The idea that government could redistribute income willy-nilly with impunity did not originate with Senator Bernie Sanders. On the contrary, it may have begun with two of the most famous 19^th Century economists, David Ricardo and John Stuart Mill. Karl Marx, on the other side, found the idea preposterous, calling it “vulgar socialism.”

Mill wrote, “The laws and conditions of the production of wealth partake of the character of physical truths. There is nothing optional or arbitrary about them.… It is not so with the Distribution of Wealth. That is a matter of human institution only. The things once there, mankind, individually, can do with them as they like.”[1]

Mill’s distinction between production and distribution appears to encourage the view that any sort of government intervention in distribution is utterly harmless – a free lunch. But redistribution aims to take money from people who earned it and give it to those who did not. And that, of course, has adverse effects on the incentives of those who receive the government’s benefits and on taxpayers who finance those benefits.

David Ricardo had earlier made the identical mistake. In his 1936 book The Good Society (p. 196), Walter Lippmann criticized Ricardo as being “not concerned with the increase of wealth, for wealth was increasing and the economists did not need to worry about that.” But Ricardo saw income distribution as an interesting issue of political economy and “set out to ascertain ‘the laws which determine the division of the produce of industry among the classes who concur in its formation.’

Lippmann wisely argued that, “separating the production of wealth from the distribution of wealth” was “almost certainly an error. For the amount of wealth which is available for distribution cannot in fact be separated from the proportions in which it is distributed.… Moreover, the proportion in which wealth is distributed must have an effect on the amount produced.” 

The third classical economist to address this issue was Karl Marx. There were many fatal flaws in Marxism, including the whole notion that a society is divided into two armies – workers and capitalists.[2] Late in his career, however, Marx wrote a fascinating 1875 letter to his allies in the German Social Democratic movement criticizing a redistributionist scheme he found unworkable. In this famous “Critique of the Gotha Program,” Marx was highly critical of “vulgar socialism” and considered the whole notion of “fair distribution” to be “obsolete verbal rubbish.” In response to the Gotha’s program claim that society’s production should be equally distributed to all, Marx asked, “To those who do not work as well? … But one man is superior to another physically or mentally and so supplies more labor in the same time, or can labor for a longer time.… This equal right is an unequal right for unequal labor… It is, therefore, a right to inequality…” 

Yet Marx offered a glimmer of utopian hope about the future in which things would become so abundant that distribution would no longer be a matter of concern: “In a higher phase of communist society … after the productive forces have also increased with the all-around development of the individual, and all the springs of cooperative wealth flow more abundantly – only then can the narrow horizon of bourgeois right be crossed in its entirety and society inscribe on its banner: From each according to his ability, to each according to his needs!”

That was not a prescription but a warning: For the foreseeable future Marx knew nothing would work without work incentives. If income were equally distributed to “those who do not work,” why would anyone work?

Contemporary public economics — “optimal tax theory” and the newest of the “new welfare economics” – also teaches that to tax a man “according to his abilities” would give able men a very strong incentive to use their skills to hide their earnings (and therefore their abilities) from tax collectors. This predictable response to tax penalties on high earnings is confirmed by economic research on the elasticity of taxable income. 

Distributing government spending “to each according to his needs” must likewise give potential recipients a strong incentive to exaggerate their needs. People who got caught doing that used to be called “welfare cheats” and considerable cheating still goes on in food stamps, Medicaid, etc. The Earned Income Tax Credit, for example, gives low-income working people an extra incentive to not report cash income from tips, casual labor or illicit activities.

In The Undercover Economist, Tim Harford rightly notes that “when economists say the economy is inefficient, they mean there’s a way to make somebody better off without harming anybody else” (called “Pareto optimality”). But argues that Nobel Laureate Kenneth Arrow figured out a way to efficiently redistribute income with “appropriate lump-sum taxes and subsidies that puts everyone on equal footing.” As Harford says, “a lump-sum tax doesn’t affect anybody’s behavior because there’s nothing you can do to avoid it.”

Unfortunately, Harford says “an example of a lump-sum redistribution would be to give eight hundred dollars to everybody whose name starts with H.” That simply shows that if the subsidies were not ridiculously random then the subsidies will affect behavior and will not be lump-sum. The government could collect a lump-sum tax of $800 from every adult and then send a lump-sum subsidy of $800 to every adult with no net effect, for example, but why do that? If the goverenment tried to tax people on the basis of abilities or to subsidize on the basis of needs, even Marx knew that would have a terrible effect on incentives.

The whole idea was curtly dismissed by another Nobel Laureate, Joseph Stiglitz, in his 1994 book Whither Socialism? (p. 46): “The ‘old new welfare economics’ assumed that lump-sum redistributions were possible,” wrote Stiglitz; “The ‘new new welfare economics’ recognizes the limitations on the government’s information.”

The reason governments cannot simply take money from some people according to how able they are, and give it to others according to how needy they are, is because people who were aware of that plan would not be foolish enough to accurately reveal their abilities and needs. Actual taxes and transfer payment distort behavior in ways that undermine economic progress and commonly produce results (such as trapping people in poverty) that are the opposite of their stated intent.

* * * * *  

div[2] “It would be convenient if ‘workers’ and ‘capitalists’ formed two distinct groups; however in practice there is substantial overlap of the group of workers and the group of owners of capital equipment and other property.… Despite this, theorists have devoted much attention to models of imaginary economies with just two factors of production, labor and capital, to suggest conclusions about the proportions of total income that will be channeled to each of the two factors and their owners.” D.G. Champernowne & F.A. Cowell, Economic Inequality and Income Distribution, Cambridge U.K.: Cambridge University Press, 1998, p. 123.

We have good news and bad news.

The good news is that President Obama has unveiled his final budget.

The bad news is that it’s a roadmap for an ever-growing burden of government spending. Here are the relevant details.

• The President wants the federal budget to climb by nearly $1.2 trillion over the next five years.
• Annual spending would jump by an average of about $235 billion per year.
• The burden of government spending would rise more than twice as fast as inflation.
• By 2021, federal government outlays will consume 22.4% of GDP, up from 20.4% of economic output in 2014.

I guess the President doesn’t have any interest in complying with Mitchell’s Golden Rule, huh?

While all this spending is disturbing (should we really step on the accelerator as we approach the Greek fiscal cliff?), the part of this budget that’s really galling is the enormous tax increase on oil.

As acknowledged in a report by USA Today, this means a big tax hike on ordinary Americans (for what it’s worth, remember that Obama promised never to raise their taxes).

Consumers will likely pay the price for President Obama’s proposed $10 tax per-barrel of oil, an administration official and a prominent analyst said Thursday. Energy companies will simply pass along the cost to consumers, Patrick DeHaan, senior petroleum analyst for Gas​Bud​dy​.com, which tracks gas prices nationwide, said in an interview with USA TODAY. .…a 15-gallon fill-up would cost at least $2.76 more per day. It would also affect people who use heating oil to warm their homes and diesel to fill their trucks.

Isn’t that wonderful. We’ll pay more to fill our tanks and heat our homes, and we’ll also pay more for everything that has oil as an input.

While middle-class consumers will see a big hit on their wallet, the Washington Post explains that Obama wants the new tax revenue to fund an orgy of special-interest spending.

…the tax would raise about $65 billion a year when fully phased in. …The administration said it would devote $20 billion of the money raised to expand transit systems in cities, suburbs and rural areas; make high-speed rail a viable alternative to flying in major regional corridors and invest in new rail technologies like maglev; modernize the nation’s freight system; and expand the Transportation Investment Generating Economic Recovery program launched in the 2009 economic stimulus bill to support local projects. …The budget would also use roughly $10 billion per year in revenues for shifting how local and state governments design regional transportation projects. Obama would also propose investing just over $2 billion per year in “smart, clean vehicles” and aircraft.

More railway money pits and Solyndra-style boondoggles? Gee, what could go wrong?

By the way, the Administration is claiming that the big new energy tax won’t really hurt our pocketbooks because oil prices have been falling. Here are parts of a story by the Washington Examiner.

President Obama said the oil supply glut that has forced prices down to about $30 a barrel makes his proposal to levy a $10 per-barrel tax on crude oil timely. …the White House appears to be of the view that consumers would have an easier time paying it during record low prices.

Gee, how thoughtful of them.

But is anybody under the illusion that the politicians in Washington will repeal the tax when energy prices rise?

Anybody? Bueller?

Here’s one last gem. As cited by the Los Angeles Times, the President offered this pithy statement.

“Rather than subsidize the past, we should invest in the future,” Obama said during his weekly Saturday address.

Now think about what he’s saying. Obama wants us to believe that the absence of a tax today and in the past is actually a subsidy!

Not that we should be surprised. Our friends on the left have a strange habit of arguing that we’re getting a subsidy when we’re allowed to keep our own money. Indeed, they even have a concept called “tax expenditures” that is based on that perverse notion.

P.S. The folks at Politico have a story about Obama’s plan, and there’s a bit of speculation about how it could become an issue for Hillary Clinton in the 2016 presidential race.

…the proposal could be particularly awkward for Hillary Clinton, who has embraced most of Obama’s policies but has also vowed to oppose any tax hikes on families earning less than $250,000 a year.

I think this analysis is absurd.

Hillary will promise all through the campaign that she opposes tax hikes on everyone other than the rich. But then, just like Obama, she’ll break that promise if she gets to the White House.

P.P.S. Lest anyone think I’m taking a partisan jab at Hillary because she’s a Democrat, keep in mind that I’m terrified that Republicans may decide (not withstanding their “dead on arrival” comments) to like Obama’s scheme. After all, many of them last year were very tempted by gas tax hikes to fund more pork-barrel spending.

P.P.P.S. And what’s really depressing is that I explained just last month that it would be very simple to shrink the relative burden government (and also balance the budget very quickly if that’s what you care about) if the federal budget “only” grew by the rate of inflation.

P.P.P.P.S. One final comment is that I might be tempted to accept an oil tax in exchange for the abolition of a tax — perhaps the death tax or capital gains tax — that collects a similar amount of revenue.

But I’d have two condition: First, the net result has to be a tax system that is less destructive to prosperity. Second, I’d have to be convinced that the swap wouldn’t backfire, with politicians somehow winding up with more power and/​or money when the dust settles (which has been my concern about the Rand Paul and Ted Cruz plans to impose a value-added tax, even though their plans theoretically would produce a much less destructive tax system).

President Obama has released his budget for fiscal year 2017. The president’s spending and revenue proposals will be mainly dead on arrival on Capitol Hill, including his $3 trillion in proposed tax hikes.

So it is more interesting to look at the budget baseline, which presents projections assuming no changes in law going forward. Since Obama’s proposals will go nowhere in Congress, the baseline gives us a better picture of what the next president will face when he or she comes into office next year.

Under the baseline, fast-growing spending inflates the deficit from $616 billion this year to $1.4 trillion by 2026. As the deficits accumulate, federal debt held by the public will soar from $14 trillion this year to about $24 trillion by 2026.

If you stacked $24 trillion in $100 bills in a pile, it would stretch 16,000 miles high, or about the height of 150,000 Washington Monuments. Government debt—driven by deficit spending—is by far Washington’s largest monument.

Where is all the spending going? The chart below shows federal outlays divided into four pots, as a share of gross domestic product (GDP) from 1970 through to 2026, with projections under the baseline. The chart reveals that entitlement spending—driven by rapid growth in Social Security and health programs—will increasingly dominate the budget in coming years.

I suspect that entitlement spending will also dominate the next president’s tenure in office as it drives up debt to unprecedented and dangerous levels, although you wouldn’t know that from the campaign trail so far this year.

When I give speeches in favor of tax reform, I argue for policies such as the flat tax on the basis of both ethics and economics.

The ethical argument is about the desire for a fair system that neither punishes people for being productive nor rewards them for being politically powerful. As is etched above the entrance to the Supreme Court, the law should treat everyone equally.

The economic argument is about lowering tax rates, eliminating double taxation, and getting rid of distorting tax preferences.

Today, let’s focus on the importance of low tax rates and Cam Newton of the Carolina Panthers is going to be our poster child. But before we get to his story, let’s look at why it’s important to have a low marginal tax rate, which is the rate that applies when people earn more income.

Here’s the example I sometimes use: Imagine a taxpayer who earns $50,000 and pays $10,000 in tax.

With that information, we know the taxpayer’s average tax rate is 20 percent. But this information tells us nothing about incentives to earn more income because we don’t know the marginal tax rate that would apply if the taxpayer was more productive and earned another $5,000.

Consider these three simple scenarios with wildly different marginal tax rates.

1. The tax system imposes a $10,000 annual charge on all taxpayers (sometimes referred to as a “head tax”). Under this system, our taxpayer turns over the first $10,000 of his or her income to the IRS, which means the average tax rate on $50,000 of income is 20 percent. But the marginal tax rate would be zero on the additional $5,000 of income. In this system, the tax system does not discourage additional economic activity.
2. The tax system imposes a flat rate of 20 percent on every dollar of income. Under this system, our taxpayer pays that tax on every dollar of income, which means the average tax rate on $50,000 of income is 20 percent. And the marginal tax rate would also be 20 percent on the additional $5,000 of income. In this system, the tax system imposes a modest penalty on additional economic activity.
3. The tax system has a $40,000 personal exemption and then a 100 percent tax rate on all income about that level. Under this system, our taxpayer pays $10,000 of tax on $50,000 of income, which means an average tax rate of 20 percent. But the marginal tax rate on another $5,000 of income would be 100 percent. In this system, the tax system would destroy incentives for any additional economic activity.

These examples are very simplified, of course, but they accurately show how systems with identical average tax rates can have very different marginal tax rates. And from an economic perspective, it’s the marginal tax rate that matters.

Remember, economic growth only occurs if people decide to increase the quantity and/​or quality of labor and capital they provide to the economy. And those decisions obviously are influenced by marginal tax rates rather than average tax rates.

This is why President Obama’s class-warfare tax policies are so destructive. This is why America’s punitive corporate tax system is so anti-competitive, even if the average tax rate on companies is sometimes relatively low.

And this is why economists seem fixated on lowering top tax rates. It’s not that we lose any sleep about the average tax rate of successful people. We just don’t want to discourage highly productive investors, entrepreneurs, and small business owners from doing additional things that result in more growth and prosperity for the rest of us.

We’d rather have the benign tax system of Hong Kong instead of the punitive tax system of France. Now let’s look at the real-world (though very unusual) example of Cam Newton.

Writing for Forbes, a Certified Public Accountant explains why the quarterback for the Carolina Panthers lost twice at the Super Bowl.

Remember when Peyton Manning paid New Jersey nearly $47,000 in taxes two years ago on his Super Bowl earnings of $46,000? …Newton is looking at a tax bill more than twice as much, which will swallow up his entire Super Bowl paycheck, win or lose, thanks to California’s tops-in-the-nation tax rate of 13.3%.

You may be wondering why California is pillaging Cam Newton since he plays for a team from North Carolina, but there is a legitimate “nexus” for tax since the Super Bowl was played in California.

But it’s the marginal impact of the tax that matters. More specifically, the tax-addicted California politicians impose taxes on out-of-state athletes based on how many days they spend in the Golden State.

Before we get into the numbers, let’s do a quick review of the jock tax rules… States tax a player based on their calendar-year income. They apply a duty day calculation which takes the ratio of duty days within the state over total duty days for the year.

Now let’s look at the tax implication for Cam Newton.

If the Panthers win the Super Bowl, Newton will earn another $102,000 in playoff bonuses, but if they lose he will only net another $51,000. The Panthers will have about 206 total duty days during 2016, including the playoffs, preseason, regular season and organized team activities (OTAs), which Newton must attend or lose $500,000. Seven of those duty days will be in California for the Super Bowl… To determine what Newton will pay California on his Super Bowl winnings alone, …looking at the seven days Newton will spend in California this week for Super Bowl 50, he will pay the state $101,600 on $102,000 of income should the Panthers be victorious or $101,360 on $51,000 should they lose.

So what was Cam’s marginal tax rate for playing yesterday?

Losing means his effective tax rate will be a whopping 198.8%. Oh yeah, he will also pay the IRS 40.5% on his earnings.

In other words, Cam Newton will pay a Barack Obama-style flat tax. The rules are very simple. The government simply takes all your money.

Or, in this case, more than all your money. So it’s akin to a French-style flat tax.

Some of you may be thinking this analysis is unfair because California isn’t imposing a 198.8 percent tax on his Super Bowl earnings. Instead, the state is taxing his entire annual income based on the number of days he’s working in the state.

But that’s not the economically relevant issue. What matters if that he’ll be paying about $101,000 of extra tax simply because the game took place in California.

However, if the Super Bowl was in a city like Dallas and Miami, there would have been no additional tax.

The good news, at least for football fans, is that Cam Newton has a contract that prevented him from staying home and skipping the game. So he didn’t have any ability to respond to the confiscatory tax rate.

Many successful taxpayers, by contrast, do have flexibility and they are the job creators and investors who help decide whether states grow faster and stagnate. So while California has the ability to pillage Cam Newton, the state is basically following a suicidal fiscal policy because other people can choose to stay away.

An editorial in today’s New York Times calls for a financial transactions tax – a tenths of a percent charge on the market value of every trade of a stock, bond, or derivative. My Working Papers column two years ago described the pitfalls of such a tax. While tax rates in the range of tenths of a percent sound small they would have large effects on stock values. Bid-ask spreads are now 1 cent for large cap stocks. A 0.10 percent tax would add 5 cents to the spread for a $50 stock.

The alleged purpose of such a tax is to reduce the arms race among High Frequency Traders who exploit differences in the timing of bids and offers across exchanges at the level of thousandths of a second to engage in price arbitrage. In the Fall 2015 issue I review a paper that demonstrates that this arms race is the result of stock exchanges’ use of “continuous-limit-order-book” design (that is, orders are taken continuously and placed when the asset reaches the order’s stipulated price). The authors use actual trading data to show that the prices of two securities that track the S&P 500 are perfectly correlated at the level of hour and minute, but at the 10 and 1 millisecond level, the correlation breaks down to provide for mechanical arbitrage opportunities even in a perfectly symmetrical information environment. In a “frequent batch” auction design (where trades are executed, by auction, at stipulated times that can be as little as a fraction of a second apart), the advantage of incremental speed improvements disappears. In order to end the arbitrage “arms race,” the authors propose that exchanges switch to batch auctions conducted every tenth of a second. No need for a tax. 

Among Democrats seeking their party’s nomination, all candidates have proposed raising the highest tax rates to a least 43.6% (Clinton) or 45% (O’Malley). Sanders famously admired Ike’s top tax rates of 91–92% from 1951 to 1963, but later suggested he’d settle for keeping top brackets of 43, 48 and 52% (including capital gains) while raising all the lower rates by 2.2%. Clinton and O’Malley assert or assume that raising only tax rates on the highest incomes would raise vast sums, enough to finance their many proposed new spending plans for various grants and benefits.

Leading Republican candidates, by contrast, would at least roll-back the highest tax rate to 35% (Rubio), 28% (Bush, Kasich & Christie) or 25% (Trump). Senators Cruz and Paul would go further by replacing both payroll and corporate taxes with a 15–16% value-added tax (on payrolls and profits) while keeping a 10–15% flat tax on income. Huckabee hopes to replace income and payroll taxes with a ~30% federal tax on all retail sales. Carson and Santorum suggest a flat tax of 14.9% or 20% respectively.

Let’s put aside the VAT and lower corporate tax rates for now, to focus on individual income tax rates.

As the graph shows, the U.S. has had considerable experience with top tax rates as high as 91–92%, as low as 28%, and everything in between. 

The individual income tax averaged 7.7% of GDP since 1946. 

Revenues from this tax were 7.5% from 1951 to 1963 when the highest tax rate was 91%, then rose to 7.8% from 1964 after all tax rates were cut by 30% (with a top rate of 70%). Revenues rose again to 7.9% of GDP from 1988 to 1990 when the top tax rate was only 28%. We obviously can’t just assume that raising the highest tax rates will raise more revenue, nor that lowering them will necessarily lose revenue.

Revenues from the individual income have never reached 10% of GDP, and exceeded 9% only 5 times in U.S. history – 1944, 1981 and 1998–2000. Revenues came close to 9%, briefly, when the surtax of 1969 raised all tax rates by 10%, not just the highest rates. Revenues can rise as a share of GDP because GDP falls, of course, which is what happened after 1969 and 1981. The unprecedented revenue surge in the tech boom of 1998–2000 has much to do with cutting the capital gains tax from 28% to 20% in 1997 combined with the quintupling of NASDAQ stocks, which also created big stock option payouts for thousands of non-executives.

Why does all this history matter? Because Republican Tax Reform plans are being judged against last August’s Congressional Budget Office (CBO) “baseline projection” for revenue. Failure to hit those baseline numbers has been described as “losing trillions” over a decade. But baseline revenue projections are not forecasts, as the CBO warns, and they totally unrealistic.

First of all, baseline projections are required to assume that dozens of supposedly temporary tax breaks (like the 30% tax credit for solar and wind investments) magically sunset on schedule and disappear, even though they are routinely “extended” by Congress at the end of each year. This is why the CBO just reduced projected 2016–2020 baseline revenues from 18.4% of GDP to 18.1%. The new revenue estimates for the next few years are already much lower than the August projections being used to score Republican tax reforms. And about $700 billion of the alleged 10-year revenue loss from tax reform is due to this fanciful convention of assuming no tax breaks are ever extended.

The second problem is that even though individual tax revenues have rarely touched 9% of GDP, CBO baseline projections assume revenues from individual income taxes supposedly rise from 8.1% of GDP in 2014 to 9% in 2017, 9.2% in 2020, 9.6% in 2026 and so on – reaching 13.3% of GDP by 2090 – according to a Tax Policy Center study. The main reason is that the CBO assumes real household incomes grow faster than the assumed 2.4% inflation and the combination pushes more and more families into higher and higher tax brackets each year. Because these are totally static estimates, the ever-increasing average individual tax burden is assumed to have no effect at all on economic growth or tax avoidance. 

In short, much of the alleged “revenue loss” from Republican proposals to eliminate tax rates higher than 28% is because such reforms rule out the “real bracket creep” that makes the fanciful CBO baseline revenue projections rise year after year, forever.

The Congressional Budget Office has just released its new 10-year fiscal forecast and the numbers are getting worse.

Most people are focusing on the fact that the deficit is rising rather than falling and that annual government borrowing will again climb above $1 trillion by 2022.

This isn’t good news, of course, but it’s a mistake to focus on the symptom of red ink rather than the underlying disease of excessive spending.

So here’s the really bad news in the report.

• The burden of government spending has jumped from 20.3 percent of GDP in 2014 to 21.2 percent this year.
• By the end of the 10-year forecast, the federal government will consume 23.1 percent of the economy’s output.

In other words, the progress that was achieved between 2010 and 2014 is evaporating and America is on the path to becoming a Greek-style welfare state.

There are two obvious reasons for this dismal trend.

• Notwithstanding laughable claims from the White House, Obamacare is contributing to rising spending on healthcare entitlements.
• Republicans keep capitulating on the BCA spending caps, enabling more wasteful outlays for so-called discretionary programs.

Here’s a chart that shows what’s been happening. It shows the rolling average of annual changes in revenue and spending. With responsible fiscal policy, the red line (spending) will be close to 0% and have no upward trend.

Unfortunately, federal outlays have been moving in the wrong direction since 2014 and government spending is now growing twice as fast as inflation.

By the way, don’t forget that we’re at the very start of the looming tsunami of retiring baby boomers, so this should be the time when spending restraint is relatively easy.

Yet if you’ll allow me to mix metaphors, bipartisan profligacy is digging a deeper hole as we get closer to an entitlement cliff.

Now let’s shift to the good news. It’s actually relatively simple to solve the problem.

Here’s a chart that shows projected revenues (blue line) and various measures of how quickly the budget can be balanced with a modest bit of spending restraint.

Regular readers know I don’t fixate on fiscal balance. I’m far more concerned with reducing the burden of government spending relative to the private sector.

That being said, when you impose some restraint on the spending side of the fiscal ledger, you automatically solve the symptom of deficits.

With a spending freeze, the budget is balanced in 2020. If spending is allowed to climb 1 percent annually, the deficit disappears in 2022. And if outlays climb 2 percent annually (about the rate of inflation), the budget is balanced in 2024. And if you want to give the politicians a 10-year window, you get to balance by 2026 if spending is “only” allowed to grow 2.5 percent per year.

In other words, the solution is a spending cap.

Here’s my video on spending restraint and fiscal balance from 2010. The numbers obviously have changed, but the message is still the same because good policy never goes out of style.

Needless to say, a simple solution isn’t the same as an easy solution. The various interest groups in Washington will team up with bureaucrats, politicians, and lobbyists to resist spending restraint.