The Purpose and Performance of Our Tax System

What is the purpose of our democratic society’s tax system?  It’s very different from, say, Louis the Sun King’s France.  His Minister of Finance defined taxation as:  “plucking the goose to obtain the largest possible amount of feathers with the smallest possible amount of hissing”.   We only want to collect enough, not as much as possible.  How well does our system perform?  We have better measures than hissing:

  • Effectiveness – % of government activities it funds – is it enough?
  • Overhead – % of what is collected the process costs
  • Fairness – % of the population considering it fair
  • Clarity – extent to which the population understands what the taxes pay for

Effectiveness has two aspects.  First, a perfect tax system would, not every quarter or year, but over the long haul, fully fund our government’s activities.  By this measure, our current system is an abject failure.  The problem is not so much that the gap widens during economic downturns, e.g., lower collections and higher spending post-2007, but that what’s collected is almost always significantly lower than what’s spent.  I’ll comment below (see clarity) on why that is so.  At this point we only need acknowledge that our current tax system is seriously ineffective.

Revenue_and_Expense_to_GDP_Chart_1993_-_2008

The other aspect of effectiveness is what % is collected of the amount the system intends to collect, i.e., how much is illegally evaded.  This 2011 study by the Federal Reserve Bank says: “18-19% of total reportable income is not properly reported to the IRS, giving rise to a “tax gap” approaching $500 billion dollars”.   It is estimated that around $3T of income tax was evaded from 2001-2010.

Overhead means the cost of collecting.  By this measure, too, our system gets a failing grade.  This report, using IRS data, estimates it at 30% for the income tax system.  Local property taxes, for example, have lower overhead.  Embedded point of purchase taxes, e.g., on gasoline, have about 5% overhead.  I haven’t tried to estimate overhead for our overall system.  It would be good to get it a lot closer to 5% and have it cause less hissing.

Measuring fairness is a challenge.  How to define it?  The dictionary definition is simple, “a proper balance of conflicting interests” or “showing no more favor to one side than another” but it is not so obvious how to measure that in a tax system.  Since we are a democracy, the best way is what % of the people considers it fair.   From a recently published 131 page compendium of survey results I selected some of the most illuminating ones about fairness and clarity.

How many of us consider the current system fair?  See below.  A little under half (3% + 40%) and mostly only moderately fair.  A quarter (24%) considers it not at all fair.  Three of five, however, (59%) regard what they personally must pay as fair.  Perhaps they are the same 56% who consider that middle-income people pay their fair share?  Many more, however, (68%) feel the system benefits the rich and three of five (60%) want those who earn more than $1M a year to pay a minimum of 30% in taxes.  Two of five (40%) consider that lower income people pay too much.  Maybe they are lower income?  Fully two thirds (66%) believe everyone should pay some tax although that question is somewhat loaded.  Almost two thirds (64%) think corporations pay too little tax.

  • Would you say that our [federal] tax system is very fair, moderately fair, not too fair or not fair at all? (p. 20, Dec. 2011 Pew) Very fair – 3%,  Moderately fair – 40%, Not too fair – 31%, Not fair at all – 24%)
  • Do you regard the income tax which you will have to pay this year as fair? (p. 23, Apr. 2012 Gallup) Yes – 59%, No – 37%
  • Do you feel the present tax system benefits the rich? (p. 25, Apr. 2012 CNN/ORC) Yes – 68%, No – 29%
  • Are middle-income people paying their fair share in federal taxes, too much or too little? (p. 26, Apr. 2012 Gallup) Too much – 36%, Fair share – 56%, Too little – 6%
  • Are lower-income people paying their fair share in federal taxes, too much or too little? (p. 27, Apr. 2012 Gallup) Too much – 40%, Fair share – 33%, Too little – 24%
  • Are corporations paying their fair share in federal taxes, too much or too little? (p. 27, Apr. 2012 Gallup) Too much – 11%, Fair share – 21%, Too little – 64%
  • Would you favor requiring households earning $1 million a year or more to pay a minimum of 30% of their income in taxes? (p. 31, Apr. 2012 Gallup) Support – 60%, Oppose – 37%
  • [Should] everyone pay some minimum amount of tax to help fund government? (p. 20, Feb. 2009 Harris/Tax Foundation) Should – 66%, Current system is fair – 19%, Not sure – 15%

So, our current tax system is perceived to be less fair than we want.  Another way to look at it is in terms of results.  The tax system takes money from people at different rates and redistributes some of it to others depending on relative circumstances.  How fairly do we think it does that?   Almost three of five (57%) feel money and wealth should be more evenly distributed.  Opinions are, however, equally divided (47% to 49%) on whether the government should redistribute it by heavy taxes on the rich.

  • Do you feel that the distribution of money and wealth in this country today is fair? (p. 33, Apr. 2011 Gallup) Fair – 35%, Should be more evenly distributed – 57%
  • Do you think that our government should or should not redistribute wealth by heavy taxes on the rich? (p. 33, Apr. 2011 Gallup) Should – 47%, Should not – 49%

Another perspective is, are we paying the right amount of tax relative to government spending?  Half of us (47%) think we pay too much tax and half (47%) think what we pay is about right.   But twice as many (61% to 26%) want to pay less, two thirds (67%) are against raising taxes and almost as many (61%) are unwilling to pay more.  How to reconcile the desire to pay less with closing the government’s deficit?  Three of five (61%) believe the deficit can be cut substantially without raising taxes and more than half (53%) favors balancing the budget by cutting spending.

  • Do you consider the amount of federal income tax you have to pay as too high, about right, or too low? (p. 4, Apr. 2012 Gallup)  Too high – 46%, About right – 47%
  • Would you like to see the amount Americans pay in federal income taxes increased, decreased, or remain about the same? (p. 6, Jan. 2012 Gallup) Increase – 13%, Decrease – 61%, Same – 26%
  • Would you favor or oppose raising taxes as a way to reduce the budget deficit? (p. 55, Mar. 2011 PSRA/Pew) Favor – 30%, Oppose – 67%
  • Would you be willing to pay more in taxes to reduce the federal deficit? (p. 50, Jun. 2011 Bloomberg) Willing to pay more – 36%, Not willing – 61%
  • Do you think it is possible to bring down the deficit substantially without raising taxes? (p. 54, Mar. 2011 Bloomberg) Is possible – 61%, Not possible – 37%
  • Which would you prefer to balance the federal budget deficit? (p. 56, Jul. 2011 Economist/YouGov) Increase taxes -10%, Decrease gov’t spending – 53%, Both – 29%

Now we arrive at our tax system’s clarity.  How accurately do we understand the cost of our government’s activities and how that relates to the taxes we pay?  This is where our system fails most spectacularly.  We want to pay less taxes and we imagine we could cut government spending to make that possible.  What spending do we want be cut?  Waste!

We believe almost half of all government spending (47%) is wasted.  Where?  Social Security, the largest program?  Four of five (79%) oppose cutting Social Security spending.  There is less opposition to raising the Social Security eligibility age (44% in favor, 54% opposed).  Opinions are quite evenly divided on what we could save by raising the age of eligibility.  I don’t know what % of the population knows Social Security does not in fact contribute to the deficit – we collect more Social Security taxes than we pay in benefits.

How about cutting Medicare etc, our second largest program?  Opinions are equally distributed from a lot to not much on what that would save but three quarters of us (76%) are in any case against cutting Medicare.

Should we cut defense spending, the third largest area of spending?  Three of five (58%) oppose that but almost half (47%) think we could make very large savings by pulling out of Iraq and Afghanistan and two thirds (66%) favor doing that.  Will they oppose spending the money to invade Iran?

Since the top three areas of spending account for 62% of the total, how to eliminate that 47% of waste?  Two of every three of us (42%) believe we could make very large savings by cutting aid to foreign countries and 72% favor doing that.   Sadly, our total non-military foreign aid in 2011, $32M, is one thousandth of one percent of total federal spending.

  • Do you think people in government waste a lot of money we pay in taxes, waste some of it, or don’t waste very much of it? (p. 15, Apr. 2011 CNN) A lot – 73%, Some – 23%, Not Much – 4%
  • For every dollar you pay in federal taxes, about how many cents do you think are wasted by the government? (p. 16, Jan. 2013 Reason-Rupe) Wasted – 47%
  • In order to reduce the budget deficit, would you favor or oppose reducing spending on Social Security? (p. 60, Mar. 2013 CBS) Favor – 18%, Oppose – 79%
  • Would you favor or oppose gradually raising the age of eligibility for Social Security to 69? (p. 53, Mar. 2011 Bloomberg) Favor – 44%, Oppose – 54%
  • Savings by gradually raising the age of eligibility for Social Security to 69 would be? (p. 53, Mar. 2011 Bloomberg) Very large – 19%, Fairly large – 28%, Fairly small – 24%, Little difference – 24%
  • Would you favor or oppose significantly reducing benefits for Medicare? (p. 53, Mar. 2011 Bloomberg) Favor – 22%, Oppose – 76%
  • Savings by reducing benefits for Medicare would be? (p. 53, Mar. 2011 Bloomberg) Very large – 19%, Fairly large – 25%, Fairly small – 27%, Little difference – 24%
  • In order to reduce the budget deficit, would you favor or oppose reducing defense spending? (p. 60, Mar. 2013 CBS) Favor – 38%, Oppose – 58%
  • Savings by pulling all troops out of Iraq and Afghanistan would be? (p. 53, Mar. 2011 Bloomberg) Very large – 47%, Fairly large – 28%, Fairly small – 12%, Little difference – 11%
  • Would you favor or oppose pulling all troops out of Iraq and Afghanistan? (p. 53, Mar. 2011 Bloomberg) Favor – 66%, Oppose – 30%
  • Savings by cutting aid to foreign countries would be? (p. 53, Mar. 2011 Bloomberg) Very large – 42%, Fairly large – 30%, Fairly small – 14%, Little difference – 10%
  • Would you favor or oppose significantly cutting aid to foreign countries? (p. 53, Mar. 2011 Bloomberg) Favor – 72%, Oppose – 26%

Fed Spending Pie Chart

This is already a long post so I will make only two comments about state and local taxes.  Property taxes are considered the most unfair of all, perhaps because they may force folks whose incomes drop sharply at retirement to sell their home.  Estate taxes, primarily federal but which have also been levied by some states, are also very unpopular, which is inconsistent with our idealization of the “self-made man”.

The next post in this series will say more about fairness.  How should society’s wealth be distributed?  The cynic would expect all of us to think we personally should have more.  What do we actually want?  My analysis of our current tax system and how its results compare to what we want will at that point be sufficiently complete.   I will then force myself to establish some proposals for a better system.

Business Tax

Because we tax the income of legal entities, i.e., corporations, not just people, this post extends the exploration of who we tax.   Corporations are not the only form of business enterprise so it examines our overall business tax system.  It does not, however, address who ultimately pays business taxes; the customers who unknowingly pay a higher price, owners who unknowingly provide additional capital and/or, other academics say, employees.

Personal income tax is on gross income but corporate is on net, i.e., profits.  In other words, while most costs of earning a wage are taxed, most of a corporation’s costs are not.  Both income taxes have lower rates for lower amounts of income, and both are levied by states and the federal government.  Federal rates start at 15% for the first $50K of corporate income, which is more than the total income for over 90% of US corporations.  States levy at an effective rate in the range of 2% to 5%.

In an increasingly competitive global economy, how do our business taxes compare to other nations?  Our top corporate tax rate, federal plus state and local, is among the world’s highest but that is not necessarily what businesses pay.  GE, for example, our 6th largest business by revenue and 14th most profitable, paid no tax at all in 2010.  The rate US businesses actually pay is where it starts to get complicated.

There are many ways to compute effective business tax rates, i.e., what businesses actually pay.  “Effective 1” in the table below from the US Treasury calculates it as corporate taxes versus corporate operating surplus.  Using that formula, we are at 13%, which is lower than the 16% average for OECD nations and almost the same as Canada.  The formula used by the equally authoritative World Bank, however, “Effective 2”, places us highest at 28%, almost double the OECD average and four times as high as Canada and France.  The formula used by a source with a tax reduction agenda, which gives the rate on the highest income bracket, i.e., the “Marginal” rate, shows us at 36%, which is also twice the OECD average.  Trying to figure what percentage of profits corporations pay in taxes leads to no definite conclusions.

Corporate Tax Rates

Tax collected as a percentage of GDP is a dependable measure, however.  It shows how our business tax system compares to other nations and it illuminates the trends.  This measure shows the 3.4% average for all OECD nations over the years 2000-2005 was over 50% higher than our 2.2% rate.  Only Germany’s was lower.  And the OECD average for 2008 was almost twice as high as ours.

US corporate income tax as a share of GDP dropped until the early 1980s and was relatively stable in the range of 1% to 2% for the next two decades.  In the most recent decade it has fluctuated more but has not yet dropped back to 1% as forecast in the chart below from the Tax Policy Center.

corporate_gdp

Why do US corporations pay such a small amount of tax?  This US Treasury background paper notes that our business tax system: “includes an array of special provisions that reduce taxes for particular types of activities, industries, and businesses”.  Some of those tax preferences are reviewed in what we do not tax.   The report estimates that: “If the tax base were broadened by removing these special provisions, the top [federal] corporate tax rate of 35 percent could be reduced to 27 percent.” 

The Treasury report also points out a further complication: “A substantial share of [US] business activity and income is generated by flow-through entities not subject to the corporate income tax but instead generally taxed to individual owners” and notes that: “Although many of these 27 million businesses are small, in the aggregate they generate about one-third of business receipts and total deductions and one-third of salaries and wages … [and they] produce half of business net income”.

Unincorporated Businesses

Two thirds of all US businesses reporting profits of $1 million or more in 2004 were not incorporated, far more than in other nations.  Why?  A primary reason for business owners to incorporate is to receive limited liability protection but in the US we also have S corporations, limited partnerships, and limited liability companies that offer protection.  Legislation establishing S corporations introduced in 1986 applies to companies with 35 or fewer shareholders.  Their income is passed through to the owners for tax purposes as in a partnership.  S corporations do not pay corporate income tax.

How is taxing US businesses affected by globalization?  US companies only pay local taxes on foreign subsidiaries’ profits if they are returned to the US.  This means they can dramatically lower their taxes by recording profits in subsidiaries in tax havens like Bermuda.  Their intellectual property (IP), e.g., patents, can be owned by a subsidiary in a low tax offshore jurisdiction.  Payments to the subsidiary for use of the IP by the corporation’s high-taxed US entity reduces the US entity’s profit.  The artificial profits of the subsidiary are said to be deferred because they will be taxed at US rates if they are returned to the US, but in effect they have been transferred where they are not subject to US taxes.

Deferred_Corporate_Foreign_Earnings_2001-2010

Our business tax system greatly favors large enterprises that can take advantage of foreign subsidiary tax accounting complexities.  It benefits large enterprises in many other ways, too.  They have more access to debt financing, for example, and because interest expenses are treated as a cost of doing business, that cuts their taxes.  It is tempting to delve deeper into how large businesses and their executives are favored but the goal of these posts is to explore not detailed mechanisms of our tax system but its overall results.  The next post in this series will assess those results and how they compare to what we want.  Finally, I will explore some potential changes.

What We Do Not Tax

Previous posts in this series showed what we tax and who we tax.  Now we turn to what makes our tax system so confusing, things we do not tax.  These “tax exemptions” include income that’s excluded from taxation, deductions that reduce tax, and payments distributed to people via the tax system.

Tax exemptions are government spending that differs from spending on defense, Social Security or etc only in an accounting sense.  As the CBO wrote:  “Do you receive a tax deduction for interest paid on your mortgage or taxes to your state and local governments?  Would you think about it in the same way if instead of seeing a reduction in taxes the federal government sent you a check for the same amount?”   It makes a big difference politically.  Tax exemptions are much less visible than spending programs and they generally do not need annual funding decisions.

Tax exemptions are a surprisingly large part of all Federal spending, around 30% of the total (see August 2011 National Bureau of Economic Research (NBER) Working Paper 17268 here  They are treated differently in the budget process because they are considered to be tax cuts, which makes them less vulnerable to attack than spending.  The individual and corporate income tax code now contains almost 200 tax preferences that Treasury estimates result in more than $1T of uncollected potential Federal income tax, more than a quarter of the $4T that is collected.

Share of Spending

The next chart shows the major tax exemptions.  The Joint Committee on Taxation (JCT) and CBO estimates are lower than Treasury’s but still enormous:

  • They total more than $800B in 2012.  That is more than spending on Social Security, defense, or Medicare.
  • They will total nearly $12T in the decade starting in 2013, which is 5.8% of GDP.

CBO tax-expenditures

The largest tax expenditure is exclusion of employer contributions for health care.  Employees who get this benefit do not pay tax on its value.  It is projected to equal 1.8% of GDP over the 2013–2022 period.  Next largest is exclusion of pension contributions and earnings, estimated to total 1.1% of GDP over that period, then deduction for interest paid on mortgages projected at 0.8% of GDP, preferential rates on dividends and long-term capital gains at 0.5% of GDP and the earned income tax credit for some low-income workers at 0.3% of GDP between 2013 and 2022.   The rate of growth in value of the exemptions differs.  The deduction for state and local taxes has remained fairly flat even since 1980-4 while exclusion of employer pension and medical contributions has substantially increased.

Tax Expenditure Trends - Individual

Tax expenditures were almost invisible before 1967, when Treasury Assistant Secretary Surrey originated a list of “government spending for favored activities or groups, effected through the tax system rather than through direct grants, loans, or other forms of government assistance”.   He wanted to make them visible because tax expenditures have almost exactly the same effects as traditional spending programs on the budget, resource allocation, relative prices, and the distribution of income.   Economist David Bradford pointed out that if arms manufacturers got tax credits from the Pentagon instead of cash, that spending would not show up in the Defense budget, tax revenues would fall by the same amount, and yet government would be doing the same thing.  Only the accounting would change.

Who benefits from tax exemptions?  The following table and charts are drawn from data in the December 2008 Tax Policy Center paper, “How Big Are Total Individual Income Tax Expenditures, and Who Benefits from Them?”

Distribution of Impact Tax Expenditures Table

The exclusion of employer contributions to pensions primarily benefits those with the highest incomes.  Those in the top 20% of income get an average of 2.34% more after-tax income, for example, than they would without this exclusion.  Lower rates on capital gains than ordinary income and deduction of mortgage interest, state and local taxes and charitable contributions also offer most benefit to those with the highest incomes because they have the highest marginal tax rates.  All but the bottom 20%, however, get 1.4% to 2.16% more than they would without the exclusion of employer health care contributions.  The earned income tax credit (EITC) is the only one that significantly benefits the bottom income group, as it is intended to do.

Only the EITC is overtly aimed at a specific income group.  The others are spoken of as if they benefit society in general but they in fact benefit primarily the top 20%.  Some disproportionately benefit only those in the top 1% income group.  If providing special benefits to the top 1% or 20% was defined as our national policy, it would presumably not be favored by the majority.  But the objectives of our tax system are not defined and its special benefits are almost invisible.

The next post in this series will explore business taxes and some ways they can interact with personal tax.  That is confusing.  Partners in firm’s like Romney’s Bain Capital, for example, get taxed on investment profits at the 20% capital gains rate not the 39.6% top ordinary income rate even if they only manage others’ investments.  Executives of large corporations can defer payment of income so it is not taxed in the year it was earned.  And so on.

My intent in this and the next post is to give an overall sense of some positive and negative aspects of our current tax system for different income groups and for individual, corporate and other legal entities.  These and the two previous posts are background for an exploration of goals we might set for a tax system and the pros and cons of some potential changes.

Who We Tax

What and how much our Federal, State and Local governments tax is summarized here.  Now, who pays what fraction of the total?

We’ll start with people, then corporations.  This chart shows what % of total taxes is paid by each income group.  The lowest 20% who average about $12,400 per year, paid 16% of their income in taxes in 2009.  Less than 4%, a quarter of their total, is income tax.  The rest is sales and other kinds of tax.

The next 20% who average about $25,000/year paid 21% of their income in taxes, about 40% of their overall tax being income tax.  The middle 20% who average about $33,400/year paid 25% in total.  The next 20% who average about $66,000/year paid 29%.

The top 20% is broken down in more detail.  The lower half who average about $100,000/year pay 30% and the next 5% who average $141,000/year pay 31%.  The next 4% who average $245,000/year pay 32%.   The top 1% who average $1.3 million/year pay 31% of their income to taxes.  This means that while a higher percentage of total tax is paid by each group in the bottom 80%, the rate of increase then slows and the top 1% pays less than the 9% below and little more than the 10% below them.

Wealth, Income and Taxes - 9

What may be more surprising is the share of total tax paid by each group relative to its share of total income.  The top 20% gets 59% of all income and pays 64% of all taxes.  The bottom 20% gets 3.5% of all income and pays 2% of all taxes.  The top 20% pays a greater share of taxes than they receive of income, but the ratio is not very different across the entire range of incomes.

Wealth, Income and Taxes - 10

What is the result of total taxes on each income group?  The Dept of Health and Human Services determines eligibility for federal programs using thresholds below which families are considered to be “lacking the resources to meet the basic needs for healthy living; having insufficient income to provide the food, shelter and clothing needed to preserve health”.  The Census Bureau reported 16% of Americans below the poverty threshold at the end of 2012.

US_poverty_rate_timeline

The following table shows how average post-tax income of each income group compares to what I call “disposable income”, the difference between the poverty threshold and the average post-tax income of each group.  A single person in the lowest 20% group, for example, with a pretax income of $12,400 who pays that group’s average of 16% in total taxes has a post-tax income of $10,416, which is $754 less than the $11,170 poverty threshold for a single person.  If they had a spouse and their joint post-tax income was the same $12,400, their post-tax income would be $4,714 less than the poverty threshold.  A family of four in the second 20% would be $3,175 below their poverty threshold.  Even in the middle 20% a family of five would be living in poverty.

Income by Quintile Table_Page_1

The first of the following charts highlights the result of total taxes on the lower income 90% of Americans, the second gives a sense of the very high disposable income available to the top 1%.  In a future post I will examine what distribution of wealth Americans believe is desirable.

Income by Quintile Chart 1

Income by Quintile Chart 2

Turning now to corporations, we know they, too, pay varying combinations of income, social security, property and other taxes.  I suspect their share of total taxes and total income has a similar pattern as for individuals but I have not found the necessary data to know.  Corporations have recently grown enormously more profitable, especially large multinationals.

Corporate Profits after Tax

The effective corporate  tax rate has fallen pretty steadily from 50% at the end of WW2 to 17% now.  Since there are ways not available to smaller businesses that large multinationals can use to avoid tax, I expect the effective tax rate would be much lower for large corporations.

US_Effective_Corporate_Tax_Rate_1947-2011_v2

This is not an academic exercise so I will not try to quantify total tax rates paid by corporations categorized by their income size.  It will be more illuminating to explore in the next post what we do not tax – exemptions, deductions and so forth – and how what we do not tax impacts different income groups.

 

What We Tax

Our tax system is a lot like Topsy in “Uncle Tom’s Cabin”, who says: “I s’pect I growed. Don’t think nobody never made me.”   It growed item by item, legislative session by session, with no defined goal.   What if we had a tax goal and a budget management plan?

This is the first in a series of posts about our current system and its results.  What can be taxed falls into these major categories:

  • Income, what people and corporations earn (e.g., income tax, social insurance programs)
  • Wealth, what people own (e.g., annual real estate tax, inheritance tax)
  • Consumption, what people buy (e.g., sales tax added to restaurant bill or embedded in gas price, value added tax paid at each step from raw materials through manufacturing and retail to end user)
  • Usage of public goods (e.g., road and bridge tolls)
  • Financial transactions (e.g., stock sales)

Our current system is complex for both structural and political reasons.  We have three levels of government, each of which must fund its spending.  That’s the structural cause.  Politics is far greater.  Politicians legislate what revenue will be collected, e.g., income tax rates, and what will not, which they call tax preferences.  They are popular while increases are not, and they can at the last minute be attached without debate to other legislation.   No wonder we have so many – the Federal tax code alone grew in the past 10 years from 1.4M to 3.8M words.

Mistakes and cheating are inevitable with such a system.  And complexity leads to high costs.  The IRS estimates taxpayers and businesses spent over 6B hours in 2008 complying with filing requirements, the equivalent of 3M workers who would have been paid $163B.  That would have been 11% of total 2008 Federal tax revenue.

How much do we currently tax at each level of government?  The following data (unfortunately structured a little differently from my categories above) comes from this excellent site:

US Gov Revenue FY 2013 - 1

Total tax revenue for 2013 is expected to be around $5.6T, 52% of which or $2.9T will be Federal, 29% or $1.6T State, and 19% or $1.1T Local taxes.  Less than a third (30%) of the total will be $1.7T of individual income tax, 80% of which will be Federal.  Corporate income tax at $399B will be only 7% of the total.  Social insurance taxes totaling $1.1T will be 20% of the overall total.  Another 20%, $1.14T, will be “ad valorem”, i.e., real estate and personal property tax, sales tax, inheritance tax, etc. levied chiefly by State and Local governments.

These charts make it easier to see what taxes are collected by each level of government.

All Gov't Taxes - 2013 - 5

All Gov't Taxes - 2013 - 4

How has tax changed over time?  Total government revenue grew from 7% of GDP at the start of the 20th century to 36% now, about where it was in 2000.  At the start of the 20th century Federal tax was 3%, State 1% and Local 4% of GDP.  Driven by WW1, Federal spiked to 8% and total revenue to 15% of GDP, then Federal dropped back to around 5% through the ’20s.  The Great Depression drove total tax back up to 19% in 1933, of which 6% was Federal, 4% State and 9% Local.  WW2 drove a huge spike to 30% of GDP in 1945, dominated by Federal at 24%.  Federal dropped to 16% of GDP by 1950, jumped to 20% in the Korean War and stayed mostly in the high teens since then.  State revenue hit 8% in the 1982 recession and now fluctuates between 8% and 10%.  Local revenue hit 6% in 1982 and now fluctuates between 6% and 8%.

Wealth, Income and Taxes - 4

What was taxed also changed.  At the start of the 20th century the Federal government got its revenue chiefly from import tariffs while State and Local governments levied property taxes.  Income tax was established in 1913.  It went to 5% of GDP following WW1, settled around 2% through most of the ’20s and ’30s, spiked to 16% in 1944 and settled between 11% and 12% thereafter.  Sales and other point-of-transaction taxes doubled from 5% or 6% at the start of the 20th century, peaked in the Great Depression at 14% then dropped to 10% by 1960 and 7% now.  Fees and charges grew slowly to 1% until WW2 then faster to 3% now.  Social insurance taxes established in 1937 to fund Social Security were less than 1% in the first year, grew to around 10% in the 1980s and are now 6% to 7% of GDP.

Wealth, Income and Taxes - 5

Federal revenue is now chiefly from income and social insurance taxes.  State revenue was mainly ad valorem until the ’70s although they began collecting income tax in the ’20s and social insurance in the ’30s.  It is now about equal thirds income tax, ad valorem, and fees plus business and other revenue (56% of which is earnings on pension investments).  State income taxes rose sharply in the ’70s and ’80s, then flattened.  Local revenue is about half ad valorem taxes, half fees plus business and other revenue (40% of which is from water and electric utilities).

US Gov Revenue FY 2013 - 3

Now we know what we tax and how it changed in the past century we can in the next couple of posts see who pays what % of the total and what taxes we intentionally do not collect.

Highlights so far include:

  • Total tax grew steadily as a % of GDP for half a century following WW2
  • Total tax peaked in 2000 and is now at the same level but it has twice fallen very sharply
  • Almost half of all tax revenue is collected by State and Local governments
  • Less than a third of the total is personal income tax
  • Income tax has been quite steady around 13% of GDP since WW2
  • Sales and property taxes are around the same level as corporate income taxes
  • Social insurance tax is pretty steady at 6% to 7% of GDP (but health care spending is fast increasing)

Innovation, Capital, Jobs and Taxes

We have high unemployment in part because our financial system misallocates capital.  This post starts to explore why and what to change.

I’ll use terminology from Clay Christensen’s forthcoming book, “The Capitalist’s Dilemma” because his “The Innovator’s Dilemma” is among the most illuminating I’ve ever encountered.  Why, he wondered, was the industry leader in 14 inch computer disk drives not the leader in 8 inch, and why did leadership change again in the next generation?  Why did the same thing happen in all fast-developing industries?  It’s because, he realized, industry leaders innovate only at the high end of their market.  Innovation below their market that results first in products for new markets continues to develop until it replaces products for existing markets.

Christensen terms these revolutionary innovations that transform complex, costly products into simple, cheap ones “empowering”.  Examples include the Ford Model T, the Sony transistor radio, and the IBM PC.  These innovations require long-term capital and, when successful, they create many new manufacturing, sales and service jobs.

“Sustaining” innovations that replace existing products with new versions create few if any new jobs because those who worked on the replaced products now work on the new ones.  Sustaining innovation is attractive because it offers a faster, and in the short-term less risky, return on capital than empowering innovations.  It is insufficient in the longer term because its products will be replaced by later products of empowering innovation.

“Efficiency” innovations cut the cost of making and distributing existing products and services. They cut jobs because they streamline processes.  They also free up capital.  Toyota’s just-in-time production system, for example, enables them to operate with much less capital invested in inventory.

What we want our financial system to do is encourage capital freed up by efficiency innovation to be redeployed as investment in new empowering innovations.  We want empowering innovations because they create new consumption.  We want enough of them so they create more jobs than efficiency innovations cut.  That way, we’ll have enough jobs for our increasing population.

What is happening in the US today is too much capital liberated by efficiency innovations is being invested in more efficiency innovations.

Part of the remedy is to change how we tax capital gains.  Gains from investments held less than a year are now taxed like personal income while gains on investments held more than one year are taxed at a much lower rate, 15%.  We should change that because gains from empowering innovations come, if at all, only after considerably more than one year while efficiency innovations pay off sooner.

We should tax capital gains at a set of decreasing rates depending on how long the capital remains invested.  Rates should start at the personal income rate, drop slowly in years two and three, then faster, maybe even to zero after five or eight years.  This would have little impact on the Federal budget in the short term because capital gains generate only a small part of Federal tax revenue.  In the longer term, by encouraging more investment in empowering innovation that creates new jobs, income tax revenue should grow and Federal spending on unemployment should drop.

Unfortunately, I’ve realized I should resume exploring tax policy.  Ben Franklin famously wrote: “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”  I’ll start with corporate tax because Ben did not foresee the rise of corporations, which are by nature exempt from the inevitability of death and by trickery can also escape taxation.

Essential Financial Reforms

Congress asked the Government Accountability Office (GAO) to assess the cost of the 2007 financial crisis and if the 2010 Dodd-Frank legislation will prevent future crises.  GAO just released their findings:  “the present value of cumulative output losses could exceed $13 trillion” and “[there is] no clear consensus on the extent to which, if at all, the Dodd-Frank Act will help reduce the probability or severity of a future crisis”.  $13 trillion?  If at all?  That’s alarming.

GAO studied not just the bailout cost, which looks to be $1.5T to $3T, but the overall cost.  “While the structural imbalance between spending and revenue paths in the federal budget predated the financial crisis … From the end of 2007 to the end of 2010, federal debt held by the public increased from roughly 36 percent of GDP to roughly 62 percent.  Key factors … included (1) reduced tax revenues … (2) increased spending on unemployment insurance … (3) fiscal stimulus programs … (4) increased government assistance to stabilize financial institutions and markets.”  36% to 62% is one big jump.

Consumer spending (70% of our economy) fell, GAO notes, because: “median household net worth fell by $49,100 per family, or by nearly 39 percent, between 2007 and 2010”.  They also show the high human cost of long-term unemployment from the financial sector’s collapse.

Unemployment Rate GAOMaybe later I’ll explore why Congress passed legislation GAO found may or may not “reduce the probability or severity of a future crisis“, legislation that is both enormously too complex and not what we normally think of as regulation.  The Glass-Steagall Act that transformed finance after the 1929 Wall Street Crash has 37 pages.   Dodd-Frank has 848 and does not specify rules people must follow but new regulations bureaucrats must create along with enforcement agencies.  That’s not how we do things where I’d like to come from.

The immediate, urgent question is, what must we make Congress do instead?  Now I understand the problem (see previous pasts), the solution looks pretty straightforward:

  1. Eliminate too-big-to-fail.  The collapse of the big banks and AIG threatened to paralyze our entire economy.  They were bailed out because they were considered too big to be allowed to fail.  Businesses that go wrong should fail.  And they should fail without damaging the economy.  This means banks must be limited to a maximum of, say, 5% of total US deposits and any that become insolvent must be forced into receivership under the FDIC.
  2. Regulate derivatives.  The collapse of any one financial institution could trigger the collapse of the whole system because inter-dependencies via derivatives were gigantic and invisible to regulators.   To make them visible, derivatives must be traded on exchanges like stocks and futures, and ones that could require a future payout must be treated like insurance with their underwriters required to carry reserves.
  3. Restore 12:1 leverage.  The big banks failed so fast because their capital reserves were too low.  Our economy depends on lending and they had to stop when they became insolvent.  The SEC waiver of the 1975 net capitalization rule must be reversed and SEC discretion over the rule must be eliminated.
  4. Restore Glass-Steagall.  Tax-payers have to foot the cost of the mega-banks’ mismanagement because speculation and underwriting is no longer separate from taxpayer-backed depository banks.  The separation must be restored.
  5. Regulate non-bank lenders.  Many of the loans most likely to default were originated by non-banks who securitized and sold them.  Any institution that originates a loan must be required to keep, say, 10% of its securitized loans and absorb the first 10% of default losses incurred by investors in the securitized loans.

Among other things, the Dodd-Frank Act mandates the SEC to require US public companies to repossess executives’ short-term profits that result in long-term liabilities that require an accounting restatement.  There is also discussion of ways to make senior management personally liable in the event of a taxpayer bailout.  I have little confidence in either approach.  Compensation committees will indemnify executives from such provisions.  Shareholders and taxpayers will continue to pay.

The Justice Department recently sued S&P for up to $5B for defrauding investors with inflated credit ratings.  I assume Moody’s will also be sued because they, too,were paid for ratings by investment banks that issued  mortgage securities.   We might hope S&P and Moody’s will change the way they do business to eliminate the conflict of interest.  More proactive would be to open the ratings business to competition.

Hmm, my Buddhist practice must be helping – I got through exploring all this Washington/Wall Street malarkey without feeling angry.  I feel wrathful determination to do whatever I can to get it fixed, but wrath can be positive.

Fixing the negatives will discourage allocation of capital where it will have little or no value.  Next I’ll turn to the positive and explore what could guide good allocation.

It Takes a Pillage

Our finance system stopped allocating capital where it will have most value and efficiently reallocating risk.   Previous posts showed how deregulation and bailouts introduced moral hazard, how leaders of big financial institutions responded, and how in 2007 it all blew up.  But why did Washington allow the moral hazard to develop and respond as they did to the result?  Was there a cabal of corrupt Mr. Moolas?

Fat Cat

Probably not.  The protagonists seem genuinely to have believed markets would regulate the behavior of their participants.  When it went wrong, they did not consider it self-interested to preserve the big financial institutions they understood to be the financial system.

How we conceptualize the world is shaped by our experience.  It’s instructive to explore the experience of those whose beliefs got us so far off course but future Fed Chairpersons and Treasury Secretaries will also have conceptual blinders.  To avert repeating the catastrophe we must make structural changes.

In this post we considered Alan Greenspan’s expansion of the Fed’s mission to include managing asset prices.  His successor, Ben Bernanke, holds the same belief.  Central banks do influence asset prices while raising and lowering interest rates to help manage inflation and unemployment but they overestimate monetary policy hoping it can compensate for poorly managed fiscal policy, i.e., government revenue and spending.

What set the beliefs of Treasury Secretaries?  Robert Rubin, 1995-1999, had worked at Goldman Sachs for 26 years and was co-chairman from 1990 to 1992.  He later became a director of Citigroup and was its chairman at the height of the 2007 crisis.  Larry Summers, 1999-2001, formerly Rubin’s deputy, followed his lead against regulating derivatives and for deregulating big banks.   Paul O’Neill, 2001-2002, formerly CEO of Alcoa, deplored Bush’s tax cuts, investigated al-Qaeda funding by American allies, objected to the invasion of Iraq, and was fired.  John Snow, 2003-2006, formerly CEO of CSX, had to resign when it was revealed he failed to pay income taxes on $24M at CSX .  Henry Paulson, 2006-2009, was formerly chairman and CEO of Goldman Sachs.  Tim Geithner, 2009-2013, was at Treasury from 1998–2001 under Rubin and Summers, then President of the NY Fed.

With the exception of O’Neill and Snow who had little impact, the beliefs of all these men were shaped by Goldman Sachs.  Did they act always in what they believed to be the best interests of all the people?  Let’s assume they did.  What they believed would have led them to the actions they took.   Of course they believed big financial institutions must be saved, and of course they believed it essential to bail them out.

They may well have been right.  Deregulation probably had made the big financial institutions too big to fail and bailouts had become Washington’s Pavlovian response to confidence-threatening failure of big enterprises.

But what about after the bailouts?   We already considered moral hazard created by bailouts that protect fools from the disasters they create.  What about moral hazard created after the bailouts by weak punishment of those who committed fraud?  This is where more folks think they see Mr. Moola.

Financial institutions have agreed to settlements that sound large.  Global banks agreed to pay almost $11B in the US last year.   This January, Bank of America reached a $10.3B settlement with Fannie Mae.  The Fed and Treasury reached a separate $8.5B settlement with 10 banks, including BofA.   But no institution or executives have been brought to trial.  And while $11 + 10.3 + 8.5 = $30B of settlements is a big number, financial sector stocks in the S&P 500 earned $168B in profits last year, up 21% from 2011.  The cost of the settlements was inconsequential, $30B of what would have been $200B.

The settlements make even less difference to those responsible.  Angelo Mozilo, for example, was paid almost $470M as CEO of Countrywide Financial but paid none of BoA’s settlement for what Countrywide did under his leadership.   He did settle with the SEC on unrelated insider trading charges but even there he paid only $47M of the $67M settlement because he had a $20 million indemnification in his employment contract.  Criminal convictions have discouraged insider trading.  Mortgage and other financial frauds should also have been vigorously prosecuted.

But far more important than punishment for crimes past are major changes we must make (1) to minimize moral hazard and the likelihood of another financial crisis, and (2) so the financial system will allocate capital where it has the highest value.  The first, which I will itemize in the next post, are easy to see now that I understand the problem.  The second requires more exploration.

The Dukes of Moral Hazzard

In the world of finance, moral hazard exists when someone can profit from successful bets and suffer little or nothing from bad ones.  In the 1980s Dukes of Hazzard show the Duke boys, their beefed-up Dodge Charger and their short-shorted cousin Daisy keep foiling corrupt county commissioner “Boss” Hogg’s scams but because the well-meaning boys often bail him out, he’s always coming up with new scams.  So it has been in the world of finance for the last three decades.

Daisy Duke

Moral hazard inflated the bubble whose collapse in 2007 left us wallowing in the Great Recession.  Wall Street executives made bets that profited them immensely expecting, correctly, they would not suffer when the bubble blew.  Their firm might suffer, perhaps even cease to exist, but they would keep their profits.  Their firm might pay penalties for law-breaking, but they would not.  Moral hazard defeats what finance should do, allocate capital where it will have most value and efficiently reallocate risk.  This post examined finance’s mechanisms – securities, credit and insurance – and the following one highlighted regulatory changes enabling the mechanisms to be used in ways that led to the 2007 financial crisis.  This post explores how Washington became Wall Street’s savior.

Bailouts of individual enterprises started in 1971 when defense contractor Lockheed  was rescued from financial mismanagement with $250M of loan guarantees.  Then in 1973, the Penn Central Railroad, which declared bankruptcy in 1970 but was considered “too big to fail”, was merged by Congress into Conrail, whose operating costs Congress spent $7B subsidizing.  Next, in 1980, Chrysler was bailed out with $1.5B in loan guarantees.  So, with these bailouts starting in 1971, Washington began thwarting capitalism’s creative destruction.

Lockheed was mismanaged financially, its defense and civilian mega-projects had big cost overruns and were late, and it was bribing foreign government officials.  Penn Central’s executives utterly failed to gain operational control after it was formed in a 1968 merger.  Chrysler’s executives produced its uncompetitive cost structure and low quality products.  If, to take just one example, Chrysler had declared bankruptcy, its management would have been replaced and its contracts renegotiated.  Because it was not restructured, it inevitably failed again and leaders of GM, Ford and the unions learned they, too, might expect to be bailed out.

The Chrysler bailout, the first whose rationale was to save jobs and the economy, set an especially bad precedent.  In 1987, the Fed took the next step along that path of unintended consequences which led to the 2007 financial collapse.  The Fed’s traditional mission had been to manage inflation and promote sustained output growth by supervising credit.  Now it began trying to manage asset prices.

When the Dow plunged 23% on October 19, 1987 following drops of 4% and 5% the previous week, the Fed promised before the market opened the next day to “serve as a source of liquidity to support the financial and economic system”.  No economic event had triggered the crash.  Stock prices had simply risen too far too fast, 40% in the first eight months of the year, and there was panic at the first sign of the bubble deflating.

Why, then, did the Fed do anything?  Because Fed Chairman Greenspan saw market prices not as an indicator of the economy’s health but as something he should manage.

Market prices kept heading up through the 1990s following each downward blip, e.g., the LTCM hedge fund collapse and bailout in 1998, until in 2000 the dotcom bubble collapsed.  Greenspan then began cutting interest rates almost month to month from 6% in January 2001 to 1.75% by year-end, and he kept on down to 1% in 2003.  Consumer spending, around 70% of the entire US economy, had barely dropped; only the stock market had plunged.  Greenspan’s unprecedented rate-cutting was not required to stimulate economic growth but stock prices, which it did until the next collapse.

Interest from investment was now so low that it became essential to speculate for income – trust funds and foundations must disperse 5% of assets each year.   And speculation seemed safe because a new pattern had emerged; when bubbles collapsed, the Fed would save the day.  So houses, traditionally a safe investment, became a vehicle for speculation.  Until that bubble collapsed in 2007.

The Fed was not the only creator of moral hazard.  Congress, in the 1995 Securities Litigation Reform Act to control nuisance class action lawsuits, exempted accountants from liability for fraud by their clients.  Accounting scandals soon followed.  Enron was the most dramatic and its 2001 fall also took down its auditor, Arthur Andersen, one of the “Big Five” accounting firms.

The SEC’s contribution to the 2007 crisis was facilitation of stupidity.  From 1975, the SEC limited investment bank borrowing to no more than $12 on each $1 of their capital.  In 2004 they gave the five biggest ones a special exemption that allowed them to lever as much as 40:1.  Three years later, all five of them were insolvent.  First, Bear Stearns went belly-up in a bank run when clients fearing it was over-leveraged pulled out 90% of its liquidity in two days.  Almost immediately after that Lehman Brothers became the largest bankruptcy ever in the USA.

Bear was eased into the arms of JP Morgan with $29B of guarantees from Washington.  Lehman was allowed to fail.  Its clean assets were bought by Barclays and others.  But then Washington stepped in full force.  Merrill Lynch was helped to sell itself to Bank of America.  Morgan Stanley and Goldman Sachs borrowed massively from Washington and changed their status to commercial banks so Washington would lend them more.  The Fed bailed out AIG whose massive exposure to derivatives made it “too big to fail” and Secretary of the Treasury Paulson, ex-CEO of Goldman Sachs, nationalized Fannie Mae and Freddie Mac for the same reason.

Why were these economy-threatening institutions allowed to grow so big?  Deregulation of the barriers was strongly advocated throughout the 1990s by Treasury Secretary Rubin, formerly co-chairman of Goldman Sachs.

And why were economy-threatening derivatives not regulated?  Rubin’s advice was instrumental in that decision, too.  He later became a director and temporary chairman of Citigroup.

When asset prices tumbled as the real estate bubble collapsed, banks had to stop lending, not that there was much demand for new borrowing.  It was said to be a liquidity crisis because the big banks were, or were close to being, insolvent.  The confusion led to a Wall Street crash.  In that panic, Treasury Secretary Paulson proposed a $700B program to inject capital into the big banks and buy the junk off their books while the Fed began far more massive capital injections via all the big banks.

Pretty soon Washington (the Fed, FDIC, Treasury and FHA) had a $15T commitment of monies spent, lent, and guaranteed, around the size of the entire US economy. Much of what was lent has since been repaid because the big banks were saved and many of the guaranteed loans were sound.  Nonetheless, the cost looks likely to end up in the range of $1.5T to $3T.  Those numbers are too large to imagine.  For comparison purposes, the inflation adjusted cost of WW2 was around $3.5T.

And saving the banks but did not avert global economic recession.  Furthermore, the saved big banks are still too large to fail and their executives are still profiting as they did before when, for example, the CEO of Citibank was paid $130M from 2003 until late 2007 when Citi’s stock collapsed from 55 to 2.

I’ll explore in the next post why the people who wreaked such destruction on their employers got to keep their enormous rewards and why although their employers later had to pay big penalties for fraudulent actions on their watch, none of the executives has been indicted.

The Tent of Sherlock Holmes

Sherlock Holmes and Watson pitch their tent and go to sleep.  Hours later, Holmes jogs Watson awake and commands: “Look up and tell me what you see.”  Dutifully, Watson gathers his thoughts.  “I see countless stars,” he begins, “in the immeasurable vastness of the heavens.”  He ponders how tiny he and his friend are in comparison and can say no more.  “What is it you see, Holmes?” he asks.  “I see some scoundrel stole our tent.”

Watson sees the concept he always sees, Holmes sees what changed.   This post examined finance’s mechanisms – securities, credit and insurance.  Now we can focus on what changed to make the 2007 economic collapse possible.  Because human nature did not change, we will defer to a future post how what did change was exploited.

The combination of several changes led to the 2007 perfect financial storm.

The root cause was the Basel I agreement in 1988 which, following the messy liquidation of a German-based bank, set minimum capital reserve requirements for all G-10 banks based on the relative risk of five classes of assets.  Domestic sovereign debt required zero reserves, corporate debt 8%, intermediate types 0.8%, 1.6% and 4%.  Residential mortgages required 4%.  That got bankers thinking.  How could they keep making more loans without increasing their capital reserves?

Mortgage securitization was the first answer.  It had been developed in small steps associated with the growth of Fannie and Ginnie Mae then heavily promoted by Washington in response to the 1980s Savings and Loan Associations (S&L) crisis.  Very high interest rates established to quell inflation had caused almost a quarter of Savings and Loan Associations to fail.  Securitization attracted big investors and helped stabilize the residential mortgage market.  Now commercial banks began using securitization to get mortgages off their balance sheets so they would need no corresponding capital reserves.  They could keep the origination fees and keep issuing more mortgages.

Capital reserves could also be avoided using Citigroup’s 1988 invention of off-balance-sheet entities, e.g., SIVs, Structured Investment Vehicles, which at their 2007 peak had over $400 billion of assets.

The new mechanism for securitizing mortgage loans, the Collateralized Debt Obligation (CDO), was invented in 1987 by now-defunct Drexel Burnham Lambert to securitize mortgage-backed loans for a savings institution that later became insolvent.  Their issuance exploded to more than $180 billion by Q1 2007.  The credit quality of CDOs declined as subprime and other non-prime debt grew from 5% in 2000 to 36% of CDO assets in 2007 but the credit ratings of CDOs did not change.

Rating agencies ignored the risk of a nationwide collapse of housing values when giving CDOs the highest grade.  They also tended to give high ratings to all CDOs because they were paid for those ratings by the CDO originators.

CDOs are complex instruments.  Investors worried about the risk of default on the underlying loans.  The answer was JP Morgan’s 1994 invention of the Credit Default Swap (CDS).  In return for a small payment, the buyer of a CDS would get the full amount of the loan if the borrower defaulted (the seller of the CDS would get possession of the loan).

A CDS is different from an insurance contract because it pays off  whether or not the CDS buyer suffers an actual loss.  Unlike life or fire insurance, you can buy a CDS on a loan made by someone else.  More dangerous, the seller of a CDS is not required to have capital reserves.  And there was no oversight because CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.

Credit Default Swaps soon came to be used for purposes very different from risk mitigation.  For a small outlay you could buy a CDS to collect the entire face value of a CDO if it collapsed.  Multiple CDSs could be stacked on the same CDO and CDOs began to be collateralized by other CDOs.   It was easy to see that betting against CDOs whose underlying loans would default could generate big profits, and if you borrowed enough money to make huge bets your winnings could be gigantic.

Speculative frenzy drove the total “value” of outstanding Credit Default Swaps over $60 trillion by the end of 2007, four times as high as GDP, almost the size of the entire global economy.

Meanwhile, the Fed was holding interest rates very low to maintain investor confidence after the dotcom bubble’s collapse in 2000-2001.  That enabled lower income buyers to enter the housing market, encouraged refinancing and led to lower and lower underwriting standards that culminated in NINJA (no income, no job, no asset) loans to people who would inevitably default, but not within the 90 days it took to securitize and resell their mortgage on which the originator would keep the origination fee.

The last regulatory change for the perfect financial storm is the Fed’s relaxing of the 1933 Glass–Steagall Banking Act which limited banks’ size and barred commercial banks from securities activities.  Looser “interpretation” of the Act that began in the early 1960s was far advanced by 1998 when Citibank merged with Salomon Smith Barney, one of the largest US securities firms.  In 1999 the Act was repealed altogether.

The financial system was soon dominated by behemoths.  In 1990, the 10 largest US banks had almost 25% of the industry’s assets.  That grew to 44% in 2000 and almost 60% in 2009.  The two biggest banks in housing finance had 44% of US mortgage originations in 2009.  Oversight, or indeed management, of these giants whose operations are global, complex and opaque became, and still is, little more than a hypothetical possibility.

When the $22T housing bubble burst in 2007, around $5T was very rapidly lost.  Financial institutions had too little capital reserved to cover such a loss and unknowable inter-dependencies.  They had traded so much with each other that failure of one would likely bring down others.  The CDS insurance sold by AIG and others to mitigate the risk was useless because they had no reserves to compensate those whose assets were suddenly worthless.

That was when the final change took effect, a non-regulatory one.   In 1998, Long-Term Capital Management, a hedge fund that used 100:1 leverage to buy over $100B of emerging market bonds and $1T of derivatives, had lost $5B when Russia defaulted on its debt.  Fearing market panic, the Fed pressured the banks that lent the $100B to buy LTCM’s assets so it could be promptly liquidated.  Wall Street executives learned from that event.  They would likely be bailed out, too, if their bad bets were big enough to shake the markets.

When the banks and shadow banks bets did go bad in 2007, Washington stepped in with $2 trillion of tax-payers’ money to halt what was fast shaping up to be a potentially economy-wide bank run.

Financial institutions had come under stress because of bad bets, which their high leverage turned into a crisis with potentially huge domino effects.  We cannot know how serious the results would have been if the crisis had been allowed to play out.  We do know the leaders of the giant financial institutions got the one critical bet for their own future right, the Federal Reserve and Treasury did bail them out.

I will next explore how that financial moral hazard developed; how Washington came to be Wall Street’s savior and made financial and economic crisis inevitable.