Tuesday, November 16, 2010

Loopholes, Progressivity, and Lines in the Sand

The first John Grisham novel I read was The Firm, a book that enthralled me. I became fascinated with the genre of page turner novels, because I read it on an airplane with a sleeping infant in my arms. That book was the enabler that allowed the entire flight to pass uninterrupted. Since travel with the kids was a real schlepp, the experience reading The Firm is one I'll always remember.

The Firm is a story of greed run amuck. In a scene intended to presage the rest of the story, Avery and Mitch fly to the Cayman Islands to meet with Avery's client, Sonny Capps. Seeming a real sleaze, Capps' goal in life appears to be shielding his massive income from taxation. He is willing to pay the law firm big bucks to shave a few percentage points off his marginal tax rate. Mitch doesn't seem to belong at the meeting. Just out of law school, he hasn't yet played with the big boys. But he is very bright, just as brash, and badly wanting to prove himself. From out of left field he pulls some very obscure bit of the tax code that will be forthcoming later in the year, something that will save Capps a bundle. Suddenly Capps tone changes. Now he is grateful. Afterward, Avery tells Mitch it was a job well done and that he deserved a little R&R as reward.

And that's the part of the story where the transactions were all legal.

The original copyright on The Firm dates from 1991. Bush 1 was President. The Democrats were still the majority party in Congress.

Most if not all of Grisham's novels follow a certain trajectory. A talented lawyer has a fall from grace, temptation getting to the better part of his nature. He gets into a stupor, not seeing a way out. Out of his desperation, with his ingenuity reignited, he finds a way toward salvation. His better self emerges anew. The law is not simply the road to perdition. It can be the path toward betterment, of self and society.

The Tea Party seems to have read only a bit of Grisham and then garbled the rest of the story. They've got the part about the fall from grace right. But their hero on the path to redemption appears to be Sonny Capps.

* * * * *

People are trying to make heads and tails of the early proposal by the Chairmen of President Obama's Debt Commission. There's been much written about it the past few days. I will offer my own opinion below, but before I do I want to make a point from the parable above.

Milton Friedman taught us "there is no free lunch," an important lesson to learn. Human nature what it is, many of us search for the free lunch nonetheless. Dire Straits wrote a song about it. ESPN has a Web site devoted to poker, and does extensive television programming of the World Series of Poker. And, as I've already relayed, there are characters in fiction like Sonny Capps. There may be no free lunch, but all of us can pass a buck.

Economists call the phenomenon rent seeking. It is socially deleterious. The effort put into it doesn't make the pie bigger. It only puts a larger share into the hungriest mouth, while the effort itself burns up socially useful resources.

We learned from the financial crisis that complexity can be the breeding ground for rent seeking, and the social destruction that results can be enormous. For the financial crisis the culprits were various derivatives, credit default swaps and the like. The U.S. tax code is likewise incredibly complex. It encourages rent seeking behavior by having people look for tax shelters or tax dodges. It would be much more straightforward to get rid of all the loopholes and therefore have lower tax rates.

In a NY Times Op-Ed today, Glenn Hubbard has a piece that I largely agree with supporting this point. On Friday in his column, Paul Krugman ripped the proposal, mainly for its lack of progressivity - the rich being the primary beneficiaries of the lower rates proposed. That got me wondering whether Krugman is right or if there are enough loopholes in the tax code where in fact the rich, and especially the super rich, have lower average tax rates than the rest of us.

On Sunday Frank Rich had an interesting column on this very theme. Rich says that share of national income now going to the top 1% of the population is 23.5%, which is bigger than the federal government. And based on the point made in The Black Swan, the skewness in distribution gets even greater as you go higher in income, meaning the top 0.1% get much more than 2.35% of the income. Rich bases much of his argument on the new book, Winner-Take-All Politics. The tax code is obviously not the only way such politics manifests. But my sense of it is that Krugman is wrong here, because the existing system is not progressive at all, when starting at very high incomes. If that is a right, a straight flat tax would be fairer than what we have now.

Republicans argue for limited government, putting their trust in "the market" to generate wealth and economic growth. But the Republican rhetoric doesn't discriminate between real wealth creation and rent seeking. In a world where the latter is fair game, who among the rich can afford not to be Sonny Capps? And when that happens doesn't it suck the lifeblood among those engaged in the former.

This seems to be where we are now. If all of society is one big Grisham story, where collectively we are nowhere near as clever as a Grisham protagonist, might we never find the way out?

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