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The Bana.., er... California Republic: Inflation, Taxes and Budgets

Wednesday, July 30, 2014

© Copyright 2014, Xanesti Creative Solutions
As you drive the beautiful California coastline, heading north toward San Francisco, you come across what is possibly the most unfortunately named community anywhere.  I have always wondered about the people of Half-Moon Bay.  Is this where California gets the reputation of being the land of fruits and nuts?  I mean, what can you say about a place that is two weeks shy of a full moon?

Oh, and it gets worse.  Keep driving and head inland to visit Sacramento and listen to our lawmakers tout their budget 'surplus'.  Even esteemed economists like Paul Krugman tout the 'Left Coast Rising'.

Banana Republic Booms and Busts

Krugman rather smugly credits the dubious "cash-in/cash-out" accounting surplus to the fact that Democrats have gained a political monopoly in recent years.  'Extremist' Republicans obstructing the majority was apparently the origin of our budget woes.  And those woes are now supposedly behind us.

Oh my.  Where do I even start?

Maybe with how badly leveraged our state tax system is to inflation, and I am not talking about the Consumer Price Index.  I am talking about the classic definition of inflation - of how when the money supply grows faster than the economy, prices eventually follow.  It is amusing, for example, to hear this administration report 'inflation' to be about 2%, and on that basis say that everything is OK with its monetary policies.  But then the President goes on Twitter (July 24, 2014 - see below) to campaign for a minimum wage hike with a graphic showing how from 2009-2014 the price of eggs has gone up 23%.  A previous tweet that same day showed that the price of milk has gone up 17% in the same period.  The outrage, of course, is that the minimum was has not been increased during that time.

So which is it?  Everyone who has made dinner lately can testify to getting less of things for about the same price.  The funny thing (if you can call it that) is wholesalers cannot do this either with milk (a gallon will always be a gallon) or eggs (a dozen will always be a dozen).  It is for this reason that things like milk and eggs are actually perfect indicators of true inflation.  And they also happen to be excluded from the Consumer Price Index.

But I thought inflation was 2%?
But back to California's fiscal bananas (forget the fruits and nuts).  From the California Budget Project:
Wide fluctuations in state revenues are partly due to ups and downs in California’s economy, but they also result from how the state’s tax system is designed. California’s economy is characterized by a number of very-high-growth sectors that tend to expand rapidly during upswings, and the state’s tax system is structured to capture a share of this growth. This is done through higher personal income tax rates for wealthier earners as well as through taxes on capital gains and other types of income that increase during periods of economic growth.

Technically, California does not have a 'capital gains tax'.  It treats 'capital gains' (e.g. an increase in the value of stock shares) as ordinary income.  What is definitely out of the ordinary, though, is the out-sized proportion capital gains income represents.  From 2007 to 2009 (the heart of the financial crisis) the capital gains share of California's general fund revenues fell from 12% to just 3%.  In hard dollar terms, that was no less than $9.3B (for all you jocks out there, that 'B' stand for 'billion').

This dynamic has been called the 'Facebook effect' because of how the initial public offering of Facebook in 2012 made millionaires out of the company's Menlo Park employees, resulting in a windfall of tax revenue for the state.  In 2008 0.8% of California taxpayers reported incomes in excess of $500,000.  This 0.8% accounted for no less than 82.5% of all capital gains tax revenues received by the state.

And this, then, brings us back to inflation.  With the Federal Reserve propping up bond prices both for U.S. Treasury bonds and for bonds backed by mortgages, interest rates have been artificially suppressed.  This forces investors to look elsewhere for a return.  And elsewhere has primarily meant the stock market.  As a price statistic, inflation is not seen in consumer prices because the CPI does not count the prices which will most accurately reflect underlying inflation.  (Those are the prices, by the way, which will be found most useful to politicians wishing to tweet a pose for their concern for the poor.)  It is seen, however, in the value of things usually held by those in the upper income brackets - land and stock.  And when your tax structure is progressive to the extreme, your general fund income will then be highly leveraged to that inflation.

This is why California's budget see-saws along with the stock market.  With stock index values currently at Quantitative Easing-fueled highs, the mirage of good budgetary news should not be any surprise.  But make no mistake, it has nothing to do with the Democrats' current monopoly.  And it is, in fact, a mirage.

Banana Republic Budgetary Gimmicks

And it only gets worse.  California is notorious for cooking its books to hide its public employee pension obligations.  Estimates vary widely.  Optimists put the liability at about $170B.  Pessimists estimate as much as $500B.  An LA Times article does an excellent job explaining the difference.  The optimistic estimate assumes an average rate of return on investments at 8%.  This depends, however, on riskier investments like hedge funds, the stock market and real estate - again, leveraging the income side of the books to inflation.  The pessimistic estimate uses the average municipal bond return of 5% as the basis of estimating an overall average return of 6%.  That the 2% difference translates to $500B(!) instead of $171B only reinforces how bad the problem really is.

The reason the supposedly good news is a mirage is because of what we will find when we arrive at what we thought was an oasis.  When the income side of our budget is leveraged to inflation, we are essentially being taxed on the sly.  In order for the budgetary math to hold up, we will have to assume inflationary monetary support for assets like stocks and real estate.  That inflationary support comes at the cost of purchasing power - as the system is goosed with more money, each dollar in our wallet buys less and less.  And you thought taxes were just dollars taken from your paycheck?  It is also food taken from your table.  Those who own a home and other assets like stock - namely the upper-middle class and the wealthy - have something to offset this loss of purchasing power.  The lower-middle class and poor?  They are watching powerlessly as their standard of living slips away.  Inflation is not only taxation on the sly, it is the most regressive form of taxation possible.

And this, then, goes to the heart of the ideas promoted by economists like Krugman; this is why money printing and progressive taxation - at least in its extreme California form - is self-defeating.  The more our state budget depends on taxes from the wealthy, the more it depends on inflating the value of those things which make the wealthy, well..., wealthy.  While the rich get richer via asset inflation, the dollars in the wallets of the middle class and poor buy them less and less.  Yet there Krugman and his Keynesian companions are, striking a pose for their concern for those same poor.

Banana Republic Ideas about Wealth and Taxes

At the heart of all of this is a complete failure to understand what wealth is and how it is created.  Printing money does not create wealth - and Krugman's Nobel Prize in economics will not change that.

The construction and purchase of a home is a perfect example of wealth creation.  Imagine the lot of land on which the home sits - before anything was built.  Without things like water, sewer, gas and electricity, the usefulness of the land was limited.  So a developer starts by bringing in 'utilities'.  The reason things like water, sewer and power are called 'utilities' is because that is what they bring - utility; they make it possible to use the land for stable shelter.

Having brought in utilities, the developer then builds a house.  The difference between what the land was worth 'unimproved' and what it has now become worth having been made useful for stable shelter is exactly what wealth is.  And then along comes a buyer.  The buyer arranges for a mortgage from the bank and begins making the payments.  Over the course of the mortgage, usually 30 years, the buyer gradually acquires this new wealth.

The creation of wealth, then, is about improving things.  It can be improving land to make it useful for things like shelter, commerce, recreation and education.  It can be improving the delivery of products and services.  The 'ARPANet', for example, was used only for the facilitation of government research - until the private sector commercialized the technology, and the 'Internet' was born.  And the resulting improvements to the delivery of products and services across a wide swath of the economy has created massive amounts of wealth.

Printing money does not improve anything.  But doing it in a way that suppresses interest rates and gooses equities (the stock market) creates the 'wealth effect'.  In short, as stock prices rise, people 'feel' wealthy and thus spend more.  The difference between conservative and liberal monetary and fiscal policies is perfectly encapsulated here:  Only in a banana republic would true wealth creation be replaced by 'feeling' wealthy - as a matter of public policy, no less!

Banana Republic Bar Tending

If your head is about to explode and you need a beer, well, that's perfect.  One of the ways investors value stocks is by dividing the earnings of a company per share of stock by the price of that share of stock (called the 'price to earnings' ratio, or P/E).  Historically across the stock market, the P/E ratio usually runs about 16.  That is your beer.  Today, the P/E ratio is at 26.  The difference is the head on your beer.

Just cross your arms, sit and watch.  What do you think will happen to the head on your beer?  It'll disappear because, after all, it's just a bunch of small bubbles.  But that's OK, by bar policy it's supposed to make you feel like there is more beer in the glass than there really is!

But back to budgets and banana republics.  Leveraging the income side of your budget to inflation guarantees you will have more head than actual beer.  I don't know about other places, but here in San Diego where we actually know something about beer, a glass of beer with a huge head on it tells us the barkeep has no idea what he's doing.  And a budget leveraged to inflation tells us exactly the same thing about our bean counters in Sacramento.

Lastly, a tax is - in every instance except for the looking glass of ObamaCare - a price attached to a transaction or exchange.  Let's imagine for a moment California did not charge sales tax on gasoline (which it does).  We would still have about $0.58/gallon in state and federal 'excise' taxes. (An excise tax is a fixed amount per unit of measure, e.g. a gallon of gasoline.  A 'sales' tax is a percentage of the total sale.)  So if you were to swing by the gas station and the sign were to say regular unleaded is $3.58/gallon, the price of the gas is actually $3.00/gallon.  The extra $0.58 is the price of the transaction, not the gasoline.

And here an immutable law of economics takes over.  If you want more of something, you do not make it more expensive.  Economic growth - and true wealth creation - is a function of the volume and value of transactions in the economy.  And taxes are, in each and every instance, the price of those transactions.  To point to an increase in taxes resulting in an increase in revenue - when the tax structure is progressive in the extreme and the value of what is being taxed is goosed by monetary inflation - is to mistake the head for the beer.

A return to smaller government, a less extreme progression of tax rates and overall lower taxes simply frees up resources which can be otherwise allocated to productive transactions in the economy - where improvements in products and services, and the delivery of those improvements, creates real wealth and generates stable tax revenues - a glass truly full of a fine Nut Brown Ale, not just a bunch of bubbles.

To borrow a line from the movie 'The King's Speech':

"Krugman's an idiot."

"But he has a Nobel Prize in economics!"

"Well, that makes it official, then, doesn't it?"

Maybe someday the bear will stop laughing at us.


  1. It is interesting how different people focus in on different parts of an article. To me, the most important point in Krugman’s article is that after years of gridlock the California state government is functioning again now that the Democrats are in control. John instead focused on Krugman’s comment that “the budget is back in surplus,” which is phrased in John’s article as “lawmakers tout their budget 'surplus'.” Krugman made this comment among others to show that the sky has not fallen and conditions were generally improving under Democratic control, but I don’t think he intended to say that California’s budget and debt problems are over. In fact, if you go to the article linked to that statement it quotes controller John Chiang as saying “We should remain laser-focused on paying down the Wall of Debt, reversing the many accounting gimmicks to which we’ve become addicted and keeping the State as liquid as possible to avoid experiencing the payment delays and IOUs that plagued our State during the Great Recession."

    For nearly a decade the state government had the same gridlock that makes Congress so ineffective today. Krugman’s actual words are: “California has long suffered from political paralysis, with budget rules that allowed an increasingly extreme Republican minority to hamstring a Democratic majority; ... In 2012, however, Democratic dominance finally became strong enough to overcome the paralysis, and Gov. Jerry Brown was able to push through a modestly liberal agenda of higher taxes, spending increases and a rise in the minimum wage.” You may or may not agree with these decisions, but it is the responsibility of the legislature to make them. With the gridlock broken the State government can function again in a way that Congress currently can’t. There is plenty of room for reform at both the State and Federal level, but a legislature that can’t function, can’t do it.

    The most important responsibility of the legislature and Congress is to carefully and thoughtfully evaluate the tradeoffs between the activities and services of government and appropriate tax rates. This article advocates “a return to smaller government” and lower tax rates. In the abstract, few people would disagree, but the statement naively understates the complexity of the modern world. Consider ARPAnet (The agency was ARPA, not DARPA at the time), mentioned in the article, which was a DOD government program from the late 1960’s through 1990, and evolved into today’s Internet. Would that program have been within the scope of a “smaller government”, particularly in its early days? The space program has always been considered by some to be a “frill”. It has arguably more than paid for itself through technological developments, but that was never the point – the purpose of the space program is to explore the universe and it has been spectacularly successful in doing so. At the state level, consider the water project that brought water from northern to southern California. Is that an appropriate activity for a “smaller government”? We need a functioning government to make these decisions.

    I have a few other specific comments:
    1. One reason State revenue is so dependent on income and vulnerable to income changes is the effect of Proposition 13, which froze property taxes in 1978 and made the state more dependent on income and sales taxes. It is understandable that Prop. 13 passed because people were being seriously impacted by reassessment of their property values during a time of high inflation, however it has created some longstanding inequities. If I were to sell my house, the new homeowner would pay double my property taxes.
    2. I agree that stock prices are high because interest rates are low (money flows to where it can make money), but the P/E ratio is not as bad as you suggest. The P/E ratio for the S&P 500 is 19.5 compared to a long term mean of 15.5 ( Note that it went up to over 120 at the worst of the financial crisis.
    3. I don’t think comments like “Krugman’s an idiot” are helpful.

    1. Jeff... Thank you for taking the time to reply.

      About "paralysis:" That is how people who are frustrated at the inability to see their ideas advanced characterize the problem. The minority will see this as preventing what they believe will be harmful. Ben Franklin noted that democracy is two wolves and one lamb voting on what to have for dinner. Freedom is a well-armed lamb contesting the vote.

      At the end of the day, Republican efforts are aimed at preventing fiscal profligacy. I am relieved that Jerry Brown is at least on the frugal side of his party in terms of fiscal values. But the Democratic Party’s values are still two weeks shy of a full moon as far as fiscal sanity is concerned.
      To call Congress 'ineffective' falls into the same trap. If 'effective' means freed to drive the deficit ever higher, that I'm glad they’re 'ineffective'. Both parties seem to think the Fed is an ATM and QE is the ATM card. Of course, we adults know better. But when we insist that QE-propped up borrowing is a disaster in the making, we are called recalcitrant little children. We are the only adults in the room! If Republican insistence that two plus two equals four makes us 'extremists' then make me a name tag...

      The ARPANet example, and this is true of the projects you mention, shows how public works projects do not create wealth - they enable the private sector to do so. Clearly this means there is a role for government in creating an environment where private industry can move products and services. But it is a mistake to think that government creates wealth. It doesn't as it has structural disincentives to increasing productivity.

      But government can destroy wealth, and this is the story of Prop 13. You recognize the role of inflation, but have you walked that inflation back to its cause? I will be the first to point to an under-funded war (Vietnam) as one. But the Great Society was the other. The guns and butter budgets were what caused other countries to question the dollar and demand gold in return such that Nixon had to remove the dollar from the gold standard. The resulting lack of boundaries on the money supply was what ran inflation rampant.

      It is an understatement to say people were "seriously impacted" by this. Retirees were losing their homes - the single greatest store of wealth they had built for themselves - to their inability to pay skyrocketing property taxes. Their government was not only NOT creating wealth, it was actively DESTROYING it. Prop 13 was, and remains, the only thing standing in the way of returning to this.

      Lastly, you are using the S&P P/E ratio. I use the Shiller P/E Ratio because it accounts for varying margins during business cycles and for inflation. It is fascinating because when you look at 2008 it was a little north of 26. Then at the bottom of the last financial crisis it was a little south of 15. With the historic mean at 16.6, this tells us that the bottom of the financial crisis was far closer to the 'norm' than right before it. In other words, the financial crisis was the popping of a massively inflated bubble. Proposition 13 was the only thing standing between that inflation and a resulting destruction of personal wealth. Let's not fail to note that it was 26.8 before the market crashed last time. It is 25.3 today.

      At the end of the day, we need to be able have intelligent discussions about where public funds are best spent. But what keeps us from that intelligent discussion is the absence of a stable, sound dollar. It boggles my mind to see Democrats posing as champions of the poor while the few dollars those same poor have in their wallet are losing purchasing power to the monetary policies of these same Democrats! And all the while the rich get richer by way of asset inflation. If demanding a sound dollar - and insisting that 2+2=4 - causes Krugman to call people like me 'extremists', well, I reserve the right to call him out as the idiot he clearly is.

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