The Public Policy / Taxing Interest Rates

...They aren't high after all...

...In the f i r s t place, the money so saved is "earmarked" for home mortgages and agricultural machinery...

...President Reagan benefited from both the positive and the negative aspects of Carter's gesture...

...It is as plain as can be that our tax code has got this back to front...

...This came across as something more than accepting the inevitable...

...For many Africans, Asians, and Latin Americans, the first suspicion that the President of the United States might indeed have a foreign policy came with a doomsday thud...

...W.hat is needed is a savings inducement ' which permits the savings to flow into the "supplyside" at any point in the economy...

...So the problem is that if you earn i n t e r e s t , you quite probably have to give h a l f of it back to s t a t e and f e d e r a l governments...

...It takes time to sort all these things out, but by now most lenders have sorted them out, and have within the past year moved to offset (by demanding higher interest rates) the various penalties imposed on savers in an age of inflation...

...That meant 14 Third Worlders with grievances, individualized and general...

...It is hardly necessary to point out that we...

...The President could, however, point to a personal victory in the relationship he developed 'with President Lopez-Portillo, in advance of Cancun...

...The face-to-face test did not come until Canct~n, where Ronald Reagan in person met with the leaders of 21 pivotal countries...

...I n 1931 Keynes wrote in Essays in Persuasion: "The best guess I can make is that when you save five shillings you put a man out of work for a d a y . " Fifty years l a t e r the 22 THE AMERICAN SPECTATOR JANUARY 1982 political economy is managed as though this were still true...

...It was not only a matter of not making Carteresque gaffes--no remarks about Montezuma's revenge and no proposals for giant fences along the Rio Grande...

...Why were lenders willing to accept a negative yield until July, 19807 It is difficult to answer this question (Milton Friedman recently puzzled over it, to no avail, in a Newsweek column) because it is never easy to provide a convincing account of irrational behavior...

...The government spends more than it takes in, and so has to borrow the deficit from you and me...

...But now we must consider an additional matter: What is the real, after-tax return...

...It is hard for us even to conceivs~ of such a thing today, but the purchasing power of the dollar actually i n c r e a s e d year by year...

...The same message was encapsuled 24 THE AMERICAN SPECTATOR JANUARY 1952...

...Inflation meanwhile has advanced at an annual rate of eight percent (let us be a shade on the optimistic side...

...The last time the New Economic Order came up, poor Jimmy Carter refused to go...

...His effective i n t e r e s t rate is now 9.6 percent, because this time he can treat interest paid as an expense that can be deducted from income, thus lowering his tax burden...

...Deflation itself is a rare phenomenon in the history of money...

...And at even h i g h e r income levels the tax rate o~ interest rises to 70 percent...

...The President could not claim credit for the oil glut that made the Mexicans approvr the petroleum stockpiling purchases the OPEC nations banned--a development that weakened the OPEC nations' ability to threaten and demand...

...The locus of innovation cannot be f o r e s e e n , as George Gilder has reminded us...

...And Washington thinks that Wall Street should be responding more affirmatively to the Economic Recovery Tax Act...

...If Mr...

...As long as inflation ~n the interim does not erode the value of these figures too badly, the result will be an improvement in the savings rate...

...This may well be close to the 1981 inflation rate, as it happens, but bear in mind also that the Consumer Price Index tends to exaggerate inflation by a couple of points, because it gives undue emphasis to housing costs...

...The truth is that it takes people time to learn what is rational and what is not, especially when such arcane matters as inflation, interest rates, taxation, and the interaction between all three are at issue...

...will remain at 50 percent...

...The Reagan luck went a long way...

...but "why were they so low until so recently...

...Knowledge does not find its way instantly into prices, despite what "random walk" market theoreticians believe...

...Feeling we are treated with respect, we can do anything," he said...

...Unfortunately, it is as inescapable as the laws of mathematics that you cannot encourage saving without at the same time making life somewhat easier for people in the upper income range...

...Cancun, bf course, was projected in terms of a New Economic Order, an occasion for redistributing world resources between rich and poor nations and other utopian concepts dear to enemies of imperialism, neocolonialism, and the rest...

...You lend the government $10,000, and the government pays you 16 percent annual interest...

...and not merely an age of inflation, but one in which the ghost of Lord Keynes still roams the halls of Congress...

...What is a " h i g h " s a l a r y - t h e s e days ? Well, if you are single and you earn $41,500 the government considers that you have a high salary because anything you earn above that amount, including all i n t e r e s t , is taxed at the 50 percent rate...

...In fact, what we really need is a law exempting the inflation component of all interest from taxation...

...That is to say, what is the return (or "yield," as it is sometimes called) after inflation has been subtracted from the remainder...

...S P E C T A T O R ' S J O U R N A L REAGANISM MEETS THE THIRD WORLD by Anne C r u t c h e r I n Washington, D.C., people are still shaking their heads and saying Ronald Reagan has no foreign policy...

...Looked at this way, i n t e r e s t r a t e s today are not high at all...

...In any event, the mathematics are clear enough...

...p e r c e n t tax bracket who is paid interest at the rate of 16 percent, in a year when inflation steams ahead at the rate of 9.6 percent, is breaking even and no more...

...There are some people with Tom Bethell's "Capitol Ideas" appears each month in these pages...

...Can Keynes have foreseen how much of these words would apply to himself, 45 years after they were written...

...Congress must t h e r e f o r e dare to run the gauntlet of the envy-arousal brigade in the U.S...

...There may have been some excuse in 1931 for Keynes's strange calculation, because that was a time of deflation...

...This time, thanks to our absurdly antiquated tax laws, interest paid is tax deductible...

...This problem can either be solved by improving the incentives for, and thus the supply of, savings...

...He is t r e a d i n g water...

...live in a very different climate today--one of inflation...

...To begin with, following Jimmy Carter was in itself a break...

...The Times several times in recent weeks has called for a delay in the implementation of the tax cuts, ostensibly to reduce the budget deficit...

...Returning to convertibility at the old parity level--a matter of prestige really: pretending that "the pound was worth a pound" when it no longer was--had the effect of tugging all other prices back down toward t h e i r prewar level, bringing about depression and unemployment in the process...

...But the whole $1600 is t a x e d - - a t a rate which of course depends on how much other income you have earned in the course of the year...

...What simple movie actor would be capable of implementing his benighted views...

...It was in this climate that Keynesianism emerged...

...Lopez-Portillo himself has been outspoken on the importance of demeanor...

...Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist...

...Interest paid, on the other hand, is a tax-deductible expense of living...

...This has, however, been changed by the new tax law...

...In all, a dubiously digestible ragout of ideological hostility, tender vanities, real needs, intramural rivalries and impulses to haze the new boy...

...There is no puzzle about a 20 percent prime rate, however, when you bear in mind the paradoxical fact that the United States tax code deliberately and consciously sets out to discourage saving and encourage borrowing...

...What about the new tax code, which went into effect on October 1 ? Will it make a difference...

...Multiply this by 12 to find the annual rate, and you arrive at 9.6 percent...

...What is needed is a bill that will encourage people to save as much as possible...

...Inflation alone is sufficient to d e t e r saving, of course, since it erodes purchasing power, but on top of that we actually have a government that takes away our i n t e r e s t when we earn it and gives us a tax break when we pay it...

...They are the ones who do most of the saving, after all...

...They took it that, where Jimmy Carter had human rights, Camp David, and Andy Young, his successor has only the reflexes of an old redbaiter who likes rich people and is ready to let the poor eat jellybeans...

...If someone offered you 12 percent for your money early in 1979, it probably seemed generous at the time...

...Consider a hypothetical example...

...The truth is that the Bloomsburyite still lives on in policy...

...Congress, unfortunately, will be deathly afraid of enacting any such law because they know they will once again have to face up to the barrage of complaints that they are thereby "taking from the poor and giving to the rich...

...The problem is that the legislators are almost exactly 50 years behind the times...

...but in reality, no doubt, to provide lots more taxpayers' money for those good old social programs t h a t are so dear to the hearts of Times editorial writers...

...Bear in mind, however, that not man~" low income people are in a position to lend the government $10,000...

...There was no comment out of Washington when the Mexican government recognized the Salvadoran guerrillas...

...That is to say, it encourages people to save up to a certain amount of money, but no more than that amount...

...A combination of luck and skill had laid the groundwork for a Reagan # success at Cancun...

...It is a tricky and c o n t r o v e r s i a l m a t t e r to estimate the average marginal tax rate of all lenders in the market place: controversial because some government bonds and debt instruments are held by banks...

...The average after-tax return on 16 p e r c e n t thus turns out to be 9.6 percent...

...This is either a surprising reversion to 1950s-style Republicanism or covert groundwork for repeal of the recent tax-rate reductions: the latter if New York Times editorials are anything to go by...

...Socalled 'historic standards' are irrelevant in the face of a permanent change in the consciousness of savers, who will not soon again accept negative returns, any more than workers will again be fooled into ignoring taxes and accepting inflation instead of higher wages," Gilder recently noted in the Wall Street Journal...

...This came about primarily as a result of the efforts of Winston Churchill, who had largely been responsible for Britain's return to the gold standard a f t e r World War I at the prewar exchange r a t e , ignoring the intervening inflation...

...Goods t h a t cost $!0,000 at the beginning of the year cost $10,800 at the end, and your interest has more than made up for that: But we are forgetting something important...

...So you seem to be ahead of the game...

...Historic interest rates, after all, in periods of no inflation, have usually been two or three percent...

...and others by non-profit institutions, or by the federal government itself, which do not pay tax on the interest received...

...Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back...

...Again taking inflation into account, his cost of borrowing turns out to be exactly zero...

...And yet the same policy prescription remains in place: Punish savings, reward consumption...

...The new " a l l - savers" bill, which is intended to bail out the savings and loan associations, will allow people to earn 70 percent of the c u r r e n t Treasury bill r a t e , tax free, up to a maximum of $2000 worth of interest ($1000 if you are single), for a period of one year...

...If the present level of interest rates can be explained as a simple matter of lenders demanding a real, after-tax return on the use of their capital, then the question before the house ceases to be puzzling, though a new teaser does arise: We must ask, not "why are interest rates so high...

...Reagan has also demonstrated a capacity for creative myopia in relation to Mexico...

...Reeling from the brickbats encouraged by Andy Young's willingness to consider black African dictatorships overseas branches of CORE and SNCC, he dismissed any such meeting as one more arena for beating up on Uncle Sam...

...He is merely maintaining the purchasing power of his savings...

...Moreover, "bracket creep" (movement up the tax brackets through inflation) was not as advanced in 1979 as it is today...

...If anything, they seem to be still somewhat on the low side...

...For the first six months of 1981, only the expectatitm of incompetence mitigated anxiety over the prospect of such an American loose in the world community...

...Interest received is called "unearned income" and taxed at punitive rates...

...Nevertheless, Vito Tanzi, the director of the Fiscal Affairs Department of the International Monetary Fund, who has studied this question and has written about it in Inflation and the Personal Income Tax," believes today that "the present figure is close to 40 percent...

...These were Presidential acts seen from a distance...

...This rate will, however, take effect at higher income levels ($109,400 in the case of -married, $8t,800 in the case of unmarried individuals, after 1983...

...At the end of the year you sell your T-bill and you now have $11,600...

...This was, approximately, the top Treasury bill interest rate in recent months...

...Assume, again, that the borrower pays 16 percent for his loan, and is likewise in the 40 percent tax bracket...

...With a predecessor who managed to affront the national pride of any number of countries while virtually inviting insults to American dignity around the world, President Reagan could do wonders on mere decency and common sense...

...body politic--a brigade which seems to add new platoons daily...

...or by reducing the government's demand for savings (by cutting back on government spending...

...It also meant seven Westerners with private agendas and often contradictory aims...

...The chairman of the Council of Economic Advisers is puzzled...

...Instead of admonishing the stock market, Senator Howard Baker of Tennessee, who is Senate majority leader and thus in a position to make a difference, should take a look at the relative incentives for saving and consumption some time...

...The new tax law also does space out the tax brackets, but (as few people seem to realize) the top tax rate on "earned" income in the U.S...

...sizeable savings to lend who d o n ' t earn much money--retirees, for example-but on the whole big lenders are also high earners...

...Meanwhile, the new liberal perception seems to be that all of our fiscal difficulties arise out of the budget deficit, a deficit that amounts to two p e r c e n t of GNP today, compared with 22 p e r c e n t in 1945...

...It registered in Mexico and elsewhere in Latin America as a reasonable regard for the rights of sovereign states to make their own decisions on matters of alignment and non-alignment...

...So his effective interest rate is reduced...

...When you come r i g h t down to it, they are still thinking in accordance with the Keynesian dispensation, no matter how many times we h e a r it r e p e a t e d that Keynes is dead...

...It is, as it were, unusual behavior for money to gain in value of its own accord...

...As it happens, the Consumer Price Index rose by .8 percent in August...

...Budget deficits on the order of $60 or $70 billion do of course tend to drive up interest rates because the Treasury, with its "sharp elbows" at the trough of savings, does bid up rates and so "crowds out" others...

...In the Washington visit that preceded Cancdn, he appeared to feel he had it from President Reagan...

...There were also positive gestures such as enlisting the Mexican president's contributions in talking about American immigration policy...

...Things have changed since then...

...Tanzi is c o r r e c t , then one must deduct 40 percent, on the average, from interest rates in order to find out what the after-tax interest rate is...

...for we have seen that they are close to zero in real, after-tax terms (by November they had turned decidedly negative...

...On the other, many of the underdeveloped countries were genuinely ready to welcome signs of respect and understanding from the industrialized powers...

...When we look at i n t e r e s t rates from the borrower's point of view, we arrive at the same paradoxical conclusion...

...So, arguably, saving must be discouraged and consumption stimulated when you have deflation...

...Milton Friedman himself is puzzled...

...Under such circumstances, one can at l e a s t plausibly argue (and Keynes was nothing if not plausible) that people will let their money languish in savings and won't spend it because it will increase in value without any interest at all...

...And yet the tax code quite specifically rewards borrowing and penalizes saving...

...After January 1, 1982, the top tax r a t e on i n t e r e s t "income" will be 50 p e r c e n t . ) In addition, of course, most states take a sizeable e x t r a bite out of your interest...

...The full $1600 is reported as "income" to the Internal Revenue Service--even though $800 of it isn't income at all, it is merely protection against the dwindling purchasing power of your original capital...

...This change in the law has two glaring defects, however...

...But perhaps we do begin to see the answer, nevertheless, when the whole problem is couched in these terms...

...I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas...

...Secondly, the new law has no marginal effects...

...The Wall Street Journal is puzzled...

...It also underscores the Reagan Administration's understanding of where the relevance of ideology leaves off...

...The policymakers in Washington, in their public Statements, say that they want to i n c r e a s e saving and decrease consumption--a prescription which no doubt really would reduce inflatioff...

...In Third World capitals, they're not so sure...

...the Iraqi nuclear reactor and later exercised his formidable powers in Congress to push through the AWACS for Saudi Arabia...

...Someone in the 40 *Cambridge University Press, $24.95...

...The total amount of such borrowing has now passed the one-trillion-dollar mark...

...Indeed the world is ruled by little else...

...It does take a few steps in the right direction, but not nearly enough...

...The former course is probably the most feasible, THE AMERICAN SPECTATOR JANUARY 1982 23 from a political point of view, the activities of the envy-arousal brigade notwithstanding...

...and that is what Keynesianism was all about, really--a prescription to c o u n t e r a c t the dire e f f e c t s of deflation...

...Even Irving Kristol is puzzled...

...The President's response to anklebiting by Muammar Qaddafi was not his only show of coolness and decision in dealing with the Third World...

...Keynes himself would have recognized the problem instantly, On the very last page of his famous book, The General Theory of Employment, Interest and Money, in perhaps his most famous passage, he wrote: The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood...

...There was also a display of evenhandedness in the Middle East where he accepted United Nations condemnation of the Israeli strike against Anne Crutcher is a former editorial writer with the Washington Star...

...On the one hand, the message went home that the United -States did not have to show up for a prearranged drubbing...