Connecting the dots

The Governing Elite Are The Greatest Threat To the World's Middle Class

By Charles Kadlec

The crisis of the governing class is intensifying. Last week:

• The 100 billion euro bailout of Spanish banks and massive tax increases to narrow the government’s budget deficit are followed by a rise in interest rates on Spanish government bonds to a euro-record high.  
• San Bernardino became the third California city in the past month to file for bankruptcy.
• Faced with a budget crisis that threatens to eliminate thousands of teachers, California’s government voted to spend more than $3 billion on a high-speed train to nowhere.

New research showed strong evidence that increased government spending reduces economic growth.

Their effort to refashion society by redistributing income and regulating markets is now hitting the reality of insufficient cash flow. Even worse, the governing elite’s self-love, sense of noble entitlement and arrogant belief that their good intentions trump bad results have led to a series of policy blunders that have destroyed jobs and businesses in the productive private sector, intensifying the government debt crises here and abroad.  

The poster children for the twin political and debt crises are Greece and Spain.  As Nathan Lewis reported in his July 15^th Forbes.com column, for all the talk about Greek austerity, government spending (net of the public investment budget, which is accounted for separately) is as high this year as it was in 2009.  The real austerity has been imposed on the people of Greece who have been hit with massive tax increases – including a 2-percentage point increase in the value added tax in 2010.  The result is nearly a 10% decline in nominal GDP and a staggering increase in unemployment.  As a consequence, tax revenues are virtually unchanged, and the crisis continues unabated.

This story is being repeated in Spain, whose governing elites are receiving kudos from their European counterparts for voting for a third round of tax increases, including a 3 percentage point increase in the value added tax!  (That’s equivalent to roughly a $300 billion a year tax increase in the U.S.) And, this from a party that won a landslide election last November promising not to raise taxes.

These latest tax increases will drive the 25% unemployment rate higher still.  The collapsing economy and falling real estate values have put Spain’s banking system on the ropes, as individuals and businesses lose the wherewithal to repay their loans.  In an act of solidarity, the governing elites from the rest of Europe approved a 100 billion euro loan to fund a bank bailout, which ultimately will be paid for by Spanish taxpayers, threatening to choke off even more private sector activity in the years ahead. 

In the United States at least, city governments are being allowed to run out of money, forcing necessary adjustments to the unsustainable wage and benefit packages given to public employees. In Pennsylvania, Pittsburgh, Scranton, and the state’s capital Harrisburg are among about 20 cities operating under a state law for fiscally distressed municipalities.  

In California, San Bernardino, a city of 211,000 residents 60 miles east of Los Angeles, is the latest municipal casualty of climbing payments to retired employees and a shrinking tax based caused by falling property values and the state’s anti-growth regulations and taxes. Many believe Los Angeles too is at risk.  The city closed a $238 million deficit in its $7.2 billion budget mostly through temporary fixes, and did nothing to reduce its $27 billion unfunded pension obligations.

The state’s plan to close its own $15 billion budget gap with a new round of tax increases would make things worse.  If approved by voters in November, an initiative backed by Governor Jerry Brown would impose three new personal income tax brackets starting with a 10.3% rate on incomes at $250,000, and ending with a new top tax rate of 12.3% on incomes above $500,000.  The proposal also would raise the state’s sales tax a quarter of a point to 7.5%.  

Those who believe in the primacy of government project $9 billion in new revenue.  More likely, the higher tax rates will raise little incremental revenue as they drive high income tax payers and businesses out of the state. The erosion of the tax base will only intensify the budget shortfalls faced by local governments, leading to more bankruptcies, cutbacks in vital government services, and inevitably, the breaking of government pension obligations.

At the federal level, the Democratic leadership acts as if pretending the crisis does not exist will make it go away.  The Obama Administration’s budget calls for more than $6 trillion in new debt over the next 10 years without ever achieving budget balance.  No wonder it was voted down by large, bi-partisan majorities in both the House and Senate. And the Democratic controlled Senate responds by simply breaking the law requiring it to pass a budget.  

The President and leadership of the Democratic Party do advocate raising the tax rates on those with incomes over $250,000.  They do so in the name of “fairness” because such a tax increase would at best raise $65 billion a year in revenue, hardly enough to make a dent in the current $1.1 trillion federal deficit.  

They also choose to ignore the collateral damage of such a tax hike.  According to the Joint Tax Committee, the higher tax rates would hit those who generate 53% of small business income.   Not surprisingly, a study by Ernst and Young estimates that such a tax increase would lead to a loss of 710,000 jobs.

Connecting the dots, the contraction of the tax base through the loss of jobs and incomes means the actual revenue increase would fall far short of the projected $65 billion. In addition, such an economic slowdown would directly aggravate the fiscal imbalances of state and local governments.

Meanwhile, there is new evidence the governing elite’s claim that increased government spending leads to economic growth is false.  A new study by Laffer Associates concludes:  

“The findings are as clear as a bell: looking at the stimulus plans in 34 OECD nations, those with the largest spending spurts in 2008 and 2009 had the most anemic recoveries in 2010 and 2011 in jobs and growth. Amazingly, the four nations— Estonia, Ireland, the Slovak Republic, and Finland—with the biggest stimulus programs all had the subsequent steepest declines in growth.

“Those countries with the least stimulus spending had the smallest declines in economic growth, on average. These results are right in line with the results we found looking exclusively at U.S. data over a far longer time period.”

Thus, the governing elite find themselves on a fiscal treadmill created by their own dogma.  Raising tax rates produces no meaningful increase in tax revenues, but increases unemployment, leaving the middle class poor, and the poor destitute. As they cheer on each other’s “tough decisions” to attack the productive sector with tax increases, the bond markets render a harsher verdict, marking up interest rates as the risk of default rises.

These policy blunders in turn call into question the governing elite’s fundamental claim to power – that they can produce a more fair and just society and a more secure economic environment than the highly disorganized interplay of voluntary exchanges and organizations that are constitutive of free markets and a free society. As it turns out, the lesson of the first two decades of the 21^st century may be that a governing elite with a righteous belief in their power will achieve neither a fair nor a just society. Instead, they have become the greatest threat to the economic security of the middle class and the liberty of the people they seek to rule.