Right Incentives, Wrong Incentives

As long as our government is spending $1.35 trillion it doesn’t have, let’s ask some rude questions.

What do we want more of? Saving.

What do we want less of? Debt.

Then let’s have tax policies that encourage more saving and that discourage debt.

Sounds pretty simple, right?

Then how is it that our government, under both Republican and Democratic administrations, has had it exactly backwards for more than a decade?

In order to preserve our bloated, reckless and irresponsible banking and finance system, our government has moved with bipartisan speed to bail the system out. At the same time, Federal Reserve policy has worked to reduce short-term interest rates well below the rate of inflation.

Responding to this kindness, bankers have generally run roughshod over savers and debtors alike. As I write this, the yield on most deposit accounts is about zero. The yield on 6 month Treasury bills, according to Bloomberg.com, is 0.14 percent. The yield on the average 6 month CD, according to Bankrate.com, is 1.06 percent. All of this amazing bounty is before taxes, which our government is hoping to raise.

Meanwhile, the Bureau of Labor Statistics tells us that inflation, as measured by the Consumer Price Index for 2009, is running at 2.7 percent a year. We don’t know what it will be next year, but most expect it to be that high, or higher. Even using this figure makes the benign assumption that the Consumer Price Index actually reflects something close to what most of us are experiencing. There are grave doubts about that, unless you happen to eat computers and drive TV sets.

As a consequence, our totally unrepentant financial system is being rebuilt while savers are punished with yields that guarantee their savings will lose purchasing power. Basically, our government is working hard to finish the job the financial services industry started. It has institutionalized the process of destroying our savings.

Was the bailout a pragmatic necessity?

Yes, very likely. Had something not been done, and quickly, we probably would be in even worse shape today. While ideologues would have preferred to watch everything crash and burn, most of us would rather find a way to get through the day with a bit less drama.

So what can we actually do? Answer: We can use tax policy to right some of the wrongs created by pragmatic necessity.

Here are three suggestions.

  • Make all retirement account withdrawals tax-free. The same government that can reduce interest rates can also eliminate taxes on retiree income. As I pointed out in a recent column, many retirees have seen their income plummet by 23 to 35 percent, simply because yields on savings have declined. That’s a greater amount, by far, than the tax rates at which most people pay. Let Congress remove the insult from the injury.
  • Make all dividend, interest and capital gains in taxable accounts tax-free. Retirees who need investment income to pay their bills would have more to spend. That would stimulate the economy a lot faster than public programs. Those who don’t need investment income for consumption would be encouraged to save more, reducing our need to borrow from China and other nations.
  • Abolish the corporate income tax. Without the corporate income tax, more corporations would be self-financing and (somewhat) less money would be wasted buying political influence, special legislation and weird tax breaks.

While these suggestions would reduce federal tax revenue, the reduction would be small compared to the federal deficits we are facing. Our total national income from rents, interest, and dividends is only a fraction of our total labor income.

More important, retirees would recover some of the spending power they have lost to perversely low interest rates. Similarly, savers and corporations could make new investments with cash flow that otherwise would go to taxes.

Finally, these tax cuts would work to increase the value of bonds and stocks. That’s exactly what government has been trying to do with low interest rates. The difference is that tax-free investment and savings income does more for Main Street than for Wall Street.

I’m ready for that. I bet you are, too.