The Undertaxed American Middle Class

In the Forbes column we quoted in the previous post ("Undertaxed America"), Bruce Bartlett referred to OECD data in making his case. Clive Crook referred to OECD data as well in a post on taxes in his Atlantic blog earlier this week ("America's widening fiscal gap"):

Mr Obama intends to squeeze the rich, but the scope for this may be more limited than US liberals would wish. Few Americans seem aware that the US income tax code, as a recent Organisation for Economic Co-operation and Development study showed, is already one of the most progressive.* Even before the rise in top marginal rates promised by Mr Obama, the US income tax collects 45 per cent of its revenues from the highest-income decile. Compare that with Britain at 39 per cent, Canada at 36 per cent, France at 28 per cent, Sweden at 27 per cent and an OECD average of 32 per cent.

This difference is only partly explained by the less-equal US income distribution. The fact that the US has no broadly based national sales tax - value added taxes make Europe's overall tax codes less progressive still - only underlines the point. The US tax system raises comparatively little revenue; what little it raises already comes disproportionately, by international standards, from the rich.

I have previously argued that the US will need a VAT [value added tax]. Even before Mr Obama unveiled his ambitions for healthcare reform, wage subsidies to help the working poor, better education and the rest, the US middle class was seriously undertaxed. The government's promises, on present plans, will be unaffordable. If they are honoured regardless, the only question is which comes first: broadly based tax increases or fiscal collapse.

I have wondered if there might be a simpler way to tax Americans' consumption than to implement a value added tax. Since income taxes in the U.S. are highly progressive, and IRAs and 401(k)s don't offer deductions for payroll taxes, there is little incentive for Americans in lower income quintiles to save instead of consume. For example, according to CBO data, effective income tax rates for Americans in the bottom two income quintiles were negative in 2005 (i.e., these Americans received more in transfer payments than they paid in income taxes). So why not just increase the payroll tax by some amount and then allow workers to deduct up to that entire additional amount if they make an equivalent contribution to an IRA or 401(k)? Those who contribute less than that additional payroll tax amount to their retirement accounts will be paying a de facto consumption tax.

The image above accompanied the Financial Times column from which Clive Crook quoted himself in his Atlantic post.

A Thought-Provoking Post by Aaron Edelheit

It turns out that Aaron Edelheit has a blog ("Investing in a Life of Value"), and a rather eclectic one at that. In addition to investing, Edelheit writes about religion, self-improvement, humor, and healing the world. A gentleman and a scholar, apparently. Here's a thought-provoking post of his about investing from last month, "Thinking of Investing in China?". Excerpts:

4.71%

That is the average annual return from investing in the MCSI China index since March 31 1998. This despite 40% average annual returns in the past five years.

I use this startlingly data point to make a much larger point. Sometimes large economic trends do not make great investments. And obvious top down trends don’t always make good investments.

[snip]

I believe China faces some serious headwinds going forward. Everyone seems to think China can spend anything it wants on commodities such as oil, iron ore, copper, etc., but they don’t. And when you add in the fact that China is about to start importing vast amounts of food as well and that they have a problem with water and one realizes that the country has serious import problems to overcome. And this doesn’t even take into account, the lack of accounting standards, mounting banking problems, a surging gap between between rural and urban Chinese and a lack of clear private property laws.

So before commentators and so-called experts try to convince you to invest in something hot like China consider the longer term record of investing in the country and look deeper into some of the issues affecting the country, you might be surprised by what you learn.

For the record, I have no investments in China or any company listed anywhere that has major operations in China. For reasons I cite above, I believe there are better risk/reward situations elsewhere, especially in North America.

This post reminds me of an article I read several years ago on the trade website 401kwire (bear with me for a moment, and you'll see where I'm going with this.) At the time, I was working in business development for a start-up company in the 401(k) industry. As a web-based, mostly paper-less enterprise, my company could profitably administer retirement plans for small companies. One of the bullet points we mentioned to potential investors was that (I forget the exact numbers) 80% of American small businesses with fewer than 100 employees didn't have a retirement plan, and that represented a huge potential market for us (of course, a significant percentage of these small business had high turnover, or low-paid workforces that could make a 401k impractical, etc.). After a couple of years at this company, 401kwire published an article in which the writer called the small plan market the "China" of the 401(k) industry. The writer dug up a quote from the late 19th Century by an officer of an American company that manufactured matchbooks, in which the American businessman spoke about the potential profits from selling matchbooks to however many Chinese there were back then. His point, of course, was that sometimes markets that look like huge potential opportunities remain potential opportunities (as opposed to actual ones) for a long time.

Edelheit makes some good points about the challenges facing China, and the risks of investing directly in the country, but I think there are ways to profit from the industrialization of China indirectly, by investing in companies based outside of China that are positioned to benefit from this trend (e.g., companies exporting food or raw materials to China, etc.).