Here Comes the VAT

When I was a youngster, I went to see Cecil B. DeMille movie  The Ten Commandments.  I was captivated by one character in particular.  This was the Angel of Death.  For those unfamiliar with the story Moses is attempting to convince the Egyptian Pharaoh to free the Israelites from bondage.  He brought down nine plagues upon the Egyptians due to the Pharaoh’s intransigence.   Actually, God brought forth the plagues; Moses was just His mouthpiece.  Finally, God gave the Biblical equivalent of the nuclear option: death to the first-born of the Egyptians.  He instructed Moses to mark the doorways of the Israelites’ homes with lamb’s blood so the Angel of Death would pass by these dwellings.  This is the origin of the important Jewish feast of Passover.  (In the movie  the special effects team used  dry ice to portray the Angel of Death.  They created a mist-like cloud that wound its way through the streets wreaking its vengeance on the Egyptians.) The angel  was a silent, insidious killer.

What does that have to do with the VAT, value-added tax, you may ask?  In my mind, the VAT is a silent, insidious killer, too.  While the Angel of Death was doing God’s work, though, the VAT is more akin to Satan’s.

The incessant rumblings about considering the imposition of a VAT in the US are due to the federal government’s need for staggering sums of tax revenue.  I’m not engaging in hyperbole here.  Even eighteen months ago the sums required would have been inconceivable; not so, today.    Congress and the president have obligated the US taxpayer beyond what is collectible from the income tax code.  The irony here is delicious: the pock-marked (read: loophole or exemption ridden) code will now prevent the government from generating sufficient revenues.  A simpler tax code, a flat tax would be best, would generate the most revenue, and allow the economy to produce at its maximum capacity.  Unfortunately, a flat tax eliminates the ability of politicians to buy votes by granting exemptions for whatever “worthy cause” is groveling for favors.

A good tax needs to have three characteristics: 1) it needs to be transparent; that is, one should be able see the amount of the taxes collected.  The income tax code is the exemplar.  Nothing is hidden; the code may not make any sense but one can easily see what he is paying; 2) it should be broad-based so that arbitrary exemptions are eliminated; and 3) it’s rates should be low so as to minimize the distortions that any tax will cause.  The VAT fails completely on the first characteristic.  It is the Angel of Death: a silent, insidious tax.  It is nigh onto impossible for a consumer to determine how much of the price of a good he is buying represents taxes.  This is one reason politicians like it; it is hard to trace it back to them.  It is broad-based but for the wrong reason; it is such so as to collect as much revenue as possible.  Given our political will it will become pock-marked, too.  Finally, it won’t be low.  It will generate scads of money and this will enable politicians to engage in their favorite pastime: buying votes.  The politicians won’t be satisfied with funding the current panoply of programs that are bankrupting us, they will conjure up new ones.

It is important to realize that it will NOT replace the income tax, especially considering that 50% of Americans pay zero, or less, in federal income taxes.  As such, it will be a close to a 20% decrease in the standard of living, if we use the average European rate.   I say close to because it will fund the many goodies that emanate from D.C.  If Americans were given the opportunity to buy these goodies from Govt. Inc. they would, in many (most) instances opt not to buy them or buy them in vastly reduced quantities, but they would buy some of them.

Let’s look at the comparative economic performance of the European community, specifically: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Slovak Republic, and Spain; with that of the US over the 18980-2008 period.  In 1980 the European community, VAT taxers par excellence, had 118 million people employed.  Twenty-eight years later employment was 143.2 million, an increase of 25.2 million.  Germany and Spain accounted for 11.8 million of this increase.  The percentage increase was 21.4%.  Turning to the US, its employment was 90.5 million in 1980 and 136.8 million in 2008, an increase of 46.3 million, or a 51.1%.  In the US tax rates were cut over most of this period, while the Europeans continued to levy the insidious vat.  It doesn’t take a social scientist to be able to discern which one did better.  Spectacularly better, I might add.

Raising tax rates has never reduced the deficit.  The budget surplus in the Clinton years was due to the decrease in the capital gains tax rate, which Clinton opposed by the way, that generated a veritable gusher of revenues.  In the Reagan years the tax rate cuts increased the tax revenue substantially, even though Congress couldn’t resist spending even more.   Similarly, Margaret Thatcher’s tax rate cuts in the UK brought prosperity.  Politicians don’t like self-generated prosperity since no one will turn to them for help.  They will have become redundant at best.

An unintended consequence of imposing a vat in the US is that it will make foreign goods cheaper.  You may counter,”no, they will be taxed at the checkout point, too.”  Ah, yes, those goods that are imported to the US will be but not those consumed outside the US.  We can expect to see fewer vacations to Florida or other US destinations and an increase in trips abroad, since the latter will now be relatively cheaper.  Never underestimate a politician’s ability to not think ahead and examine the secondary impacts of decisions.

I think it goes without saying that I’m not a fan of a VAT.  In order for the US to continue to prosper and grow, it needs to reduce tax rates and cut spending across the board.

Posted by Jim

The Data Delusion

A few months ago my favorite newsweekly, The Economist, ran a cover story titled “The Data Deluge” that expressed misgivings about the quantity of data being generated. The Economist’s title went with the flow of water-based metaphors for data overload including: deluged, drinking from a fire hydrant, swamped, drowning, sinking under, treading, etc. As the authors note, torture data enough and it will confess to anything so it’s only a matter of time before someone coins the term data-boarding for the condition. This note begins to explain why the whole notion of systemic data overload strikes me as one of those bogus alarms such as culture shock that is predicated on a contrived imbalance.

“The Proliferation of Data is Making Them Increasingly Inaccessible”

The Economist notes that we have moved from an era of scarce data to one of superabundance and bemoans the shortage of storage capacity relative to data being generated, invokes security and privacy issues, and reports the lament, quoted above, of astrophysicist Alex Szalay, that the proliferation of data is making them less accessible.

Economists have long realized that relative volume is a lousy measure of relative value as revealed by the diamond-water paradox. Having more of something than we “need” or can currently use is not obviously a problem: we use only a portion of the water on Earth but don’t worry overmuch about the “surplus” that goes untapped. This is a very different picture than that of Szalay’s implication that a lot of very valuable data are being wasted for want of adequate bases to store and analyze it.

It is unclear to me how previously unknown or unsuspected data, however difficult or costly to access today, can possibly be less accessible than it was when its existence wasn’t even suspected yesterday. Maybe it’s the data on the dark matter that apparently makes up a great deal of the universe even though we can’t seem to find it. How are we worse off for not being able to access information we didn’t even know existed before now? If the data went past a black hole’s event horizon it’s lost forever but if it is just out there waiting for the right theory and tools to guide us to it, we can relax.

Perhaps Szalay believes that evidence of intelligent life, other habitable planets, or new insights into the cosmos’ origin and fate is contained in the gazillions of electromagnetic signals captured each day but we can’t see it because of the clutter.  That may well be but without appropriate models to identify and make sense of it, the data is neither valuable nor useful. This point is illustrated by the accidental discovery in 1964 of the cosmic background radiation left over from the “big bang” by Arno Penzias and Robert Wilson. This event might look at first like finding an unanticipated needle in a very, very large haystack but in fact Penzias and Wilson, after removing the pigeon poop from their antenna and thus eliminating their initial hypothesis, had no idea what they had found. Fortunately Princeton astrophysicists Robert H. Dicke, Jim Peebles, and David Wilkinson, had already anticipated the leftover radiation phenomena and were preparing to search for it when word of Penzias and Wilson’s “discovery” reached them. The Nobel committee awarded the physics prize to the clueless and ignored the scientists who predicted, explained, and verified the finding. At best Penzias and Wilson were guilty of pattern recognition while Dicke, Peebles, and Wilkinson were committing science.

For expository convenience The Economist conflates data and information but in doing so it obscures a very important distinction: data has a high degree of entropy whereas information is data passed through a local entropy reducing mechanism such as a model. The event horizon of interest is the area illuminated by the model or hypothesis not by the collection of data. The location of that horizon is largely a function of search costs and expected returns. Models reduce search costs and often also increase returns to search.

Over 50 years ago, the great economist George Stigler set out the economics of information. His model applies still in today’s era of “big data” although The Economist’s article makes no use of it.  Stigler explained searching for and advertising prices in a world where prices were dispersed and search (a form of data creation or collection) and information were not free.  He showed that buyers would engage in search up to the point where, at the margin, the expected value in the form of a lower price was just equal to the incremental cost of search. On the other side of the market, sellers engage in advertising (data provision) in order to reduce buyers’ search costs and therefore increase the likelihood that buyers will find them and purchase from them. Whenever buyers (users) and sellers (providers) engage over time in trade based on their respective costs and returns an evolutionary process or game ensues in which changes in one or the other party’s’ costs or returns stimulates a reaction on the part of the others.

If we substitute the actions of the producers of data (or the means to create it) and those of the users of data for the buyers and sellers in Stigler’s example we can understand the dynamic interplay and evolutionary growth of the market for information. Today’s providers of data or the means of creating it have been increasing its availability and reducing the costs of acquiring it, much like the appearance of the telescope in Galileo’s day increased the available data about our solar system. But without a fairly good understanding of planetary movements, Galileo would have been hard pressed to locate Jupiter much less discover its four largest moons. Once the increased  returns (information) to searching the night skies became evident, scientists spent much more on search and began working off the huge data “deluge” created by the introduction of the telescope.

“Understanding Turns Out to be Overrated, and Statistical Analysis Goes a Lot of the Way”

Princeton’s Edward Felton’s statement, quoted above, goes to the heart of my discomfort about the way we manage many large databases and squeeze information from them.  When I was a young analyst, my mentors instructed me to focus my searches and avoid “boiling the ocean.” They instructed me to economize on time and data by establishing first a hypothesis using an appropriate economic model and then testing that model using the available data. The results of this exercise sometimes produced useful information – the pattern or relationship among the data. This was a practical application of the scientific method that comprised observation, hypothesis generation, prediction, and experimental validation.

But today supercrunching and data mining (aka pattern recognition) seem to reverse or depart from the scientific method. The ocean is first boiled, data is looked at from every which way and inferences are made from the patterns that emerge. Connections and correlations are identified rather than confirmed or tested against models. In some cases of course, new patterns are discovered that lead to new models. But in practice there seems typically to be no hypothesis generation stage, we move directly from observation to prediction.  I can’t argue that the patterns that emerge from data mining statistical analyses aren’t valid but it is hard to grant them the status of explanatory models. At best, it seems to me, the crunchers have greatly increased the efficiency of pattern recognition in the observation stage. This is extraordinarily valuable in some cases and, I believe, dangerous in others.

Does finding all the statistical correlations in a pile of data really reverse the entropy of the data pile? Without determining causation as well as correlation – are we really increasing the degree of organization? I suppose that we do in the same way that removing the sedimentary rock around a fossil reveals more information but I am unclear whether this rises to reversing the local entropy and welcome comments and guidance from readers.

Evolutionary economists use the phrase “routines as genes” to express the tendency toward behavioral continuity of firms  and it can be extended logically to individuals. It seems to me that without the modeling or hypothesis generation stage, our predictions are limited by an unspoken assumption of complete or nearly complete behavioral continuity. All evolutionary systems exhibit some form of behavioral continuity – selection wouldn’t make a lot of sense if the next generation operated substantially differently than its parents. But, that continuity also makes the species vulnerable to sudden environmental change – think very large meteor at the boundary of the Cretaceous and Tertiary periods.

This assumption of behavioral continuity or stable correlative relationships seems to work well in many cases but it may leave us open to disaster when those correlations are snapshots of the temporary outcomes of systems we don’t understand very well – such as the interrelationships of risks in a complex economy. How many derivatives were designed based on faulty understanding of correlations among underlying assets or subject to more multi-collinearity than suspected, or vulnerable to unsuspected network effects and acceleration?  My guess is a lot.

Posted by Bob

Are things as bad as they appear or have we just hit a soft patch in the road?

Recently, a good friend sent me an email with the following (in bold) observations and concerns asking for my take. He is concerned about the state of our country and, by implication, that of the world. He is one of the more thoughtful and reflective individuals I know. He is bright and not prone to hyperbole so when he becomes concerned then I believe it is worth thinking about his issues. Needless to say, I am flattered that he thought I might have some useful insights into these topics. They follow.

China – They are no ally but an intransigent competitor militarily and economically.

As the British Lord Palmerston said, “We have no eternal allies, and we have no perpetual enemies. Our interests are eternal and perpetual, and those interests it is our duty to follow.”
I believe that China thinks the same way. The well–being of mankind is irrelevant to them as long as they can sell another widget (the Germans fit this description, also). The leadership is trying to stave off the inevitable demise of totalitarian rule by clamping down on the internet, etc., but the genie is out of the bottle. As Marvin Zonis of the University of Chicago Business School has said, “the only ideology in China today is to get rich.” Eventually their army won’t shoot their fellow countrymen. In order to delay this from occurring the leadership needs a bad guy: the USA, as usual, is the easiest target. They have a problem, though, which is the flip side of ours. If our debt to them gets beyond our ability to service it, our economy will spiral downwards. Who, then, will the Chinese sell to? They have a vested interest in the robustness of the US economy. They are going to have to recognize that revaluating the Yuan will be required in order to maintain their economy; mercantilism doesn’t work any better today than it did 300 years ago.

Housing – So many in default.

I’m dismayed at the govt.’s response. The banks and the borrowers would have had the incentive to renegotiate the terms of the loans until the Feds stepped in. Everyone thought that the govt. could make them whole. They can’t; prices will take years to recover in some markets, especially those that the govt. intervenes in. Real estate needs to be removed from the politicization racket if we want to make properties affordable again. The fact that some mortgages are “under water” is not necessarily a reason to default or encourage default. If that was the case every auto loan would be defaulted on since they are almost always under water over its whole life. Those loans that were taken out by people expecting to ‘flip’ the property and now can’t shouldn’t be included in any bailout or loan forgiveness program. We don’t do that for individuals who buy shares of stock hoping to sell at a profit but wind up with shares worth less than they paid for them. If people are bailed out, guess what? We will encourage this practice in the future based on the belief that the taxpayers will make them whole. Not a bad racket: heads I win, tails you lose.

Real Estate and Commercial Real Estate – The banks have not told us what the real prospect of default is.

Where are the SEC, the FDIC, the Fed, and the accounting firms in all of this? Banks are supposed to write off assets when they know that the value is impaired. There are too many buildings that don’t cash flow sufficiently to support the mortgages and are unlikely to for years to come. The handful of banks that are big RE lenders are going to be in real trouble.

Consumer demand/sentiment – Remains low – people are holding back, and our businesses are so leveraged they need the few percent being cut by consumers.

The government’s policies are exacerbating this. Job creation has been anemic given the amount of stimulus. With weak job prospects people are not going to spend on durables or anything that smacks of extravagance. This will reinforce firms’ decisions to limit hiring.

Debt – Think it is controllable – but will be an ongoing drain.

See below under government

Fed – How long can Bernanke keep the economy up?

This will be the greatest feat of Central Banking virtuosity if they can drain the liquidity from the system without tanking it. The fiscal side isn’t making things any easier. Bernanke’s testimony on the inability to sustain this level of total government debt and annual deficits without substantially higher levels of taxation or, by implication, repudiation of the debt through inflation at Latin American levels, should be sobering to the Congress. It wasn’t, I’m afraid.  As Santayana said, “those who forget history are forced to repeat it.” The inflation in the Carter years almost tore this country apart. The ensuing recession to eliminate it was also costly.

Global Trade – Years ago thought it would go against us for the most part. How do you compete with billions of Indians and Chinese that will work for a $1 a day?

Their productivity and quality still are below ours. China is going to have to gradually revalue its currency (see above). I’m not so sure the anecdotal evidence about a worker being paid only $1.00 for making a sneaker that sells for $150 makes the case. At the local GM engine plant, the biggest and one of the most efficient in the world, one line produced 155 engines per hour. A worker was paid, including benefits, say $80/hr. That means he’s getting paid a little over $.50 per engine. And we know that GM wasn’t getting rich. In the 1930s and 1940s textile manufacturing migrated from New England to the South. In the 1970s and 1980s they migrated overseas. This process will continue especially if the US persists in piling mandates on employers.

Demographics – Europe and Japan and even China to an extent are coming disasters.

Europe would be classified as junk debt for its political cowardice. Again, they need to remember Santayana’s dictum. They have, in their midst, people who want nothing to do with their society or culture. These people, primarily Muslim immigrants and offspring of these immigrants, are taking advantage of the European intellectuals’ guilt (for God knows what) to sponge off countries they abhor. This is suicide on a continental scale. China is going to have an Islamist problem in its western provinces. They should not be playing buddy-buddy with an Iran who foments trouble everywhere. The Russians shouldn’t either since Jihadists are even a bigger problem for them, witness the recent Moscow subway bombing. I don’t know what Japan is doing and I’m not sure they do either. They seem to play everything by ear and fight fires as they arise.

Government – It is just unmovable.

It is stunning to watch Congress in action. They pass legislation that says any new spending has to be paid for with a cut somewhere. Along comes extending unemployment benefits, with a $10B tag, chump change by current standards, and they can’t even find that kind of money in a $4Tr budget. They just don’t get it. Years ago, when I was in Grad School and people were concerned about the US debt, the rebuttal was that we owed it to ourselves, so it wasn’t an issue. Well, today, we owe it to others and its size, and its projected size, are beyond comprehension. State governments are as bad or worse. Their implicit assumption in addressing their budget woes is that “a miracle will happen” and we will be relieved of having to make the decisions we were elected to make.

Healthcare – It is going to swallow us unless we are serious about cost control. That will be a tough fight – economic, religious, political, etc. In the end, I think, we have to ration – somehow cut expenditure near life’s end.

You are right. This current legislation won’t cut costs or really improve overall access to quality medical care in the US. We ration health care now but it will be more arbitrary and extensive in the future unless this bill is repealed. The biggest problem with health care costs is that the consumer is oblivious to them. Deductibles really aren’t high enough. There is no expectation that people have an obligation, to themselves, for their own health. Annual physicals, better diet, and more exercise should be expected of people. Insurance is not for piddling things. It is there to prevent an unforeseen event from bankrupting a family. Today it is viewed more as a Christmas club account.

Banks – I don’t trust them and wonder what the next shoe to drop is.

I have worked in banks at one time or another for over twenty years. While they have many bright people they are institutionally ignorant. They seem to have an extraordinary ability to engage in self-delusion. For all of their ability to access sound economic reasoning they persist in acting as if the laws of economics don’t exist or that they have somehow found the key to alchemy.

Countering all this is:

Maybe we’ll get tough with China on their low valued currency.

See above about their own need to confront this issue.

Our assets still exist – a house is a house even in default and prices will adjust.

This is an important point. The houses didn’t vaporize just the potential sales price. The fact that many have mortgages in excess of the potential sales price is no reason to interfere with this market. Houses still provide a stream of consumption services: a domicile to live in.

A few scientific things on the horizon – cheap gas, other forms of energy.

We could solve many problems, both domestically and internationally, if we would really allow oil and gas exploration in the US, as well as permit more nuclear power plants to be built. The environmental issues are grossly overstated. We have been drilling in the Gulf of Mexico for years with no problems, this, mind you, in spite of hurricanes like Katrina et al., occurring every year. The oil companies have been in the North Sea for years with no environmental problems even though that is one of the harshest places to explore. Allowing domestic exploration would cause the price of oil to drop under $50/bbl almost immediately. This would stop the activities of Hugo Cahvez, Vladimir Putin, and all of the rest of the OPEC crowd from fomenting problems outside their own borders. It would reduce our military expenditures, stop our pathetic fawning to these clowns, and increase employment and cash flow right here in the US.

We have the best military if we need it and can still impose some sense in the world.

Unfortunately, we currently have a president who is embarrassed by our ability to address problems. Even Hillary Clinton understands the need to occasionally project force at the bad guys. Who would have thought that she would be considered the hawk.

We still have reasonable measures of productivity and other things that produce wealth – aside from the fact that our 100 year old pipes are disintegrating.

You hit upon an important point. The private sector maintains its capital stock, the public sector doesn’t. The states and municipalities need to recognize the necessity to embark on a 10 – 20 year overhaul of the infrastructure. They can’t continue to ignore it while buying votes and thinking tomorrow will never come. It has arrived.

There must be some other good news – like a bit of international cooperation – if not altruistic – so we all don’t become Greece.

International cooperation be damned: we need to tell the rest of the world to get real. International law is a figment of peoples’ imaginations. It is like breaking a luncheon appointment.

Does this mean that the future is bleak and we are about to revert to a Hobbesian state of nature where “the life of man, solitary, poor, nasty, brutish, and short.” I do not think so. Americans, in particular, are resilient and inventive. It is clear that the majority of Americans have serious misgivings about the country’s current direction. As such, they will demand that we tack back. As long as the free market exists, individuals’ ingenuity will be rewarded and they will generate ideas and products that solve our current problems while setting the stage to address the wave of challenges. The key is that people our allowed free expression. If we get to the point that it takes a child to point out that the emperor has no clothes, then we will be in trouble because our media elite have abdicated their responsibilities, society’s that live a lie are doomed. I, for one, put my money and faith on the former: Americans can and will get the job done. Most importantly, the good news is that baseball season has started. As long as that happens, everything else will eventually come around.

posted by Jim