The government and the main opposition party in the British election due on May 7 have agreed to promise no increases in the two basic rates of income tax, nor in the rate of Value Added Tax. Thus 75% of British tax capacity has been ruled off limits. This does not however mean that either party has belatedly been converted to the desirability of radically shrinking the bloated leviathan state. Instead, their tax raising focus has fixated like a laser on capital, suggesting an intensification of the war on capital that has been ongoing in most of the world this century. Needless to say, the economic results of this war will be very painful.

Economically, there are better and worse ways of paying for our bloated governments. The extreme 19th Century Cobdenite theory, whereby all tariffs are bad and minimal government should be funded through direct taxation alone, founders on the reality that we do not have a tiny Cobdenite government and we are not going back to one. With government the size it is – a minimum of 35% of GDP in the most civilized countries, and ranging up to 57% of GDP in hellholes like France — its funding is going to do a great deal of economic damage in one way or another. The important consideration is how to allow for the funding of that government without shutting down the economic system altogether.

It therefore follows that tariffs are not necessarily a no-no. The alternative pursued by many modern governments, of massive non-tariff barriers, regulations and “anti-dumping” lawsuits cost rather than raise money and leave revenue generation dangerously dependent on income and capital taxes. The free traders’ theory that tariffs impede trade and create inefficient protected industries are entirely correct, but the alternatives to modest trade tariffs may be even more economically damaging.

The United States probably benefited on balance from its high tariffs in the McKinley era, because they allowed the country to continue into the twentieth century without an income tax or high sumptuary taxes. Conversely, Britain’s free trade regime of 1846-1931 was undoubtedly misguided, because it was effectively “unilateral disarmament” against Britain’s protectionist trading partners, hollowing out British industrial capability. It prevented the creation of an economically efficient and united Empire bloc as well as imposing higher direct taxes on British entrepreneurs.

Income taxes are an inevitable funding core for the Welfare State, and their disincentive propensities are much better understood now than in the 1950s, when extraordinary top rates of 91% in the United States and 95% in Britain were the norm. As Michael Barone remarked, President Reagan knew enough to remove the absurd top rates of U.S. tax because as a film star paid by a major corporation he was one of the very few people who had actually paid them – and had suffered a severe decline in living standards between his peak earnings years and his GE contract arrived, because of his inability to save during the peak earnings years. Currently in most Western countries, the extractive capacity of income taxes is probably close to its peak; certainly France found that increasing the top rates of tax to 1970s levels was counterproductive.

Most rich countries with large welfare states have found Value Added Taxes the most satisfactory way of funding them. They have a number of advantages. They suppress consumption, and hence encourage capital formation, the key function of a capitalist economy. They are cheap and easy to collect and yield huge amounts of revenue, because they fall on all classes and on all types of transaction. Being non-redistributive, they are less distorting of economic activity than heavy income taxes. Indeed their only limitation appears to be that as their rate rises, social programs must be increased proportionately, since goods of all kinds become more expensive. Hence even the tax enthusiasts in the EU have found that VAT rates of about 25% (representing approximately a 20% tax on transactions) are about the practical limit.

Given that both income taxes and VATs are close to their practical limits in many countries (though a VAT could be adopted in the U.S.) those of the big spenders who wonder vaguely what happens when trillion dollar deficits stretch to infinity have turned their attention to wealth taxes. After all, inequality has been increasing over the last decade (largely owing to the left’s own monetary policies) so doesn’t it make sense to reduce it again by taxing accumulated wealth?

There are two answers to that question. One is that today’s monetary policies are already taxing accumulated wealth, and have been doing it for almost two decades by holding the risk-free interest rate below its natural level, thus forcing wealth owners to leverage, buy risky assets or both. In the short term, asset values have increased as have concentrations of wealth. In all but the shortest term, the bubble asset valuations will collapse and wealth will be seen to have been destroyed.

Politics being what it is, it is doubtless just as asset values have definitively collapsed, wrecking the retirements of an entire generation and destroying the capital base, that swingeing wealth taxes of one sort or another will be introduced. There are a number of varieties of these:

• Conventional wealth taxes, the French approach of cutting the heads off tall poppies and sending them to get jobs in London. If interest rates were healthily positive in real terms, and interest and dividend income was not itself taxed, then a low-rate wealth tax might make a modest substitute for an income tax, perhaps tilting the balance between earned and investment income. As it is, it simply makes the return on wealth even more sharply negative, thus further decapitalizing the economy. Once the market has crashed, countries adopting it will find their living standards reduced to those of the Democratic Republic of Congo, as wage rates in a society without capital are naturally reduced to subsistence levels.
• Mansion Tax, proposed by Labour on properties of a value more than £2 million – a huge amount in any civilized location, but alas only a modest three-or four bedroom terraced house, perhaps 1800 square feet, in many parts of central London. This will further push anyone with such a house for whom money is still a consideration to sell up and either retire on the proceeds or move to a more civilized country. £2 million will buy you a lot of real estate even in Frankfurt, let alone Tahiti.
• Attack on pension funds, apparently in the plans of both UK parties. Having effectively ended the final-salary defined-benefit pension plan, the political classes now want to tax the capital accumulations necessary for anyone wishing to enjoy a decent retirement through defined-contribution plans in an era of impossibly low interest rates. Needless to say, these attacks will reduce even the most provident of the middle class to penury in their old age, while rewarding the spendthrift with state handouts. Far more than any but the most foolish rate of income tax, this further decapitalizes the economy and reduces living standards.

Needless to say, the best solution to the problems caused by current foolish policies is to end the policies themselves. Raise interest rates forthwith to a level at least 2% above the rate of inflation and cut back state spending to a level that balances the budget. After a short sharp shock of bubble-bursting, that would put the economy back on the right path.

However if the politicians are determined to squeeze yet more money out of the taxpayers’ stone, there’s one way they could do so that would actually benefit the economy. That would be to impose a tax at quite a low annual rate – say ½% per annum — on all debt. This is justified because in an economy in which asset values continually zoom up and then collapse, vast numbers of people and businesses who have over-indebted themselves have to be bailed out in each collapse. In the United States, according to Fed figures, such a tax would raise 0.5% per annum on $28 trillion of domestic non-financial non-government debt, or $140 billion per annum – not enough to eliminate the Federal budget deficit, but enough to put a very decent dent in it.

Such a tax would sharply discourage leverage, increase the cost of leverage, and heavily discourage silly leveraged games such as hedge funds and private equity funds. It would also discourage subprime mortgages, which would become unaffordable, and £2 million London houses, which would equally become unaffordable. It would also tax the big banks, themselves major contributors to the bubble-crash cycle, and begin to compensate taxpayers for their costs of bank rescues. At the same time, a ½% annual increase in interest costs would not make housing, automobiles or other assets unaffordable for those indulging in them to a reasonable extent.

A wealth tax penalizes saving, capital accumulation and other worthwhile economic behavior and attitudes. A debt tax would discourage speculation, leverage games, and other destructive economic behavior and attitudes. As such, it should be in the policy kit of every candidate in the upcoming UK election – and in elections of other countries in which the economy has been so grossly distorted.

-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)