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Investment Insights, Inc.

The Myth of The Free Lunch

“A chicken for every pot.” headline of a Herbert Hoover's 1928 presidential campaign ad.

“From each according to his ability and to each according to his need.” Karl Marx, 1875.

The great innovation of representative democracy is that we get to vote to choose our leaders and representatives, and that’s great. I wouldn’t have it any other way. As Sir Winston Churchill famously said, “Democracy is the worst form of government, except for all those others that have been tried.”

One of the great flaws of democracy is that elections are essentially popularity contests. It is normal for us to like those people who agree with us, which creates a strong incentive for politicians to tell us what we want to hear. It is from this that the words liar and politician have become almost synonymous.

And what is the lie we believe the most often? Free. Advertisers constantly use it on you because you fall for it over and over. Buy One Get One Free – it isn’t free if you have to buy one to get the so called free one. I’m sure you can think of plenty of examples.

In recent decades this has been playing out in alarming fashion in our national politics. The left wants Medicare for all, free college tuition, and even a guaranteed living wage for all. This will be paid for by others – specifically the wealthy, at least the ones that don’t decide to live in a more tax friendly country.

The right wants a stronger military, more police, better infrastructure and so on, but no taxes, or at least lower than they are now. They also want tax cuts because, in the infamous words of Dick Cheney, “Reagan proved that deficits don’t matter.” In other words, it’s perfectly fine to run deficits that will eventually have to be paid for by future generations.

It’s hard for me to express how I feel about that. We live in a country that was founded in rebellion against tyranny that, among other famous phrases, was characterized by “No taxation without representation.” And yet we think nothing of creating massive debt obligations for unborn generations that obviously have no voice at all about the massive burden we are placing on them.

This is the legacy of tax cuts. And it is the legacy of believing, as Dick Cheney does, in a free lunch.

A big part of how we got here is the belief that someone else will pay for our benefits. At least this is what I blame for making chronic deficits popular with voters.

But it all started with a stagnant economy, a president seeking solutions and an economist that may not have had a grasp of 8th grade arithmetic.

In the 1970’s the US economy was stuck in a period infamously known as stagflation. A nasty combination of strong inflation and extremely slow economic growth. When Ronald Reagan became president he decided to take bold action to shake the economy out of its stupor. Enter professor Laffer of the University of California. Mr. Laffer was a member of President Reagan’s economic council where he convinced the president, the other advisors, Congress and the public of a mathematical fallacy.

The idea became known as the Laffer curve. Tax cuts would stimulate the economy so much that they would pay for themselves.

Let’s look at that closely. Federal taxes take up about 16% of so of the economy. This is a moving figure so it’s difficult to have any real precision but it generally runs about 16% or a little higher.

If that figure were to be reduced to say 6%, the economy would have to double to make up for the lost revenue.

This explains why budget deficits under Reagan expanded to then record levels. It explains why his successor, George HW Bush, presided over a record tax increase.

Doing simple arithmetic it’s very easy to understand why the Laffer Curve has never worked. What’s much harder to understand is why Mr. Laffer, who is still alive, still believes in and defends his theory.

Tax cuts that are not accompanied by a proportionate decrease in expenditures will always result in increased deficits.

The last time the budget was balanced on an annual basis was in 2001, which was the last Clinton budget.

The last time the deficit went down from the previous year was in 2015, under president Obama. The tax cuts passed under president Trump in 2017 increased the federal deficit from $665 billion in 2017 to $779 billion in 2018 and $984 billion in 2019.

This nearly $1 trillion budget deficit when there were no crises, compromised our ability to deal with the next crisis. The one we are now in.

I have no problem with drastically expanding the deficit to deal with a crisis. But this only works when good times are used to pay the debt down. Instead, the Trump administration was expanding our debt while the economy was growing.

Reagan did not prove that deficits don’t matter. We are not a nation that is paying anything forward. We are borrowing forward. And if this continues, eventually there is going to be a very big problem.

But politicians are averse to actually paying down the debt. It is painful because increasing taxes often leads to slowing the economy.

The combination of the 2017 tax cuts and the vast Covid19 related spending means that there are two somewhat unpleasant visions for the not too distant future. Either we elect Democrats knowing that they most likely will raise taxes to both pay for new social programs and to start reducing the deficit and move us toward a balanced budget, or we re-elect the Republicans who have in the last 40 years shown almost no appetite for reducing deficits. Rather they continue to buy into the idea that tax cuts will stimulate the economy enough to reduce deficits, despite this never actually happening. In other words, assuming the president and the Congress continue in the future doing what they have been doing, the probability for the government of the wealthiest nation in history having its own debt crisis is very real.

The United States has tremendous wealth and vitality. We definitely can solve this problem, but not by continuing to do what we have been doing.

Hal Masover is a Chartered Retrement Planning Counselor and a registered representative. His firm, Investment Insights, Inc is at 508 N 2nd Street, Suite 203, Fairfield, IA 52556. Securiies offered through, Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Investment Insights, Inc & Cambridge are not affiliated. Comments and questons can be sent to hal.masover@emailsri.com These are the opinions of Hal Masover and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results. Indices mentioned are unmanaged and cannot be invested in directly.

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