The Obama economic team hasn’t been hitting all home runs with regards to dealing with the current crisis. “Cash for Clunkers” and the new homebuyer tax credit weren’t exactly great ideas from an economic point of view. But even with Obama’s missteps, the comments of Will and Greenspan show that the alternative is much worse. It’s as if a large chunk of our political leadership wants to give Herbert Hoover a second try. This is what scares me the most about a possible Republican takeover in Congress this year.

Long-term unemployment is a crisis. Deficit chickenhawks (to borrow a phrase from the Iraq War) like to complain that budget deficits affect generations, but so does long-term unemployment. When people are unemployed for a year or more, they lose skills, they become less employable, and worst of all, their kids suffer. This leads to poverty, and more importantly, lower tax revenues, for years. How will we solve the budget deficit when everybody has to move to a $7 an hour job? How much in taxes does that generate?

We can put at least some of these people to work. Our national infrastructure is crumbling. Build some bridges, fix some sewer systems, create a smarter electric grid. Anything to get people back to work, maintaining their skills, and providing stability for their families. Hooverism didn’t work the first time around, why should we try it again?

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What’s the problem? To answer that, it helps to first get an idea of why the financial system exists. In the simplest of terms, banks and the entire financial system exist to help move capital where it can do the most good. That "capital" can be anything from my checking account to my retirement savings to the multi-million dollar revenues of gigantic companies, and, in turn, it can be used on anything from mortgages to student loans to bonds to venture capital, just to name a few.

If I have extra money lying around, I could seek out investment opportunities, maybe give somebody an educational loan, or a mortgage, or invest in a business startup. This would cut out the middleman, but it would also require a lot of work on my part: I’d have have to check these applicants out, evaluate their finances, determine what a fair interest rate or percentage of equity would be, stay on top of collections, initiate legal proceedings if they fall behind, and so forth. It’s possible to do this (and the internet has made it a lot easier, with sites such as www.kiva.org allowing for the matchup of lender to lendee), but for the majority of people, it’s not worth the hassle.

That’s where banks and other financial institutions come in. They serve as middlemen in this process. I give them money, and they loan it back out. A local bank or credit union is going to take my money and probably turn it into home mortgages or business loans. If I have more money to invest, I could do things like buy corporate bonds, stock, or invest in hedge funds that do the same. They handle the details, and often provide research, information, and advice. For these services, and for acting as middlemen, they get a cut.

In the process, the goal for everybody involved is to put that money to good use. My savings account money goes to a family’s mortgage so they can buy a house, live in a good neighborhood, and go to good schools (sounds very "Bedford Falls", doesn’t it?). Or it goes to somebody who is starting a new business and adding to the economy. These are small examples, but the process scales up to companies floating bonds to build a hundred-million dollar factory that will employ hundreds of workers. In all these examples, I get a return on my investment, the people receiving the money put it to good use to better themselves and the economy, and everybody benefits.

Of course, there is risk involved. Perhaps the mortgage is going to somebody who can’t pay their bills, or the small business goes under. Failures are inevitable, but even in failure there is knowledge to be gained. Failure tells us that a particular allocation of capital isn’t a good idea, and so tells the market to redistribute it to other, more beneficial areas.

Where did it go wrong? In in ideal situation, banks are supposed to only be the conduit, the pipe that moves money into productive activities. However, banks realized that they could get more money by not merely directing the flow of capital to other industries, but to themselves. The flow of money became not a straight line, but a maelstrom swirling from bank to bank. Money was not invested in new factories and new technology, but in new financial instruments like CDOs and creating algorithms to programmatically trade better than the competition. Finance, instead of being a means to an end, became an end in itself. That is the true source of these insane bonuses: with that firehose of money directed not at other industries, but at itself, there is simply too much money sloshing around. It is inevitable that much of the money will go to employees in the financial industry.

For this to change, and for those bonuses to become a thing of the past, banking must "become boring" as Paul Krugman argues. Instead of directing money towards financial "innovations", which are of dubious benefit to anybody not immediately involved in the financial sector, money should be directed towards those endeavors that provide profit and social benefit. There’s a whole host of things that we could to to push finance in this direction: regulation of some of the more dangerous derivatives, a tiny (such as 0.25%) transaction tax on all stock trades that would discourage the programmatic day-trading that is endemic, or perhaps a new, super short-term capital gains rate (say for assets held less than 30 days) that would discourage short-term speculation and encourage long-term investment, which is what the finance industry is supposed to foster.

Obviously, there will be plenty of people who will fight any attempt to roll back the huge gains in the size of the financial industry, which has more than doubled in relative size in the past 30 years or so. Resistance doesn’t just come from the people making those bonuses either: opponents of reform argue that regulations will do everything from eliminate credit card reward programs to make it harder to get a mortgage. To a certain degree, this is correct. However, I would gladly give up my credit card cash back program if it meant a return to a saner, less dangerous, and far more boring financial system.

Fortunately for all of us, the state of Minnesota is pretty good when it comes to collecting statistics on taxes and spending. One of the key measurements is what is known as the Price of Government. Simply put, this is the total of all state and local taxes (income taxes, sales taxes, property taxes, excise taxes, fees, the works), divided by the total statewide personal income. In short, it shows what percentage of Minnesota income is sent to all state and local levels of government in the form of taxes.

The Price of Government helps us understand whether taxes are “high” or “low” relative to previous periods in the state’s history, and what the trends are. This information is generated in the state economic forecasts. Here are the numbers for the November 2008 economic forecast, the most recent available with Price of Government Information:

From that graph, it looks like things bounce around a bit at random, mainly between 15.5% and 16.5% of state personal income. In general, though, on this graph it looks like if we were to raise taxes, it would push us above where taxes have been in the past, above that 16.5% threshold, the maximum on this graph. But is that the maximum? As a matter of fact, it isn’t. Let’s now look at the November 2002 economic forecast, which shows data going back even further:

Now this is interesting. Prior to 1999, and for much of the 1990s, the price of government was significantly higher, above 17% for every year between 1992 and 1998. It was only after the huge budget surpluses and consequent tax cuts in 1999 that the price of government fell substantially.

This demonstrates that taxes in Minnesota as a percentage of personal income are up to two full percentage points from their peak in the 1990s: it can hardly be said that the tax burden now is more onerous than it has been in the past. Even the recent peak of 16.5% in Fiscal Year 2006 is more than a full percentage point below the 17.7% peak in Fiscal Year 1994. Moreover, the 1990s were not exactly a period of low economic growth. In fact, as everybody remembers, it was a period of sustained growth. This puts quite a few holes in the “higher taxes would destroy economic growth” theory that many conservatives espouse.

So much for the aggregate tax total, now on to who is paying those taxes. For this, we can look to something called Tax Incidence. This shows us how much people pay in taxes based on their income. Every two years the state does such a study, and here are the results for the most recent, the 2009 Tax Incidence Study:

The first decile, the 10% of people who make the least amount of money, include many people such as teens and college students who work part-time; this is why the first decile is so clearly out of step with the others in terms of tax incidence. The rest of the deciles, though, show a pretty clear pattern. The group paying the highest percentage of income in taxes is the fifth decile, right smack in the middle (this group is made up of people making approximately $35,000 to $45,000 per year). As you make more money, the percentage of your income that you pay in taxes decreases, until you reach the top 1% of income earners, who are paying taxes at a lower rate than all other deciles.

Let’s state that again: If you make over $480,000 a year, you pay a lower tax rate than somebody making $20,000 a year when you consider all state and local taxes. The income tax is not progressive enough on the high end to make up for the regressivity of sales and property taxes on the low end.

This information may be somewhat technical in nature, and thus not reported in the media very often, but it is pretty important context for evaluating claims about taxation, especially taxation on the wealthiest people in the state. I think it would be helpful if all evaluations of tax proposals included this information so people could form educated opinions of them.

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