering salaries (e.g. actors and athletes), most “rich” are wealthy because they own productive assets and investments.

One can’t understand the impact of taxes on the rich (nor see it immediately) just by looking at macro economic data.  The “1%” do not reduce their personal consumption if taxes are increased on either incomes or capital gains. This is because they don’t spend all of their income, much less net worth, on consumption.

One needs to understand the concepts of investment, and risk-adjusted rate of return. Obviously, whatever portion of a rich man’s wealth is taken away in taxes will not be invested. The wealth will be consumed, either by the government, or those to whom the government gives it.

An increase in tax serves to replace investment with consumption. This may even boost GDP that year or even for a few years. But eventually, the destruction of capital will be felt in the economy.

This is important, because capital is the leverage on human effort. We don’t work any harder or any longer today than people did 10,000 years ago, but we are vastly more productive due to capital accumulation.  If we deliberately enact policies to decumulate capital in favor of present consumption, this would have a disastrous effect on our quality of life.

There is a more complex and pernicious effect of increasing taxes on the rich. And it is politically incorrect to say it. But it needs to be said.  We need less pandering and more honest discussion.  So bear with me.

Let’s compare and contrast to the wage earner. If the tax on a wage earner who makes $8 per hour goes up 10%, the wage earner may work an additional 10% more hours (if he can find the work), or he must spend 10% less.

The one percenter, however, has different choices. He is investing his wealth to generate a profit. For every investment, he calculates the risks and the returns if the investment is successful. He must then subtract the tax. If the net result does not justify the risk, he won’t invest.  The higher the tax, the more possible investments he will pass over, because they fail this test.  He always has an alternative: the Treasury bond.  Only if the risk-adjusted rate of return exceeds the Treasury will the rich man invest.

If he chooses not to invest, the result is that innovative start-up technology companies, energy exploration projects, new drugs and medical devices are starved for funding. But Treasury bonds go up and up, as does the consumption subsidized by the government.

This piece should not be taken as a recommendation to raise the taxes of the poor wage earner. But if one looks at the true economic impact of taxes, I think I have shown that taxing the rich hurts the economy—especially in the long term.

The correct solution is to cut spending, and cut it some more, and then cut it again, and then really begin to cut. But that is outside the scope of this piece.

Zero Hedge posted an article that asks an interesting question.  Every European country owes money to other European countries.  This creates a web of cross-linked debt.  Instead of each country laboring under the full nominal amount, why don’t they just cooperate and cancel out everything but the net debt?  This remainder would be very manageable for every country.

 Anyone with “common sense” should be able to grasp one thing about this supposition.  Each country borrowed, and hence got itself into debt, to run a budget deficit for many years.  This means each country consumed more goods and services than it could pay for by tax revenues.  Does it make any sense that this accumulated debt over many years or decades could be eliminated by a simple trick?

 As with many errors in politics and management, the fallacy becomes obvious if one eschews the “big picture view” (i.e. woozy floating abstractions) and dives in to the details.

 I read the paper on the site linked in the piece on Zero Hedge.  It was not clear to me if these numbers include only the sovereign debt of each country’s national treasury or if it includes banking system debt.  To make this simpler, let’s assume only sovereign debt.  This makes our case harder to prove, but stronger once proved.

 The paper discusses the problem of maturity and acknowledges that its simplistic method of putting all debt into three categories (short, medium, and long) was not realistic.  It notes that the fact that the true amount of debt at each maturity is withheld by the central banks is telling.

 What the paper neglects to address is that, in our worldwide regime of irredeemable debt-based money, debt is the basis for “money”!  Each central bank that buys this debt uses it on the asset side of the balance sheet against which it can issue money on the liabilities side.  Anyone who takes this asset away would be pulling the rug out from underneath the central bank!  The central bank would either keep the liability but witness the value of its currency crash as this would effectively be massive money printing in the true sense of the word: naked, unbacked paper created ex nihilo.  The affected currency would collapse, and prices of goods in terms of this currency would skyrocket (while they were quoted in this currency at all)!

 Or it would have to somehow call the liabilities, i.e. pull money and hence liquidity out of the markets.  How would this work?  Our system is based on (exponentially) growing amounts of credit and debt.  Every time the economy slows and begins to liquidate the malinvestments, the only antidote is to issue ever-greater amounts of fresh credit.

 So, how can this article blithely suggest that all of this credit could be pulled?  That would bring about a deflationary collapse, wherein every kind of debtor except the sovereign cannot get its hands on cash no way, no how.  The wave of defaults that cascaded through the economy would ensue until no debt, and no money, remained.

 One of the perversities of debt-based irredeemable paper is that it does not survive balance sheet consolidation.  The writers of this paper, and Zero Hedge failed to understand this simple (but unobvious) fact.

Peter Tchir wrote a piece yesterday describing yet another hole in the banks’ balance sheets:

I am not sure I fully understand it, but to me it looks something like this:

A bank has a duration mismatch.  Its funding is short-term, which means it must be rolled over frequently.  This subjects the bank to the risk of a rise in interest rates, which would make its cost of funding higher.  And of course if rates rise, then the market value of the bond it bought is lower.

So when they go to buy a new bond, they also buy an interest rate swap.  The calculus is as follows:

1) if interest rates fall, their funding will get cheaper (a gain), the bond they bought will go up in value (a gain), and the swap loses value (a loss);

2) if interest rates rise, their funding will get more expensive (a loss), the bond will go down in value (a loss), and the swap will rise in value (a gain)

 By calculating the amount of swaps to buy, the bank thinks it is controlling its risk.  The bank wants to make a pure spread: Interest on bond – funding cost – swap cost.

 But today as Mr. Tchir writes, the problem is that the bond is losing value not because rates are rising but because the issuer is in trouble.  So the swap is not providing the protection that the bank hoped for.  The bank’s funding costs may or may not be falling, but it is certainly taking a loss from the fall in the price of the bond due to credit risk and a loss due on the interest rate swap as well.

Capitalism died when they decided to subsidize railroads for the sake of national prestige in the mid 19th century.

Capitalism died when, to compensate for the consequences of subsidized railroads, they passed anti-trust laws in 1890, under which it is illegal to have lower prices, the same prices, and higher prices than one’s competitors.

Capitalism died in 1913 when they started taxing income, and created a central bank.

Capitalism died after 1929 under the flailing interventionism of Hoover.

Capitalism died in 1933 when FDR confiscated the gold of US citizens, outlawed gold ownership, and defaulted on the domestic gold obligations of the US government.

Capitalism died when FDR stacked the supreme court, and created a veritable alphabet soup of regulatory agencies that could write law, adjudicate law, and execute law.

Capitalism died when FDR created the welfare state replete with a ponzi “retirement system”.

Capitalism died in 1944 when the rest of the world agreed to use the US dollar as if it were gold, at Bretton Woods.

Capitalism died under Johnson’s Great Expansion of FDR’s welfare state (Medicare).

Capitalism died when Kennedy removed silver from coins.

Capitalism died in 1971 when Nixon defaulted on the remaining gold obligations of the US government to foreign central banks.

Capitalism died when rampant expansion of counterfeit credit led to a near-death experience for the US dollar in the 1970′s.

Capitalism died when they ended the era where investors paid a firm to rate the debt they were going to buy. Congress enacted a law giving a government-protected franchise to Moodys, Fitch, and S&P.

Capitalism died when they decided to tax dividends at a higher rate than capital gains, thus distorting capital markets.

Capitalism died when they created Fannie, Freddie, Ginnie, and Sally.

Capitalism died when in 1981 Reagan and Volcker conspired to begin a long boom by a process of falling interest rates that continues to this very day, destroying inconceivable amounts of capital with every tick either up or (mostly) down.

Capitalism died when Greenspan discovered that market corrections could be overruled by another shot of crack cocaine, i.e. dirt cheap credit effluent, i.e. lowering the rate of interest.

Capitalism died with the growth of laws and court decisions granting legally privileged status to some kinds of employees but not others (and trampling all over the rights of employers). For example, the Americans with Disabilities Act.

Capitalism died with the passage of Medicare Part D.

Capitalism died with the bailouts, stimulus and other lies, deceit, fraud, and theft post 2008.

Capitalism died when Obama set aside the rule of hundreds of years old bankruptcy law and precedent to give unions priority in the bankruptcy of GM.

Capitalism died when Obama socialized medicine.

Capitalism died with every new regulatory package for financial markets: “Operation FD” in the late 1990s (as I recall), Sarbanes-Oxley, and now Dodd-Frank. With each one of these, the process is the same. Congress floats an idea publicly to “go after” the banks and dealers and brokers. Then the banks must go to Washington, spend money like water, and 6 months of back-room deals later, a multi thousand page document emerges as law. Then the regulatory agency must write regulations, so the banks spend more money, and a year of backroom dealings later, a hundred thousand page regulation emerges. Then this is to be enforced by armies of regulators. …

Capitalism died with Zero Interest Rate Forevah(TM).

Capitalism is long since dead. Whatever the name for today’s failed system is, “capitalism” is not that name.

Jude Wanniski, a writer for the Wall Street Journal, coined the term “Laffer Curve” after a concept promoted by economist Art Laffer.Laffer himself says the idea goes back to the 14^th century

 The idea is that if one wants to maximize the government’s tax revenue, there is an optimal tax rate. (Ignore for the moment whether or not you think this makes good economics in the long run, or whether or not you think this is even moral.)

 Laffer noted that if the tax rate is zero, then the government gets no revenue. But likewise, if the rate is set at 100%, the government also gets no tax revenue. Mainstreamers say that there is no incentive to produce income at 100% tax rate, and this is true. But even more importantly, there is no means: a 100% tax rate is pure capital destruction.

 The “Laffer Maxima”, i.e. the tax rate which maximizes the tax take, is somewhere between 0% and 100%. The Wikipedia article shows a picture of a Laffer Maxima at 70%, and implies that although it’s somewhat controversial this may be the right number.

 There are two points about the Laffer Curve that are important to consider.

 First, what in the world makes any economist think that he can gin up some differential equations and compute the right value for this Maxima? In the first place, every market is composed of an integer number of people transacting an integer number of trades, and each of those trades consists of an integer number of goods. People do not behave like particles in an ideal gas—they have reason and volition. The very idea of modeling a large number of people with equations is preposterous. Never mind that degrees are awarded every year to economists who purportedly do just that.

 Second, what makes anyone think that the Laffer Maxima is a constant?

 Let’s do a thought experiment that is in the vein of the Austrian School of economics. Let’s consider the boom-bust cycle, or what Austrians note is really the credit cycle. The central bank first expands credit, which flows into wealth-creating as well as wealth-destroying activities (malinvestment). As the expansion ages, an even greater proportion of credit funds wealth-destroying activities. Sooner or later the boom turns to bust. Malinvestments are liquidated, people are laid off from their jobs, portfolios take big losses, tax revenues decline, etc.

 One clue can be found right there, in my description of the bust: tax revenues decline.

 OK, maybe the Laffer Curve remains static and the only thing that changes is the absolute tax dollars?

 Let’s continue comparing the boom and the bust phases. In the boom phase what’s happening is that economic activity is being stimulated, i.e. beyond what it would naturally have been. This fuels demand for everything: commodities, labor, construction, fuel, professional services, etc. And all of the people hired in the boom are demanding everything too. It feeds on itself synergistically, for a while.

 At this stage, the frictional cost of taxes may be masked by the lubricant and fuel of credit expansion. This is especially so when everyone feels richer and richer on paper. People spend freely and we saw this in spades in the most recent boom that ended in 2007.

 Now let’s look at the bust phase. The net worth of most people is falling sharply. Many are laid off, their careers, and sometimes lives, shattered. A huge component of the marginal bid for everything is withdrawn. People struggle to make ends meet. Budgets are stretched to the max.

 I submit for the consideration of the reader that in the bust phase, any change in the tax rate drives a big change at the margin of economic activity. The tax rate is more significant in the bust phase than it was in the boom phase. The Laffer Maxima is not a hard-wired, intrinsic value of 70 (or 42 for fans of Douglas Adams). Like everything else in the market, it moves around. It is subject to the forces of the markets.

 I will close with an example. Consider the marginal restaurant. Let’s say it is generating $25,000 per month in gross revenues. Net of $24,700 in expenses, it is generating positive cash flow of $300 per month. Why would the owner even keep it open? Well, times may get better…

Now, let’s say the tax rate goes up a little, say 100 basis points. The restaurant, making little money, pays essentially no taxes anyway. So this does not cause a direct impact. But what about the patrons of the restaurant? If their blended tax rate was 25%, then an increase of 100 basis points (i.e., to 26%) is a tax increase of 4%. These people will have to reduce their budget by 4%.

 One logical place to cut is eating out. Suppose that they reduce their spending in the restaurant by $1,000, in aggregate.  Now our restaurant has $24,000 per month in gross revenues. But its fixed costs cannot be reduced. And even the labor can’t be reduced in this case. The only reduction will be food supplies. So let’s say food supplies are reduced 1/3 of $1,000, or $333. So now the restaurant has expenses of $24,367. Whereas it formerly made $300 profit per month, now it makes a loss of $367 per month.

 The owner can’t continue this very long. And so he closes shop. He defaults on the loans on the fixtures and tenant improvements, lays off 8 people, leaves the electric and gas companies with fixed infrastructure which no longer produces revenue for them, etc.

 The impact to the economy (and hence to the total taxes collected) is negative and disproportionate to the tax increase.

So let’s look a little deeper.  December basis fell massively, and cobasis rose equally.  The other months were unaffected.

Basis is the profit you would make to carry gold (buy spot and simultaneously sell a future).  Basis = Future (bid) – spot (offer).

When it falls, it could be either a falling bid on the future or a rising offer on spot.

Cobasis is the profit you would make to de-carry gold (sell spot, buy future).  Cobasis = Spot (bid) – future (offer).  When it rises, it could be a rising bid on spot or a falling offer on the future.

For both to be true, it means either spot is rising or the future is falling.  But since the bases in the other months did not exhibit this behavior, it rules out spot rising, and that means that the Dec gold future fell.

What could cause a gold future to fall relative to spot and the other future months?  Put it another way, what would cause unbalanced selling of a future relative to other months?  One hint is that the February contract deviated from the other farther-out contracts and had a rising basis and falling cobasis.  February moved higher in price relative to other contract months.

This is caused by the contract “roll” as naked longs must sell their Dec futures and if they wish to remain long gold, buy a farther-out contract (i.e. February).  This action, especially if it happens en masse, would sharply press the bid down in Dec.

It is equally interesting that the offer is falling too.  What of the conspiracy theory that the banks have massive naked short positions?

If they did, they would be forced to buy them back as the contract expired.  This would lift the offer on the future.  In that case, the cobasis would be falling, the opposite of what is occurring.

This is the basis (no pun intended) of how one would go about debunking the allegations that the precious metals markets are manipulated by massive short-selling of futures.

As a side note, the spread between the Dec 2011 contract and Feb 2012 contract also widened sharply.  It had been falling since late October, accelerating in November.

Yesterday, it was possible to buy Dec (at the offer) and sell Feb (on the bid) for a profit of almost $6 an ounce.  While this is too small to be actionable if you have to pay commissions and fees and storage for two months (about $8.50 for a retail account), it’s telling.