On Tuesday of this past week, the Treasury Department released its accounting of expenditures and revenues for the month of May.  As expected, the budget deficit came in at about $125 billion, or, on an annualized basis, about 9.5% of anticipated 2012 GDP.  As for spending, total adjusted annualized non-trust expenditures are on track to reach about $3.6 trillion, or about a third of all spending by consumers.

With these recently released numbers in mind, one must wonder what will happen with income tax rates in the coming year.  Starting in 2013, tax rates on Americans are set to increase – for individuals in the higher income tax bracket, the top marginal tax rate is set to increase by 13%, the capital gains tax rate is set to adjust up by 33%, and the dividend tax rate is set to rise by 164%.

Treasury department spending May 2012

The potential tax increases would reverse a long term trend of tax burden reduction.  Professional forecasters and the taxpaying public are apprehensive about the effect these potential tax increases, coupled with necessary federal expenditure reductions, could have on overall economic growth.  Because the debate is political, the end result will come down to such things as fairness, class warfare, and influence peddlers.

Top tax rate 1946 2012

 

Although the end results will likely come down to such emotional issues, under the surface, there appears to be real and growing concern among professional analysts, and maybe the general public, that the return on investment in government spending has deteriorated throughout the years, and is now generally a poor investment decision.

It wasn’t always the case.  For example, in the early years of countries that first adopted public education, the return to the government and society at large (as measured in output and consumption) was probably positive.  The countries gained a competitive edge in human capital, and multiplier effects followed.  The return was probably high, at least as measured in terms of wealth gain.

Investment return on federal education spending

 

With more countries competing away the first mover advantage to public education, my suspicion is that most people are becoming aware that the return to public education is low, and likely negative.

What does a negative return on investment in education have to do with higher tax rates on the rich?  Simple – one group is paying for a loss in the other.  Of course, the issue of taxes on higher income individuals is much broader than just the diminishing, if not negative, return to public education.  A higher tax rate may cover the costs of such things as tax collecting, food regulation, transportation, and health care.

Don’t these expenditures have positive multiplier effects associated with such spending?  Maybe, but any potential positive multiplier effects probably should be compared against the negative multiplier effects of tax increases, government reporting and monitoring, and regulation.

As another example, consider the recent testimony given before Congress by Commissioner Douglas Shulman in January 2012.  He testified that budget cuts would be counterproductive by reducing revenue from forgone audits.  The general argument is that an IRS auditor “brings in,” on average, 10 times his salary.  Besides the fact that the data don’t actually show a correlation between IRS auditor employment and Treasury revenue, the issue is about marginal gains, not average revenue.

The return on investment to an additional auditor is probably very low, if positive, because the big corporate or individual audit findings are already being done and new auditors are likely to get accounts that, in the end, don’t pay for the auditors’ salaries.

These two examples of negative returns to government investment are only the tip of the iceberg.  My suspicion is that the historical trend of income tax rate reductions coincides pretty closely with society learning that the return to many government programs, although well intentioned, are losing investments, and, as any investor knows, if you pick too many losers, you go out of business.

With income tax rates set to increase in the coming year, maybe now is the time for society to consider reversing some of its experiments?

By Roger Thomas