Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

When a baby is born, I believe it cries for two reasons. First, the baby is scared about entering this “mad” world. Second, it realizes that, when assigned a Social Security number, the government will take away the complete freedom promised to it by the U.S. Constitution.  

Given the importance of Social Security (“SS”) to Americans, I present here a summary of the major changes in SS scheduled to take effect in 2022.  

I will begin by presenting a brief history of SS.

HISTORY OF SOCIAL SECURITY

On August 14, 1935, the Social Security Act of 1935 (“Act”) was signed into law by Democrat President Franklin D. Roosevelt. The Act was an important component of Roosevelt’s New Deal, which was intended to combat the Great Depression.  While the New Deal put into place measures to regulate business and banking, and provided temporary work relief to combat the Great Depression, the Act also became a model of how the U.S. government could provide a safety net for its citizens.

Specifically, the Act established the basis for future benefits. Examples include: unemployment insurance, aid to the homeless and children, maternal and child welfare funding, and many other such public services.

The last major overhaul of SS occurred in 1983 when (1) SS benefits first became taxable; (2) a gradual increase in the SS payroll tax was first instituted; (3) the age at which workers can start collecting SS was increased; and (4) the age at which workers can begin receiving full SS benefits was established.

MAJOR CHANGES TO SOCIAL SECURITY IN 2022

In October 2021, the Social Security Administration (“SSA”) announced a number of changes that will become effective in 2022. Below is a summary of the seven most important of those changes. This summary is based in part upon information that has appeared in a wide variety of publications.

One. Social Security Payments will Increase

Each year, SS payment increases are determined based on a cost of living (“COLA”) adjustment. Based on that criterion, in some years there will be no increase in SS payments, while in other years the COLA adjustment will result in increased SS payments. In 2022, SS payments will increase by 5.9%, which will be the largest COLA since 1983. While the actual increase in SS payments will vary for each recipient, the average SS recipient will receive about $92 more per month.

It should be noted, however, that in 2022, Medicare Part B costs will also increase, thereby offsetting some of the increase in SS payments. Although this increase does not technically reduce SS payments, it has the effect of reducing a recipient’s net SS income.

Two. Full Retirement Age Rises Once Again

Full retirement age (“FRA”) is the age at which a person becomes entitled to receive full SS benefits. The FRA was 65 for a long time, but it has increased in small increments over time, and will reach 67 in 2022. 

The FRA is important because it determines lifetime SS benefit amounts. A recipient can elect to start receiving SS benefits before the person’s FRA, but doing so will reduce the person’s lifetime benefits. Conversely, a recipient can delay receipt of SS benefits up until age 70, thereby increasing the person’s lifetime benefits. Delaying receipt of SS benefits beyond age 70 does not increase SS benefits.

Three: Maximum Taxable Income Increases

In 2021, the SS payroll tax is applied to earned income up to $142,800. In 2022, the maximum taxable income amount will increase to $147,000. It is estimated that only about 6% of the workforce will be affected by this increase, and that they will pay an additional $530.80 in SS payroll taxes. This adjustment has become necessary to help increase SS funding. The 6.2% SS payroll tax rate will remain unchanged in 2022.

Four: Maximum Monthly SS Payments will Increase

In 2021, at FRA, the maximum monthly benefit is $3,148. In 2022, that amount will increase by $197 to $3,345.  Typically, benefits are calculated based upon a worker’s highest earning 35 years. It is noteworthy that most workers are not expected to earn sufficient income during their lifetimes to claim the maximum monthly benefit.

Five: Earning Limits for Recipients will Increase

1. Earning income while collecting SS benefits. In 2022, SS recipients who have not reached FRA will be allowed to earn up to $19,560 with no reduction in SS benefit payments. For every $2.00 earned in excess of that amount, $1.00 will be deducted from the recipient’s monthly SS payment. 
2. Earning income after reaching FRA. SS recipients who reach FRA are treated differently. In 2022, the new earned income limit will be $51,960, an increase of $1,449 from the 2021 maximum amount. During the year a SS recipient reaches FRA, the recipient’s monthly SS payments will be reduced $1.00 for every $3.00 (up from $2.00) of income earned, but only for the months prior to the month in which the recipient reaches FRA. Thereafter, a recipient’s SS payments are no longer reduced, no matter how much is earned.

It should be noted however, that, contrary to a commonly held belief, any reductions in SS benefits due to earnings exceeding the earned income limit are not penalties. That is because the reduced SS benefits are eventually paid back when the worker reaches FRA. 

Six. Disability Income Scheduled to Increase

Social Security Disability Insurance (“SSDI”) is a program that pays benefits to disabled persons who worked long enough – and recently enough – and paid SS taxes on their income, but can no longer work.  This program provides much-needed income for these unfortunate individuals. About eight million people currently receive SSDI benefit payments.

In 2022, disabled persons who qualify as blind will be allowed to earn up to $2,260 per month, an increase of $70.00, without having their benefits withheld. Disabled persons who are not blind will be allowed to earn up to $1,350 per month, an increase of $40, without having their benefits withheld. Finally, in 2022, a disabled worker who has a spouse and one or more children will receive $2,383 per month, an increase of $133.

Seven. Higher Income Needed to Qualify for Social Security Benefits

American workers wishing to receive SS benefits must demonstrate that they have earned 40 lifetime work credits, of which a maximum of four work credits can be earned during a given year. These work credits are assigned to workers based on their income in a given year. In 2022, one lifetime work credit will be awarded for every $1,510 of earned income, up from $1,470. So, in essence, in 2022 workers must earn $6,040, up from $5,800 in order to earn the maximum four credits for the year.

OTHER THINGS TO CONSIDER IN 2022 AND BEYOND

Research studies have concluded that, unless corrective action is taken, SS will be unable to pay full benefits starting in 2034, a year earlier than previously forecast, due to the impact of the Covid 19 crisis. While that is a frightening thought for SS recipients, it is likely that corrective action will be taken.  Possible actions include increasing both the FRA and the maximum income subject to SS tax until the viability of SS is fully assured.

As a final thought, here are a few helpful tips for you to consider in order to make the most of your lifetime SS benefits.

#1 Claim Deserved Benefits

When a SS benefit recipient dies, the person’s SS benefit payments do not necessarily stop. SS survivor benefits can be paid to widows, widowers and dependents of eligible workers who satisfy certain criteria to receive those benefits.

Supplemental Security Income (“SSI”) is another government program that provides monthly payments to adults and children with a disability or blindness who have income and resources below specific financial limits. SSI payments are also made to people age 65 and older without disabilities who meet certain financial qualifications.  SSI is a federal program funded by general tax revenues (not SS taxes). It provides monthly payments to meet basic needs for food, clothing and shelter. The base monthly federal amount varies depending on the recipient’s living arrangement and countable income.  This is a valuable source of income that should be checked out by anyone who may qualify to receive benefits under the program.

#2 Avoid Paying Taxes on Social Security Income

For those who hate to pay taxes on SS income, there is a choice. Few people realize that in 2022, 38 states and the District of Columbia will not tax SS benefits. These states include the following nine states that don’t have any income tax at all: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. 

Moving to a different state just to avoid paying taxes on SS income may not be a practical strategy for many SS recipients, but for some, this might be a way to avoid paying taxes on SS income.

#3 Spousal Benefit

Finally, there is a little-known SS benefit known as the “spousal benefit” that is available to a worker’s spouse who has never worked, or to a worker’s spouse whose own SS benefit is less than the spousal benefit.  The conditions applicable to claiming the spousal benefit are complicated, so for best results couples should research the availability of the spousal benefit before either of them elects to start receiving SS payments.

BOTTOM LINE In this blog, I have primarily discussed the major SS changes scheduled to take place in 2022 and beyond. I hope that, by knowing these changes in advance, persons potentially adversely affected by them will be helped when it comes to planning how to respond.

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Travis Smith provided technical support for this article. However, the author takes full responsibility for the contents of this blog.

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

If you think estate planning is only for the super-rich, think again. With a meteoric stock market rise and a few other developments on the horizon, it is highly likely that estate planning is  an important issue for you. And since this subject should be handled only by skilled estate planners, with special permission, I am reproducing an excellent piece on estate planning by John Giarmarco. Please let me know if you find this piece both informative and useful.

John Giarmarco, JD, LLM
Giarmarco, Mullins & Horton, PC

Under a new administration, proposed tax legislation has been introduced that could significantly impact estate tax planning. While it is not clear if, or when, any of these proposals will be enacted, it is vitally important to be prepared and plan ahead.

Proposed Legislation

While many of the provisions enacted under the 2017 Tax Cuts and Jobs Act are set to expire in the next few years, changes may occur earlier if any of the recently proposed legislation is enacted. The American Families Plan, announced by the Biden administration, aims to close tax loopholes that are seen as allowing wealthy individuals to avoid tax on inherited wealth. The For the 99.5% Act, sponsored by Sen. Bernie Sanders and Rep. Sheldon Whitehouse, aims to curtail planning strategies used mainly by 0.5% of wealthy Americans to avoid tax. And on September 13, 2021, the House Ways and Means Committee released the proposed tax provisions of the broader budget reconciliation bill that Democrats hope to pass in the upcoming weeks. The House’s draft bill includes various provisions that will affect gift and estate tax planning, as well as legacy planning.

Current Law in 2021

The current estate, gift and generation-skipping transfer (GST) tax exemption is $11.7 million per person, with a top tax rate of 40%, which is set to “sunset” at the end of 2025 (to pre-2018 levels) to approximately $6 million ($5.6 million adjusted for inflation). An annual exclusion of $15,000 per donee/per year is also available to individuals, without any limit on the number of donees. Upon death, certain assets receive a “step-up” in cost basis, meaning its basis becomes its value at death. This can result in the elimination of taxable gains on inherited assets. Federal capital gains and dividend tax rates are presently 23.8% (including the net investment income tax), and the top individual income tax rate is 37%.

Proposed Changes Under The American Family Plan

Through its American Families Plan (the Plan), the Biden administration has proposed an elimination of the step-up in basis. While it has not been specified how that will be implemented, it will most likely mean that upon one’s death, a capital gains tax would be imposed upon all unrealized gains that exceed $1 million. Under current law, if a person buys a stock for $10, never sells it, and the stock is worth $100 when the person dies, the $90 of gain is never taxed, and the basis of the stock in the hands of the heirs will ibnecreased (or “stepped up”) to $100.

Under the Plan, the $90 of gain would be taxed, but only if and to the extent that the total gain in all unsold assets exceeds $1,000,000. Accordingly, if a person buys an asset for $250,000 and it is worth $2,000,000 when the person dies, the untaxed gain would be $1,750,000, and $750,000 of that would be subject to a capital gains tax. The $1 million exemption is intended to exclude smaller estates, and would not apply to charitable gifts. The

$250,000 exemption for principal residence gains would remain in place, and be in addition to the $1 million. Exceptions would apply for certain family-owned businesses and farms, with a 15-year payment plan allowed for illiquid assets. It is unclear if this would be in place of, or in addition to, the imposition of any estate tax on larger estates – potentially subjecting estates to historically high effective tax rates.

The estate tax exemption was not addressed under the Plan, although it has been suggested that Biden would propose a reduction to $3.5 million. The Plan has a proposed effective date of January 1, 2022.

Proposed Changes Under the For The 99.5% Act

In late March, the For the 99.5% Act (the Act) was introduced to Congress, and proposes several changes that could significantly affect how wealth is transferred, including:

Reductions to Exemptions and Increases to Tax Rates. For gifts and estates occurring after Dec. 31, 2021, the Act would reduce the estate and gift tax exemptions from their present high level and increase the top tax rates as follows:

1. Gift Tax Exemption reduced to $1 million per person.
2. Estate and Generation-Skipping Transfer Tax Exemption reduced to $3.5 million per person.
3. Estate Tax Rates: increased as follows: $3.5 million-$10 million – 45%; $10 million-$50 million – 50%;

$50 million-$1 billion – 55%; and $1 billion and greater – 65%.

Reductions to Annual Exclusion Gifts. Starting in 2022, the act would reduce the annual exclusion to

$10,000 per year/per donee, and limit the donor to $20,000 annual exclusion gifts in total. These limits will greatly restrict an individual’s ability to make gifts without using their lifetime exemption.

Limitation on Use of Long-Term (Dynasty) Trusts. The GST tax is assessed on transfers of wealth to generations two or more removed from the donor, in addition to gift or estate tax. However, like the gift and estate tax, an exemption is available. Under the laws of Michigan, Florida and several other states, trusts may be established to last forever, or at least for hundreds of years, thus preventing the trust assets from being taxed or subject to creditor claims as they pass from one generation to the next. The Plan would “strengthen” the so- called generation-skipping transfer tax (currently a 40% tax on distributions from certain trusts to grandchildren and more remote descendants) by applying it to any trust established to last more than fifty years.

Limits on Valuation Discounts. Currently, closely held business interests can be discounted for lack of marketability and for minority interests – allowing a greater amount of assets to be transferred at a lower estate tax cost. The Act proposes to eliminate or reduce allowable discounts for businesses not actively engaged in a trade or business, thereby curtailing planning for family entities frequently used in estate planning to effect an efficient transfer of wealth. This change would be effective upon enactment.

The End of Grantor Trusts and Sales of Appreciating Assets to IDGTs. A so-called “grantor trust” is ignored as a separate taxpayer for income tax purposes. Thus, the grantor (the creator of the trust) can sell appreciating assets to this type of trust in return for a note from the trust without realizing capital gains because, for income tax purposes, no sale is considered to have occurred. (This transaction is sometimes referred to as a sale to an intentionally defective grantor trust, or IDGT. Another consequence of grantor trust status is that all trust income is taxed to the grantor because, for income tax purposes, the trust does not exist. tThheustr,ust

can increase in value without the burden of paying income taxes. Normally, if a taxpayer were to pay another taxpayer’s income taxes, that would be gift. However, the IRS has ruled that it is not a gift when a grantor pays taxes on the income of a grantor trust. The Plan would effectively end the use of grantor trusts as wealth-shifting devices by including the value of such trusts in the grantor’s gross estate for estate tax purposes and taxing distributions from such trusts as gifts from the grantor.

Changes to Grantor Retained Annuity Trusts (GRATs). GRATs are a common planning technique to transfer appreciation on assets outside the taxable estate. A “zeroed out” GRAT allows for a transfer with little to no gift tax due. The GRAT pays the grantor an annuity for a certain term (usually two years), and the appreciation of the trust’s assets that exceed the applicable rate are transferred out of the taxable estate to the beneficiaries. The shorter term allows for greater leverage to capture upswings in the market, without having to account for the inevitable downswing. The Act would require a minimum GRAT term of 10 years, and require a gift tax to be assessed on the greater of $500,000 or 25% of the value of the property used to fund the trust. This would eliminate the most beneficial aspects of using this type of planning.

Proposed Changes Under the House Ways and Means Draft Bill

With respect to the gift and estate tax exemption, the House’s draft bill proposes an acceleration of the 2017 Tax Cuts and Jobs Act’s sunset provision from January 1, 2026 to January 1, 2022, which would reduce the exemption amount to the 2010 level of $5 million (per person), as adjusted for inflation. The House’s draft bill also makes several changes to the grantor trust rules. First, the assets of a grantor trust will generally be included in the estate of the grantor upon the grantor’s death. Second, if grantor trust status is terminated prior to the death of the grantor or a distribution is made from the trust, the value of the trust or the amount of the distribution will generally be treated as a gift. Third, sales between a grantor and a grantor trust will be taxed. The changes to the grantor trust rules will apply to trusts created on or after the date of the enactment of the bill and will apply to any contribution to an existing trust on or after that date.  Finally, the House’s draft bill also provides that no valuation discount, including for lack of marketability or lack of control, is permitted for nonbusiness assets. Nonbusiness assets are passive assets that are held for the production of income and not used in the active conduct of a trade or business. There are exceptions for assets used as the working capital of a business or in hedging transactions and for real property used in certain businesses.

Planning For the Year Ahead

This year is an opportune time to make the most of your estate and gift tax exemption and the low interest rate environment.

“Locking In” the Estate and Gift Tax Exemption. Many ultra-high net worth individuals have already used most, if not all, of their gift tax exemption. If individuals and married couples have not used their exemption(s) and can afford to, they should give serious consideration to completing gifts equal to their remaining exemption(s) in 2021, ideally to a generation-skipping trust for the benefit of their descendants. Depending on your and your family’s goals, circumstances, remaining exemption, and cash flow needs, gifting up to $23.4 million, or even

$11.7 million, to a trust for your beneficiaries may not be feasible. A long-accepted way to address this concern is to create a trust that benefits both the Grantor’s spouse and descendants. These are commonly referred to as Spousal Lifetime Access Trusts (SLATs). A SLAT is a simple and effective way to address the possible need of the senior generation to access the property transferred—it provides direct access for the beneficiary spouse and “indirect” access for a Grantor spouse. Grantor trust provisions, such as ones allowing the Grantor of the trust to swap assets or take loans from the trust, offer tax flexibility and access to funds by loan. SLATs have become so popular that couples have created trusts for each other. This is not without risk and should only be done with different trust provisions and with creation of the trusts separated in time. Finally, it is important to remember that potential estate tax savings should never be the sole determinate of your financial planning decisions. Individuals who have stretched themselves thin to make significant gifts sometimes have profound “donor’s remorse.” Thus, make gifts if you can, but, more importantly, make them if you’re comfortable doing so.

Freezing the Size of  the  Estate.  Perhaps  you have already utilized your exemptions and are seeking ways to further reduce the tax burden on your estate or you are not ready to commit large transfers of your property. In either situation, an excellent alternative is to freeze the growth of your estate with strategies like Grantor Retained Annuity Trusts (GRATs) and installment sales with trusts or family loans. GRATs and installment sales have thrived in the low interest rate environment because assets have often grown in value at a rate above the rate of the annuity, in the case of GRATs, or the interest rate on a note. Thus, these strategies essentially “freeze” the size of one’s estate and transfer significant appreciation, which would have otherwise remained in the client’s estate, out of his or her estate.

What To Do?

With all these potential changes on the horizon, it would be a good idea to contact your GMH estate planning attorney with any questions you may have and to review potential avenues for further estate planning if you will have a taxable estate under the proposed laws ($3.5M per person/$7M for spouses). If any of these tax proposals are enacted as currently suggested, common estate planning techniques used to effectively and efficiently transfer wealth to future generations will be greatly restricted or eliminated. We continue to monitor the progress of these proposals, but as none of the changes are anticipated to be retroactive, now is the time to consider taking advantage of the existing tax provisions and rates.

Potential Changes to Gift and Estate Tax Laws in 2022

Dates and Taxes Ahead

A number of tax proposals being considered in Congress could significantly affect estate planning for those with larger estates – over $3.5 million ($7 million for spouses). You’ll find resources in this newsletter to help you stay informed about potentially significant changes to the Federal Gift and Estate Tax.

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

Introduction

The current economy is subjected to conflicting signals on an almost daily basis. The coronavirus delta variant’s impact on the economy is forcing the Biden Administration to take unusual steps, much to the chagrin of the general public. And as if that is not enough, false theories on the pandemic that are being asserted as facts are further muddying the water. This is not an environment in which the creation of even an intermediate-term financial plan is either possible or appropriate. Recognizing that, I offer this blog as a reflection of my “personal views” on the subject. No one has endorsed these views or even subjected them to a reality check. You are therefore advised to proceed with caution before acting on the views expressed in this blog. 

PART 1

Abstract Thinking

1. Investors are often prone to act on the basis of what a friend of a friend heard from someone else about the current state of the economy. In making financial decisions, many people rely on this risky “advice,” which is frequently unwarranted.  Hence, this practice should be summarily avoided.

2. Another common practice among research-oriented people is for them to make up their minds about an issue and then conduct in-depth research, focusing only upon resources that support their desired conclusion. (I have been guilty of that a few times.)  In academic circles, this process is known as Confirmation Bias. Please be alert to the possible existence of confirmation bias when considering the opinions and recommendations of others.

Fortunately, there is an approach that often works. When you are dealing with someone who disagrees with your opinion on an issue, follow the advice of Stephen Covey: “Listen to him carefully with the goal to understand, not to be understood.” Then continue your research until you really understand where the other person is coming from and if, as a result, you suspect confirmation bias, that’s the time to end the conversation.

3.  During the past six months, consumer prices rose 4.4%, which translates into an annual inflation rate of approximately 9%. Much uncertainty and disagreement exists regarding the degree and nature of policy actions that should be taken to contain this inflation, and neither side is willing to give even the slightest ground.

So, to find an answer, let’s look to the past. The current rate of inflation mirrors the stubborn inflation rate prevailing in the 1970s which, for a long time, could not be tamed by any means. (In passing, it should be mentioned that during the 1920s and the 1940s inflation rates were far higher, but those occurred during World Wars I and II).

Now let’s consider two critical questions. 1) Is the current inflation similar to the seemingly permanent inflation we experienced during the 1970s? At that time inflation got integrated with the economy, causing inflation to co-exist with high unemployment, a condition known as stagflation. 2)  Or is the current inflation more like 1951, when the inflation rate also spiked to 9% but was short-lived and quickly forgotten?

Not surprisingly, there is disagreement over which historical reference is more comparable to what is occurring today. Fed Chairman Jerome Powell believes that the current inflation is temporary and that the Fed has taken actions that are consistent with that position. Others, including many in the Biden Administration, feel exactly the opposite. As a result, it is virtually impossible to predict what policy measures will be taken to address the inflation issue, making any intermediate-term sensible personal financial planning virtually impossible.

PART 2

Planning in a Pandemic-Affected Economy

What I have presented thus far seems to suggest that no further discussion of financial planning is appropriate. However, after a great deal of reflection, and notwithstanding the uncertainties associated with financial planning during a pandemic, I recommend the following 10 actions for consideration when reviewing a financial plan.

1. Emergency Funds

The top financial planning priority during the pandemic should be the accumulation of emergency funds. Emergencies can hit at any time. It is unwise to assume that the government will come to the rescue every time an emergency strikes. It is better to have accumulated extra cash that is not needed, rather than to run out of cash in time of need and face serious financial problems. 

2. Current Financial Plan

Assuming that inflation will continue to be an issue through 2022, this is a good time to review a current financial plan. The experience of the past six months can be used as a guide when a plan is reviewed, keeping in mind that if a current financial plan has been working reasonably well, it might not be advisable to make any drastic changes.

3. Modify Monthly Budget to Suit the New Normal

This action may require some work. Prices for many goods and services – such as food, gasoline, airline travel, housing, used vehicles and recreational activities – have skyrocketed. Assuming that these prices are not coming down any time soon, it would be advisable to modify monthly budgets to provide for these price increases.

4. Retirement Savings and Investment Accounts

Over the past 18 months, investors have been thrilled to see their 401(k) plan balances and other retirement and investment accounts grow exponentially. It’s understandable to want to take advantage of this appreciation and withdraw some of these retirement funds or liquidate some of these investments.  [However, it is important not to forget that the market can go down as well as go up.] In addition, it is important to remember that retirement account investments grow tax-deferred, which results in more funds being available during retirement.

5. Estate Planning

Most people erroneously believe that having a will completes the estate planning process. It doesn’t. And even a will can be rendered invalid if it is not properly prepared and signed. Estate planning is a complex subject that should be handled by an attorney, and reviewed periodically to see if revisions are appropriate. Unless major work is involved, a review is fairly inexpensive.

6. Investment Planning

Even though stock prices are at or near all-time highs, this is still a good time to consider investing in stocks, notwithstanding the occasional downturn in the stock market, but only after consulting with a financial planning professional.

7. Revisit Asset Allocation

The recent increase in stock prices may have resulted in the need to consider reallocating the amount of retirement plan and investment account assets invested in equity and fixed income investments if equity investments have become a larger than desired percentage of the account balances. Once again, any such action should be taken after consulting with a financial planning professional.

8. Federal Reserve and Government Actions

The Fed is likely to continue influencing the economy like it has rarely done before, and it is also likely to collaborate with the federal government to develop a unified plan to influence the economy.  So it is important to be aware of these actions and adjust financial plans if appropriate.

9. Charitable Contributions

In recent years the funding needs of charitable organizations have grown exponentially, as is evidenced by the ongoing appeals donors receive from the charities they support. Charitable contributions reflect the personal choices of donors, and that’s as it should be. It is advisable for donors to make a list of charitable organizations that are important to them and then allocate their charitable contribution budget among the organizations so that when appeals are made, an appropriate gift can be made.

10. Financial Plan Stress Test

Each financial plan should be assessed periodically, with the assistance of a financial planner, to make sure that it can survive key issues faced in retirement, such as (1) an unexpected financial setback, a market correction, extreme inflation or a lengthy retirement; (2) unexpected health care or long term care costs; or (3) maintaining a desired standard of living throughout retirement. 

If a financial plan does not pass such a stress test, it should be changed to address its deficiencies.

Bottom Line

This is the third, and final, blog on the subject of inflation, in this case focusing upon its impact on financial planning. Please let me know if this series of three blogs succeeded in conveying my message effectively. 

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog.

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

For decades, inflation in America has been treated as a non-issue. But today it has suddenly become a major concern in our daily lives, as evidenced by the media’s coverage of the issue.  This development makes one wonder what happened to the modern monetary-fiscal theory that was supposed to resolve any future inflation problems.

This confusion is understandable. But I have good news for you. In this blog and the one that will soon follow, I will share with you an untold story that might provide just the solution we are looking for. If that piques your curiosity, please read on.  

Unpredictable Nature of Current Inflation

Trying to figure out what is going on with inflation today is like riding a wild ocean wave. So, as a first step, I present below key factors that are seemingly driving the current inflation, along with select safety nets that exist today.

Part A: New Factors

1. For several decades we became accustomed to a 2-3% rate of inflation. Today, however, depending on the measuring technique you use, the rate of inflation hovers around 5 -7%, and going higher. The Social Security Administration has recognized this, and increased the COLA (cost of living adjustment) for next year to 6.2%, a number unheard of in modern times.

2. In the past, inflation did not seem to be affected by growing federal debt. In fact, inflation barely budged upward when the ratio of federal debt to GDP crossed the ominous 100% mark. Now, there’s concern over whether the actions that controlled inflation in recent years are still effective. 

3. The COVID-19 pandemic has played a role in increasing prices people are paying for crucial goods and services.  Gas prices have shot up from $2.00 to $4.00 per gallon. A pound of beef that you could recently buy for $3.00 now costs $5.50. Prices for used cars – if you can find a good one – are going through the roof. Home buyers are paying $50,000 to $100,000 more than what the same homes sold for only a year ago. The list is endless.

4. Price increases, however, are not uniform across the board. While prices on some items are increasing rapidly, other prices are staying stable, and some are even declining.

5. Product shortages, transportation problems and labor shortages are among the market factors being offered as justification for higher prices. In addition, the Federal Reserve stimulus, fiscal stimulus, and artificially low interest rates might also have had an impact on inflation.

6. The unemployment rate is very high by recent standards. And yet, signs like “Now Hiring” are popping up everywhere.                                                       

Part B: Safety Nets

1. A variety of important safety nets are in place today that were non-existent in the 1930s. Examples include Medicare, Medicaid, Unemployment Insurance, and a host of other lesser-known plans.

2. President Biden’s $3.5 trillion infrastructure plan, in addition to focusing on infrastructure needs, will also address child care, education, elder care, health care, and climate change. If this plan passes, the government will begin addressing the needs of ordinary Americans from cradle to grave, notwithstanding the Federal Reserve-federal government partnership plan that is firmly in place.  

In Search of a New Economic Policy

We have noted that due to the severity of the Great Depression in the 1930s, the Fed was incapable of bringing the economy out of the depression. Keynes convincingly argued that the only solution to this problem was to form a disproportionate monetary-fiscal policy partnership in which the government would adopt a massive expansionary posture to fight the depression. Keynes’ theory was universally accepted. As a result, the idea of the government cooperating with the Fed to formulate an inclusive economic policy rather than the Fed independently attempting to revive the economy with monetary policy alone, was firmly established.

That brings us to the untold story I mentioned earlier.  What I deliberately omitted from my previous blog’s discussion was a reference to the following two highly respected economic theorists who promoted a very different approach to fighting the Great Depression that failed to stand up to Keynes’ powerful thesis.

Friedrich Hayek. Hayek, an economist at the Austrian School, was awarded the 1974 Nobel Prize for Economic Sciences. Hayek believed that the prosperity of society was driven by creativity, entrepreneurship and innovation, which were possible only in a society with free markets. He further espoused his theory by stating that the “natural interest rate” is an intertemporal price, which is a price that coordinates the decisions of savers and investors through time. The cycle occurs when the market interest rate – the interest rate prevailing in the market – diverges from this natural interest rate.

Hayek’s unmistakable advice was that a recession, or a depression, represents a situation in which the market interest rate has deviated from the natural interest rate. He felt that, rather than delegating to the government the task of fixing it by spending money arbitrarily, the best policy was to rely upon the creativity, entrepreneurship and innovative power of the free market system to solve this recession problem.  In other words, he contended that government intervention in solving this problem is unnecessary, and in fact, harmful.

Joseph Schumpeter. Schumpeter is best known for his theories on business cycles and the development of capitalist economies. He also embraced the concept of entrepreneurship. As he put it, the entrepreneur is the cornerstone of capitalism — the source of innovation, which is the vital force driving a capitalist economy.

The most powerful argument against government intervention in a recessionary economy is what Schumpeter called self-controlled “creative destruction.” This is what happens when an old, inefficient economy is replaced by a new economy that is more efficient and better suited for long-term growth and prosperity.

Hayek and Schumpeter: Policy Recommendation

Hayek and Schumpeter felt that a depression is the natural way an economy adapts to the new environment, and that fighting the Great Depression of 1930 should be left to capitalistic entrepreneurs, and that this natural pattern of evolution should not be interrupted by government intervention.  This view was diametrically opposed to Keynes’ prescription for massive government involvement. As we have already noted, during the Great Depression, Keynes was the winner of this debate, and Hayek and Schumpeter’s recommendations were considered but finally rejected.

Grounds for Changing Current Economic Policy? 

To be perfectly clear, I am not arguing for rejecting the Keynesian theory altogether; the original theory (excluding the newly created substitutes without his will) still remains intact. My objective is to determine if current conditions warrant a modified economic theory from the one that exists today.

Here is a summary of what we have learned so far. Keynes argued that the Great Depression was caused by a general shortfall in demand that should be corrected by undertaking massive federal expenditures. In sharp contrast, Hayek and Schumpeter argued that, in the 1930s, labor and capital resources were wrongly allocated, and the Great Depression was a natural mechanism by which the free market system readjusted those resources. Once that was done, without government intervention, they felt that the economy would come back to life, supported by an appropriate allocation of labor and capital resources. 

This short discussion of two contrasting views of how to formulate a new economic policy provides an important background for the following question: At this critical juncture, is it in our long-term best interest to let our government provide a safety net for every American from cradle to grave?  

Bottom Line

This blog is certainly not the right place to undertake an in-depth analysis of a complex subject such as the formulation of a new economic theory or policy. I have nevertheless raised a philosophical point for you to ponder: Has the time come to seriously consider a modified economic policy leaning more heavily on the incredible strength of our free enterprise system? Under that new policy, the government would still have an important role to play; but more responsibility for supporting our economy would be shifted to the genius of our entrepreneurs and the free enterprise system.

 [Note: Because of space constraints, a discussion of how to manage today’s inflation will be deferred to a future blog.]

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog.

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

Introduction

In this blog I will review the history of inflation as a prelude to future policy measures concerning inflation. True, by our normal standards this blog is much too long. But the value of a comprehensive historical perspective of inflation in one place far outweighs its length.

In this blog I will discuss the topic of inflation in three parts. In Part 1 I will identify the events that planted the inflationary seeds in America but prevented inflation from reoccurring for three decades. In Part 2, I will describe each of the major events that spread the evils of inflation for an unprecedented 30 years. Finally, in Part 3, I will highlight the current changes in monetary and fiscal policies that give us the tools we need to achieve full employment with stable currency for the long term.

PART 1
Underground Growth of Inflation: 1933-1963

Phase 1: 1933-1945

Two events played a role during this period.  First, in 1933 the seeds of the Great Inflation were quietly sown in the depth of the Great Depression. Before the depression hit, it was the sole responsibility of the Federal Reserve to resolve all monetary problems, be they inflationary or recessionary in nature. However, the severity of the Great Depression rendered the Fed incapable of bringing the economy out of the depression. That development resulted in the idea of the government cooperating with the Fed attempting to revive the economy with monetary policy alone. And, as we will see later, with that the dye was permanently cast for a federal government-Fed relationship.

Second, the publication of Keynes’ General Theory in 1936 was much-acclaimed because it established the important role of the government in fighting a recession. This provided the theoretical foundation for the government’s playing an active role in bringing the economy out of depression when monetary policy alone was unable to perform the task. Interestingly, while neither the Great Depression nor the Keynesian theory directly dealt with inflation, together they did lay the foundation for a coordinated government-private sector initiative to resolve all economic problems.

At this point a caveat is in order. Keynes rarely showed any interest in establishing the role of the government in fighting inflation. Thomas M. Humphrey, in his scholarly paper entitled “Keynes on Inflation,” pointed out about Keynes that “on the policy front his name is now popularly identified with excessive government spending, mounting budget deficits, and inflationary money growth; and . . . with the idea that inflation can be contained with . . . [income] policies and wage-price controls.” Humphrey’s paper about false accusations of Keynes, which is rarely cited, is critical to the arguments I will present later. 

Phase 2: The Hidden Inflation, 1946-1963

            The Employment Act of 1946. With the passage of this Act, the role of the government in striving for full employment was made official. The main purpose of the Act was to lay the responsibility of economic stability of inflation and unemployment onto the federal government to “coordinate and utilize all its plans, functions, and resources . . . to foster and promote free competitive enterprise and the general welfare; conditions under which there will be afforded useful employment for those able, willing, and seeking work; and to promote maximum employment, production, and purchasing power.” Note that there was no direct mention of the Federal Reserve, which was still solely responsible for formulating monetary policy.        

            The Prosperous Era, 1946-1952.  Following the end of World War II, America became the undisputed leader of the industrial world and, by default, the dollar became the international currency. Thanks to America’s initiative, institutions like the International Monetary Fund, the World Bank and the European Union, were formed to foster international trade and revive the world’s major powers that were devastated by the war.

          The Expansionary Era, 1952-1963.  This was an exceptional period which was earmarked by the establishment of the Dwight D. Eisenhower National System of Interstate and Defense Highways Act. Along with the establishment of highways there were two other important developments. First, there was massive growth in the auto industry resulting from the public’s need for greater independence.  Second, there was a housing renaissance. With the development of the new highway system and ownership of automobiles, workers no longer had to live so close to work. That created a new dream of home ownership for millions of Americans, resulting in the unprecedented housing boom. As expected, the housing boom triggered the exponential growth of the mortgage and personal loan industries. In fact, it is no exaggeration that these industries contributed significantly to the solid growth of the American economy between 1952 and 1973 when it was adversely affected by the Arab oil embargo.  

In 1961, Democrat President John F. Kennedy replaced Eisenhower, and Americans waited anxiously to see how the country would change direction. Unfortunately, during Kennedy’s initial years in office, the Vietnam War, the Cuban Missile Crisis, and internal conflicts among his top officials, occupied much of Kennedy’s attention. Then, in November 1963, he was assassinated, bringing his tenure to a tragic ending. Incidentally, during his presidency Kennedy had little to worry about when it came to inflation; in 1964 the inflation rate was 1.31%, a dream of any president.  

Phase 3: The Great Society and Paper Money Standard, 1963-1973

           The Great Society. In 1964, Lyndon Johnson, soon after becoming president, launched the Great Society. Early in Johnson’s tenure several socially-motivated laws were enacted, including the 1965 Social Security Act Amendments, which created Medicare and Medicaid, and the Voting Rights Act of 1965. Those developments firmly established Johnson’s life’s legacy.

It is ironic that, partly because of the distractions created by the Vietnam War and Johnson’s in-fighting with Attorney General Robert Kenney,  and also because the financial side of economic policymaking was not his strong suit, Johnson launched the Great Society with its massive expenditures plan without first developing a financially secure plan to pay for them. The resulting inflation was inevitable. The inflation rate, which was 1.31% in 1964, started to rise rapidly, reaching 5.37% in 1969, a devastating development for policymakers to handle. Inflation, which had been dormant for three decades, had finally raised its ugly head for good.     

           Abandonment of the Gold Standard. Historically, American had honored the gold standard which maintained the desired ratio between gold stock and the issue of currency.   However, in 1971 to stave off a run on US gold reserves, meaning that other countries could no longer redeem dollars for gold, Nixon halted convertibility. Then, under intensifying pressure, in 1973 the president scrapped the gold standard altogether. In technical terms that amounted to adopting the Irredeemable Paper Money standard, which means that the U.S. dollar is no longer redeemable for gold; this is the system that exists today. This constituted the second major impetus to the inflation problem. With no checks on issuing currency, as expected, government debt exploded from 30% of GDP in 1970 to 105% of GDP in 2021. 

PART 2
Inflation at its Worst: 1973-1985

Phase 1: The Phillips Curve

A. W. Phillips published a relatively obscure study in 1958. After analyzing long-term data pertaining to British private companies, Phillips concluded that in the long run unemployment and inflation were inversely related. It was music to the ears of policymakers, since they felt that this theory, known as the Phillips Curve, meant that they could bring down the rate of unemployment by generating a predictable higher rate of inflation, or lower inflation by creating a higher rate of unemployment. The theory slowly entered the policy discussions in the U.S. in the 1960s, but was never tested for effectiveness in the U.S. Some economists, like Nobel Laureate Milton Friedman, questioned its reliability as a policy instrument in the U.S. But such questions were largely ignored, primarily because the prevailing economic conditions with controlled inflation made them irrelevant.

Now fast forward to 1973, when the Arab oil embargo triggered inflation at unprecedented levels. Since no other “neat” policy prescription was available, the Phillips Curve theory was revived as a way of predicting how much additional unemployment would need to be created to bring down the inflation rate to an acceptable level. That was an inappropriate use of the Phillips Curve theory because the oil embargo had pushed both inflation and unemployment to their unprecedented levels (stagflation). Unfortunately, it was the misuse of the Phillips Curve, and not necessarily its power to predict policy measures under normal circumstances, that weakened the original Phillips Curve as a viable national policy measure.    

Phase 2: Monetary Policy, 1973-1985

The period of 1973-1980 was characterized by ballooning federal debt, high inflation and unemployment, and failure of economic policies to cure stagflation associated with slow economic growth. But that was not all.  In August 1974, a scandal forced President Nixon to resign and his Vice President, Gerald Ford, became president. Only two years later, Ford lost the election to Jimmy Carter, and America had its third President in only two years. Through this politically tumultuous period, policymakers failed to tame the stagflation situation, and slow economic growth continued.  

It was in this environment that the “demand-pull, cost-push” inflation theories emerged. To put them in simple terms: Demand-pull inflation occurs when the increase in aggregate demand generated by households, businesses, government and foreign buyers exceeds the supply of goods and services. When that happens, which can be caused by an expanding economy, inflation can be contained by taking steps to increase the supply of goods or temporarily temper the demand by other means like wage and price controls. By contrast, cost-push inflation is caused by an increase in the cost of raw materials and/or labor. This type of inflation can be contained only by taking measures to contain the rising costs without adversely affecting the long-term economic growth.

Unfortunately, since to a large extent both the inflation and the recession in America were caused by a surprising oil embargo that seriously threatened the normal operation of the U.S. economy, the newly discovered demand-pull, cost-push theories could not be successfully applied to solve the stagflation problem.  

Following several years of repeated failures to tame inflation, a new avenue opened up when in 1978 the Full Employment and Balanced Growth Act was passed, which amended the Employment Act of 1946. This Act explicitly directed the Federal Reserve to set as its prime objective full employment and price stability, by establishing targets of 3% unemployment for people 20 years and older and the reduction of inflation to 3% or less. In retrospect, it appears  (although there is no proof) that Volker was persuaded to accept the position of Chairman of the Federal Reserve when two years later President Reagan appointed him to that position. It is certainly to President Reagan’s credit that he gave complete freedom to Volker to formulate monetary policy without interference from the government.  

Over the next five years, 1980-1985, Volker took several tough-minded actions to address the issue. True, during the first two years some of Volker’s short-term measures were ineffective. In fact, to Reagan’s displeasure, Volker’s policies created a short recession and the future looked gloomy. Still, Volker remained relentless in his efforts to contain inflation, and by 1985 finally succeeded in this near-impossible mission. By 1985, inflation had fallen to a comfortable 5% level, never to challenge that level again. The period of the Great Inflation was finally over.  

PART 3
Modern Monetary Policy, 1985-2021

Phase 1: Return of Supply Side Economics

After giving full responsibility to Paul Volker to formulate monetary policy to control inflation, Reagan turned his attention to the rest of the sluggish economy controlled by the private sector. As expected, he leaned heavily on the Supply Side Economics (SSE) to formulate the government’s economic policies concentrating on the private sector. SSE holds that increasing the supply of goods translates to economic growth.  SSE practitioners often focus on cutting taxes, lowering borrowing rates and deregulating industries to foster increased productivity.  The result was as expected. Between 1985 and 2009, SSE dominated the economic policy-making scene, resulting in lower taxes and massive deregulation. While both had a great deal of success, Reagan had to increase federal debt to achieve his objectives, which was contrary to the SSE theory.

After Reagan, Democrat President Bill Clinton embraced SSE too, although he included social programs financed by the government as an integral part of his primary objectives. And when George W. Bush became president in 2000, SSE gained new life. Economic policies under President Bush were highly influenced by SSE, and he was not shy of making that claim.

Phase 2: SSE under a Democrat President, 2009-2016

After almost 30 years of unprecedented economic growth, Bush left behind the worst recession the country had ever experienced, leaving it to Democrat President Barack Obama to fight the recession. Obama used the Keynesian guidelines to create an active monetary policy with generous participation by the federal government to fight the recession. While the real GDP grew at a 2% annual rate during the Obama Administration, the recession was wiped out and the economy seemed ready for a rapid advance in the future. Understandably, under Obama, SSE took a back seat again, which suited Obama well.

Phase 3: SSE under a Republican President, 2016-2020

As soon as Republican Donald Trump became president, SSE gained new life. This time, contrary to the established use of supply side economics during a recession, this time the U.S. economy was on an expansionary roll and not in recession. Taxes were reduced on high income taxpayers, corporations and capital gains, adding a whopping $1 trillion to the already bulging government debt. Equally notable, while the stock market and housing market boomed, U.S. economy grew only at a nominal rate of 2.3%, demonstrating that the massive tax cuts had negligible impact on the economy’s growth.  

Phase 4: Democrat President, 2021

Democrat Joe Biden was barely inaugurated as president when he started to take a series of actions based on Keynesian principles. These include: the passage of the stimulus package, extension of unemployment benefits, and forgiving student loans. Of course, it is too early to tell how Biden’s use of Keynesian economics by rejecting SSE will eventually pan out.  

After a long journey I have finally arrived at the all-important conclusion of this blog. The Federal Reserve was created in 1913 as an independent institution solely responsible for pursuing an efficient monetary policy. Over time, economic conditions have continued to change and with that the role of the Fed underwent transformation as well.

At present, the Federal Reserve’s main objective is defined as achieving full employment with a stable currency, and it is given the freedom to partner with the federal government to achieve these objectives. This approach is brand new, and it bodes well for the country. Complementing this development was the passage of the Monetary Control Act of 1980, which required all depositary institutions to meet Federal Reserve minimum reserve requirements, and phased out interest rate ceilings on customer deposits.

This, then is the new backdrop against which the latest upsurge of inflation should be analyzed. That will be the subject matter for my next blog.   

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog.

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

I bet you have had enough of the COVID-19 pandemic and delta variant, and that you are ready for an interesting blog. Well, here comes one, but it uses – guess what – economic theory as the subject matter. If that surprises you, I understand. Hopefully, you will find this blog an intriguing distraction from all things pandemic related.    

PART I

Monetary and Fiscal Policies As We Have Always Known Them

Textbook Definition of Monetary and Fiscal Policy

U.S monetary policy refers to actions that its central bank, the Federal Reserve, takes to achieve macroeconomic policy objectives. These include price stability, full employment, and stable economic growth. By contrast, fiscal policy refers to the tax and spending policies of the federal government. Fiscal policy decisions are made by Congress and the Administration; the Federal Reserve plays no role in formulating fiscal policy.

Congress has established maximum employment and price stability as the macroeconomic objectives for the Federal Reserve, but it has determined that implementation of these monetary policy objectives should be free from political influence. As a result, the Federal Reserve was established as an independent agency of the federal government.

Great Depression Modified the Basic Concept

The Great Depression of the 1930s demonstrated that monetary policy is rendered impotent when basic monetary policy actions fail to revive a battered economy. In such an atmosphere, the government has little choice but to use its fiscal policy powers of taxing, borrowing, and spending to revive the economy. This conceptual framework is based upon John Maynard Keynes’ General Theory. And since this policy was implemented under a Democrat president, the Democrat political party naturally came to be known as Keynesians.    

Beyond the Great Depression

Interestingly, in the 1950s, it was Republican President Dwight Eisenhower who became the champion of using active fiscal policy to finance massive infrastructure and other socially-desirable expenditures. In addition, although Keynesian Democrats continued to dominate economic policy-making activities until the 1970s, it was Republican President Richard Nixon who declared that the U.S. would no longer convert dollars to gold, thereby completely abolishing the gold standard and allowing the federal government to resort to borrowing without traditional checks and balances. (The result was scary. Federal debt as a percentage of GDP increased from around 30% in 1970 to a whopping 105% in 2020.) Republican President Ronald Reagan – who popularized the slogan “I’m from the government and I’m here to help” – embraced the theory of Supply-side Economics, a 1980s theoretical concept proclaiming that increasing the supply of goods leads to economic growth. Practitioners of this theory preferred to focus on cutting taxes, lowering borrowing rates, and deregulating industries to foster increased production. Supply-siders, mostly Republicans, continued to challenge the Keynesian Democrats, instituting their preferred theory as the basis for formulating national economic policy.

The 21^st Century

As the U.S entered the 21^st century, Supply-side Economics continued to be used by Republican President George W. Bush as the basis for managing the economy. Unfortunately, it did not turn out well for the supply-siders, and toward the end of Bush’s term the economy experienced the worst recession America had ever experienced. So, in 2009, instead of relying solely on monetary policy to revive the economy, Democrat Barack Obama, influenced by the traditional Keynesian policy, extensively used fiscal policy initiatives to fight the recession and ultimately succeeded. Subsequently, in 2017, in spite of the fact that the economy was operating at near-full employment, instead of reducing foreign debt by creating a surplus budget, Republican President Donald Trump reverted to supply-side economics by significantly lowering taxes (which increased federal debt by $1 trillion), deregulating industries, and encouraging the Federal Reserve to keep the interest rate near zero.  

PART II

Now the Intrigue

What Part I Demonstrates

Part I demonstrates the following:

• Democrats like Presidents Obama and Biden, follow the traditional Keynesian Theory (like Obama’s stimulus plan and Biden’s American Rescue Plan) by arguing that monetary policy alone cannot meet the challenge and that these fiscal policy initiatives are needed to boost demand during a severe recession.  
  
• Republicans, however, reject the Keynesian Theory and argue that the right policy to fight a recession (like the one in 2009) should be to cut spending, not increase it, since such a cut would increase demand by supporting higher public confidence. In addition, Republicans also argue in favor of supply-side economics and tax reductions (as occurred in 2017) claiming that this would create new incentives to work and invest, resulting in an expansion of the already-booming economy.

Finally, the Intriguing Part

Ironically, in the world of economic theory, the coronavirus pandemic has succeeded in creating a unique situation no one ever predicted. It has completely flipped the theoretical arguments of the two political parties. Here is the proof.
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Democrats now claim that the infrastructure and other spending plans will create significant growth in employment, which in turn will also have the positive supply-side effects of raising the economy’s long-run potential. By contrast, Republicans, by taking a Keynesian position, which argues against aggressive fiscal policy during solid economic growth, now warn that the proposed massive government expenditure will build unsustainable inflationary pressures that will, in turn, negatively impact employment and economic growth, Consequently, Republicans forcefully argue that the Democrats spending plans will actually make  matters far worse and should be abandoned. 
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Bottom Line

Did you find this unbelievable flip-flop story concerning a well-established set of economic theories intriguing? It is truly a rare occurrence.

But allow me to conclude this blog with a somber note. When the two main political parties again flip their positions—which is inevitable– what if they accidentally bump into each other hard and succeed in inventing a middle-ground, unified economic policy that we can all agree is good for all Americans?_________________________________________________________________________

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

PART II

In Part I of this blog I established three powerful ideas addressing the question of fairness of our tax system. In Part II I will examine the fourth idea based upon the impact of the rapidly changing relationship between the public and the private sector.  

Major Developments in the public-private sector relationship

Keynesian Theory of Employment

In the 20^th century, starting notably with the Great Depression of the 1930s, and theoretically supported by Keynes’ classic General Theory of Employment published in 1936, the concept of government’s role in helping the private sector was firmly established.

Keynes convincingly argued that normally our economy follows a business cycle pattern. In that cycle, when the economy is booming, the government should provide only the essential public services, leaving the private sector to act independently. However, when a recession or a depression hits, the government has little choice but to partner with the private sector to get the economy out of a recession. And the history shows that is exactly what took place during the Great Depression of the 1930s. 

Government’s role in creating safety net

1. The Social Security Act in 1935, representing the first major act of this nature, however, did not quite fit the category of a public-private partnership. Rather it was a heroic effort on the part of the U.S. government to throw a lifeline to the private sector that was in a free fall.

2. The spirit of partnership between the government and the private sector was first established 1945 and continued through 1980. The end of World War II which ended up making America the undisputed leader of the industrialized world created an atmosphere ripe for establishing such a partnership. This shared understanding came to be known as the liberal consensus.

3. An outstanding demonstration of this liberal consensus is the National Interstate and Defense Highways Act of 1956, which laid the foundation for establishing an interstate highway system in the U.S. Subsequently, as the highways connected the remote areas with the mainland, the government played a major role in developing two other private industries; namely, the  housing industry supported by the private mortgage business, and the automobile industry which made it possible for people to reach remote locations even with the absence of public transportation. All of these activities vastly expanded the country’s living universe.

4. Liberal consensus clearly demonstrated that the majority of Americans strongly  believed that the government had a significantly role to play in regulating business, providing a basic social safety net, investing in infrastructure, and promoting civil rights. The result was startling, if expected: The establishment of what came to be known as the Great Society in America. The government undertook several measures to provide a life-time safety net for all people, Medicare and Medicaid Acts of 1965 being two of the shining examples such partnership. But the progress in this direction did not stop there. In 1970 the government replaced gold with U.S. dollar as the backing for money supply, laying the foundation for unrestricting increase in public borrowing. In fact, in recent years, the ratio of foreign debt to the GDP has passed the ominous 100% mark and the march shows no signs of slowing down.

5. In 1980, with the election of Ronald Reagan to the presidency. the Republican Party rejected that vision of the government, arguing that, as Reagan said, “government is not the solution to our problem; government is the problem.” But while Reagan limited that statement with the words “in this present crisis,” since the 1980s Republican leaders have worked to discourage the liberal consensus.. It is extraordinary that the concept of liberal consensus has never disappeared, as can be evidenced by the launching of Biden’s infrastructure plan of 2021.

6. Subsequently, a new dimension was added to the public-private partnership in the 1980s when the government partnered with the Federal Reserve in its quest to bring the runaway inflation under control, a task which until then was strictly in the monetary policy domain. This new, ever-changing relationship between fiscal and monetary policy has continued to prevail even during the 21^st century in ways that had never been dreamed of by anyone.   

Tax Rules for Different Situations

Traditionally, as the major source of income, taxes have provided the necessary funds for the government to play its traditional role. But over the years new sources of taxes have been created to meet the financial needs of an expanding slew of obligation. These sources of funds have distinctly different flavors, as we shall now observe.

1. In the pursuit of establishing a Great Society the government identified a number of items that deserved various degrees of tax breaks.  Examples include: encourage home ownership through the establishment of private mortgage companies, develop oil and gas industries, assist municipalities which had little taxing power, provide financial support for  colleges and universities, and save our waterways and vast wilderness across the country. While many of these tax changes were political in nature, the new tax system did provided tax breaks as a means of support for these causes. Equally important, the tax law categorially stated that only the money declared as realized income during a given year can be taxed, and came with a guarantee that this after-tax income can never be taxed. .

2. Tax rules mostly applied to incomes generated by U.S. corporations in the U.S., which implied that the foreign incomes of U.S. corporations escaped U.S. taxation. This sent a clear signal for our corporations to move their businesses outside of the U.S, indeed a colossal income loss for the IRS.

Tax Avoidance for the Rich

We have finally arrived at a point when we can honestly answer the question: Does the American tax system favor only the rich? We are of course not talking about tax evasion, which is strictly illegal.  Interestingly, it is claimed that tax evasions currently stand at a whopping $7 trillion—large enough to cover Biden’s entire $6 trillion infrastructure package and still leave money for a fully-paid gala bipartisan party to celebrate the occasion.

Techniques of tax avoidance

1. Since tax avoidance is completely legal, enormous energies are devoted to finding ways to avoid paying taxes. And that brings me directly to the issue at hand: If for whatever reason I am unable to take advantage of these tax reduction strategies available to everyone, then I have no moral grounds to criticize those rich taxpayers who do succeed in their mission.

2. Here are some examples of how all taxpayers can legally lower their tax brackets.  

A. Shift income to other forms of payment. This is a technical matter and cannot be adequately dealt with here. But a commonly used technique is for the taxpayer to arrange for a shift of an equivalent amount to a tax-deferred retirement account. The retirement money is not currently taxed, and this shifted income also escapes current taxes because it was not received by the taxpayer as current income.

B. Use as many tax breaks as the law allows to reduce Gross Income so the AGI is minimized to the lowest possible level.

C. Arrange for Income due this year to be postponed until a future date when presumably  the taxpayer would be in a lower tax bracket (after retirement for instance).

These are but only a handful of techniques used by rich people to achieve their objectives. Similar strategies can be discovered with relative ease.

BOTTOM LINE

Based on the research I have just presented, I feel that so long as these tax reduction opportunities are available to everyone, while we can be jealous, we cannot unfairly blame these rich people for gaming the system. Of course, it is perfectly justifiable for us to help change the existing rules so the rich would have no choice but to participate more fully in building our Great Society. If that is your desire, I wish you the best.     

 And now that you know the rest of the story, it is your favorite quiz time. Please send me your answer today so I may share the results with my readers:

Your answer: 1___2___3___4___5___6___7___8___9___10___ (Mark as many as apply. Thank you for participating.

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog.­­

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

THOUGHT FOR THE DAY
“The more taxes I pay, the happier I am.”  Herbert Joly, past Chairman, Best Buy

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

PART I

Following the news release indicating that in 2020 even the billionaires like Warren Buffet and Jeff Bezos hardly paid any taxes, many of my readers suggested I publish a blog denouncing this despicable tax avoidance incident. I agreed only to the first part but not the second. We do not make a definitive statement until it is supported by extensive research and facts.

My initial research suggests that we need to present four distinctly different ideas as the basis for critically evaluating the topic of tax evasion by the rich.  These ideas are as follows: 1. History of the U.S. tax system. 2. Basis of U.S. tax structure. 3. Principles of a good tax structure. 4. Significant changes in the relationship between the public and the private sector, laying the foundation for establishing an ever-changing tax structure. In this blog I will address the first three subjects.  The fourth idea will be addressed in my forthcoming blog.

HISTORY OF THE U.S. TAX SYSTEM

Historical Perspective

Few people realize that Adam Smith, in his 1776 seminal work, The Wealth of Nations, clearly set forth the following four principles that created the foundation of our tax system: 

It is extraordinary that, despite significant changes to our economy over the last two centuries, the basic principles of taxation espoused by Smith have not materially changed. However, since significant changes in our financial system did occur over these centuries, a modified, and arguably improved, set of tax principles – which I refer to as the modern principles of taxation – has evolved.

Basis of the U.S. tax system

Free Enterprise System

The free enterprise system assures that people, without interference by the government, have the freedom to decide which goods and services will be produced, and who will be entitled to have them. If this free enterprise system functions efficiently, then it will maximize the nation’s wealth. Equally important, the system will also guarantee that the wages of workers are equal to the value of their productivity, and that there will be no need for the government to interfere in the labor market. 

Private and Public Goods

The operation of the free enterprise system rests on two pillars: private goods and services and public goods and services. Under this system, the majority of goods and services produced by the private sector is called private goods, but there still exists a significant number of goods and services that the private sector is either not willing or not able to produce. Hence, by default, these are known as public goods and services andbecome an integral part of our economic system. Examples of public goods and services include defense appropriations, Social Security, Medicare, Medicaid and Unemployment Insurance. In addition, in recent times, the government has undertaken the task of dealing with massive projects like fixing the nation’s infrastructure, climate change, income inequality, improving children’s education and much, much more. These projects are mostly beyond the ability of the private sector to handle, which results in the government assuming the responsibility for producing and providing these public goods and services for the private sector.   

Taxes as Payment for Public Goods and Services

That brings me to the central point of this discussion. We do not object to paying for the goods and services we choose to buy. But we have a hard time accepting the obligation to pay taxes to the government so it can provide the goods and services that the private sector cannot produce. The predictable result is that there is a universal distaste for paying taxes, since many consider them to be an unwarranted extortion.  This line of thinking of course is archaic. Our tax system is demonstrably based upon a set of sound principles. 

Principles of a Good Tax Structure

Principle of Equal Treatment

The most important of all tax principles is that two taxpayers with the same income should pay the same taxes. But this simple premise rarely applies because the basis for collecting taxes is not a taxpayer’s income – or gross income as it is called – but the taxpayer’s adjusted gross income (AGI).  A taxpayer’s gross income can be reduced, for tax purposes, by a variety of legally available deductions to arrive at the taxpayer’s AGI.

Assume, for example, that the three taxpayers listed in the following table have the same $100,000 of gross income, but have widely varied deductions that result in a significantly different AGI.

The first taxpayer has minimum deductions that reduce AGI to $90,000. The second taxpayer has significant deductions that reduce AGI to $30,000. Finally, the third taxpayer has even larger deductions that reduce AGI to only $9,000. Inasmuch as the first $9,876 of AGI is not subject to income tax, that taxpayer owes no taxes at all despite having the same gross income as the other two taxpayers.  Such differing tax consequences for taxpayers with the same gross income is often viewed as evidence of our unfair tax system; but all three taxpayers were treated equally and fairly under applicable tax law, which allows the deductions claimed by all tax payers to reduce their AGI.  

A remaining question relates to how our tax system determines what items can be deducted from gross income to determine AGI, because every dollar deducted from gross income escapes being taxed. The answer to this vexing question is somewhat convoluted because most allowable deductions exist for either political or economic reasons. Examples include deductions available to farmers, homeowners, municipal bond holders, and oil and gas producers. Here again, it can be safely concluded that by any measure our tax system is to be fair and equitable so long as the same deductions are available to all similarly situated taxpayers.

Principle of Capacity to Pay

There are three significantly different examples of this principle.

1. Our tax system claims that it is grossly unfair to determine a taxpayer’s capacity to pay based upon the taxpayer’s ability to spend money on goods and services. Those who disagree with this position forcefully argue that a taxpayer’s capacity to pay should instead be based instead upon accumulated wealth so tax payments cannot be permanently postponed. However, meaningful consideration of this concept has never materialized. The closest example of this capacity to pay concept in our current tax system is the imposition of taxes on wealth upon death via the imposition of the inheritance tax. But even there the inheritance tax burden is grossly limited, since for an individual it is imposed upon only estates valued above $11.7 million, which is far above value of the estates of most Americans.   

2. Our progressive tax system is also an example of the principle of capacity to pay. No taxes are levied until AGI exceeds $9,876 for a single taxpayer. AGI above that amount is subject to progressively higher income tax rates, up to 37%. This clearly reflects the well-established capacity to pay principle.  

3. A third example of the capacity to pay principle is indirect taxes, such as excise and sales taxes, because the more taxpayers spend on luxury items, the more taxes they will have to pay.

Principle of Taxes Representing Payment for Government Benefits

The payment of taxes supporting essential government benefits is rarely recognized as the price taxpayers must pay for goods or services the public sector offers. As noted above, however, there are many valuable benefits routinely provided by the government with its tax revenue that are neither recognized as public goods and services nor represent what the private sector is willing to buy and pay for. Nevertheless, the principle of characterizing taxes as a payment for government-provided goods and services is basically sound, live and well.  

BOTTOM LINE

In this blog I have presented three important characteristics of our tax system. These are: 1. History of principles of the U.S. tax system. 2. Basis of U.S. tax structure. 3. Principles of a good tax structure. The fourth concept relates to significant changes in the relationship between the U.S. government and the private sector laying the foundation for establishing an ever-changing tax structure. I plan to address that topic in my forthcoming blog.

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog.

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

THOUGHT FOR THE DAY
“The more taxes I pay, the happier I am.”  Herbert Joly, former CEO, Best Buy

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

After weeks of dealing with serious issues like COVID-19, a $6 trillion infrastructure plan, and the immigration fiasco, we deserve to enjoy a topic many of us can relate to and, hopefully, all of us can get a chuckle from. But p-l-e-a-s-e, do not take any of these stories personally or seriously; they are meant to be enlightening and entertaining.

This blog describes 10 incidents in which foreigners in America and Americans in foreign countries had experiences that ranged from frustrating to educational to humorous.  

EPISODE #1

Years ago, Juan Pablo Perez Castillo and his parents came to this country from Colombia, South America and settled in Houston. Shortly after arriving in Houston, Juan felt he needed to adopt an American name because no one could remember his real name, much less correctly pronounce it. So, against his parents’ wishes, he officially changed his name to John Dunn. 

To help pay for John’s college tuition, John’s father worked two jobs.  After John graduated from the University of Houston, he left for New York in search of a lucrative job at which he hoped to make a fortune. Unfortunately, that was the last time John’s parents ever heard from him. His distraught mother cried often, but to no avail.

Then, one day, Jose Ventura, a distant Columbian relative of John’s father, reported that he would be going to New York on a two-week vacation. Upon hearing the news, John’s mother pleaded with Jose to find John in New York. Even though Jose had never met John and had no idea how to find a person among eight million people, Jose reluctantly agreed to try his best to find John and deliver to him a letter from his mother. 

Once in New York, Jose went straight to Manhattan and entered the first tall building he came across, hoping to find John. He took an elevator to the 18^th floor, where he asked the first person he spotted: “Hi, do you have a John?” The person, assuming that Jose was looking for a restroom, which is often referred to as a john, directed him to a nearby restroom. When Jose reached the restroom, he saw a man, who he thought might be John, coming out of the restroom. He asked the man: “Are you Dunn?” The man replied: “Of course I am done, but why do you ask?”

That did it. Jose shoved John’s mother’s letter into the man’s hand and growled: “You call your mother right now, you ungrateful son. She can’t stop crying and wants to hear your voice right now.”

Replica of  Jose yelling at who he thought was John

EPISODE #2

When I first arrived at the University of Florida in 1957, I was quite uncomfortable with my surroundings. But I took everything in stride, convincing myself that I would soon get used to a new way of life. Little did I realize that it was going to be an uphill struggle.

On the first day of my graduate class in economics, the professor did something that heightened my discomfort. He cautioned the foreigners, who comprised a majority of the students in the class, that besides the normal challenges of heavy coursework, we would also have to deal with the peculiarities of the English language. To prove his point, he handed each of us a list of words with double meanings and said: “Get used to your confusing surroundings, but don’t forget to have fun.”

I kept that list for a long time until I found the following similar list published in a newspaper. 

It still surprises me that I managed to survive my uncomfortable surroundings and the confusing English language, and even prospered, albeit not much as many would say.

As a postscript to this incident, I share with you another experience. In 1973, one of my female students came to my office to complain about her failing grade. She recited the typical excuses, but to no avail. When she left my office, exhausted and visibly angry, she said: “Professor Mittra, please excuse me for saying so, but you are the only person in America who not only speaks with an accent but also listens with an accent. So there is no sense talking to you.”

EPISODE #3

Rick Kyoto, a Japanese engineering graduate student at the University of California in Berkeley, had attended an English school in Tokyo and was fluent in the language. One evening, while dining at one of the city’s famous restaurants, he decided to have fun by finding a creative way of using the English language. When the waiter came to take his order, the following conversation ensued: 

Waiter: “May I take your order, sir?”

Rick: “Sure, please bring me ghoti, my favorite food.”

Waiter: “That might be a delicacy in your country, sir, but we don’t serve it here. Please pick an item from our menu.”

Rick: “You are mistaken. I know you serve ghoti here. Please call the manager.”

When the manager arrived, he reiterated what the waiter had said: “You are asking for a foreign food that we do not carry.” 

At that point, Rick said: “You are mistaken. Let me explain.” He then produced the following chart:

Rick: “So now I ask, do you have ghoti – or if you prefer – fish?”

Fish or Ghoti?

EPISODE #4

Nathaniel Davos migrated from the Philippines to the U.S. and found employment as a clerk at the Admissions office of Oakland University in Rochester, Michigan. Nathaniel also picked up a second job at a local grocery store. His life’s ambition was to send his son, Aaron, to a prestigious east coast university, in hopes that would help him become highly successful in life.

However, Nathaniel’s ambitious dream was shattered one day when Aaron, who was eight years old at the time, made the shocking announcement that he didn’t want to continue in school or attend college, so that his Dad didn’t have to spend any money for his education. The following conversation ensued:

Nathaniel: “Aaron, if you quit school and become uneducated, then you will have trouble supporting yourself and may starve.  Do you realize that?”

Aaron: “Don’t worry, Dad.  I will do just fine in my dream job as a garbage truck driver, which won’t require any education.  So, just relax.”

Nathaniel: “And what, may I ask, led you to that decision?”

Aaron: “I have been watching our garbage truck driver and I like everything about his job.”

Nathaniel: “And what did you like about his job?”

Aaron: “First of all, the driver works only once a week – on Tuesday.  Second, he sits in the truck’s driver’s seat while the other garbage collectors work their tails off collecting the garbage.  Third, the whole time, the driver enjoys himself listening to his favorite music on the radio.”

Nathaniel conceded that Aaron was very perceptive, but he reiterated to Aaron that his decision to quit school was wrong. Aaron agreed, and changed his mind about quitting school and not going to college. Nathaniel remained skeptical, however, worried that Aaron might invent another way to do nothing in life, something possible only in America.

EPISODE #5

At Oakland University, where I was a finance professor, it was the standard policy to set aside two hours every week for students to meet with me for any reason. During such a meeting time in the fall of 1974, a neatly dressed foreign gentleman in his 50s entered my office, sat down on the chair facing me and said: “How much?”

Thoroughly confused, I said: “Sir, this time is alloted to students only. I don’t know why you are here, but please come back at 5:00 p.m. and I will talk to you then.”

Unfazed, he responded: “Let’s cut the formalities and get to the point. My son Juan is in your economics class. At present, he has a failing grade. How much would it cost to get him through this course?”

I was flabberghasted. Not only had I never experienced anything like that, but, to the best of my knowledge, no other professor I knew had ever been approached with such a proposition. Still, keeping my cool, I responded: “Sir, we don’t allow such practices in America. The best I can do is to give your son extra help. If that interests him, ask him to see me. Now this meeting is over.”

The man got up, looking extremely agitated, and left my office shouting, in Spanish:

“Aye ke lastima, aqui en Estados Unidos, por que no entiando, mucho dinero pero un poqo trabaho?” (What a shame, here in the U.S. why no one understands, lots of money for little work?)    

EPISODE  #6

A standard practice at Oakland University was to invite foreign students to be guests of professors if they arrived on campus before the university officially opened. In 1969, a professor of business from Greece was selected to have as a house guest a female student from Columbia, South America. The professor was a bit nervous because he did not speak Spanish; but he relaxed when I assured him that all he needed to say was Muchas Gracias (Thank you very much), and things would work out just fine.

On the appointed day, I picked up the student at Detroit Metropolitan Airport, and we had a great conversation on our drive to the professor’s house. Once there, the student – who, incidentally, was on the physically heavy side – entered the house, expecting a warm welcome like mucho gusto, como esta usted? (Greetings, how are you?). But what happened then is one for the books. Still looking nervous, the professor came forward and blurted out: “Macho Grasa.”Unfortunately, even though to a person unfamiliar with the Spanish language that expression sounded about the same as Muchas Gracias, in Spanish that expression literally meant: “You fat male,” or coloqually, “You fat pig.” The student, upon hearing such an insulting greeting, rushed out of the house, not realizing that her unfortunate experience was the result of an inadvertent misunderstanding of the Spanish language. I leave it to your imagination as to what happened next.

EPISODE  #7

An American couple that spoke no Spanish, went to a little restaurant in Caracas, Venezuela, where no one spoke English. They assumed, however, that the waiter would know the English names of the restaurant’s main menu items, so they ordered beef steak, well done. The waiter looked puzzled, because he couldn’t understand their order. So, after trying a couple more times, the wife got creative. She drew the picture of a bull on a napkin and gave it to the waiter, who sprinted into a back room and returned with two tickets for a bull fight.

EPISODE #8

Dr. Sam Davidson, a noted New York psychiatrist, was once invited to play golf at the King of Thailand’s personal golf course. The person who extended the invitation was the King’s cousin, who came to New York to be trained as a psychiatrist and befriended Davidson.

Davidson and the King’s cousin traveled to Thailand and, on the appointed day, arrived at the exquisitely manicured golf course in Bangkok. Davidson was convinced that this was going to be the experience of a lifetime.

However, Davidson soon noticed something that baffled him. The King’s cousin’s  shots were not that extraordinary or accurate. And yet, when they walked toward the greens to hit their next shots, Davidson found that the King’s cousin’s golf ball was always in the right spot, as one might expect from great golfers like Tiger Woods. On one hole, the King’s cousin hit his drive into the water. And yet, as they approached the water hazard, there the ball was, right in the middle of the fairway. Davidson must have looked perplexed, but before he could address the issue, the King’s cousin started laughing hysterically. After he regained his composure, he explained that, in Thailand, the royal family enjoys a special golfing privilege. No matter how poorly a ball is hit, a caddy retreives it and places it in the best possible position. Everyone who plays golf with the members of the royal family is fully aware of this special privilege.

Davidson has never been able to forget that cultural shock, no matter how hard he tries.

Replica of Thailand King’s Personal Golf Course

EPISODE # 9

The date was August 23, 1964. It was a beautiful night. I had just arrived at Caracas International Airport and was in the designated area waiting to pick up my baggage. Suddenly I heard an American tourist, who was standing in front of a pay phone, cursing loudly. I assumed that the phone was not functioning – a common occurrence in Venezuela. I walked over to help him, but I didn’t have much luck. He was complaining that the Venezualans can’t even keep the phones at the airport working. He was concerned that he couldn’t call the Hotel Tamanaco to arrange transportation from the airport to the hotel where people spoke English.

After listening to him for a while, I started to walk away. That got his attention, since he figured I was the only one there who spoke English. He repeated his concern about not being able to contact the hotel.  I offered to try the phone, hoping I could make it work, if he would give me his coin.  He questioned whether I thought I was a miracle worker but reluctantly handed me a U.S. dime.  I looked at the coin and shook my head.  This guy was trying to operate a Venezualan pay phone by inserting a U.S. dime and, at the same time, condeming his host nation when he didn’t realize that making a pay phone call required using a Venezualan 25 centimo coin, pictured below.

Once I realized his mistake, and without saying a word, I inserted the correct coin into the pay phone. I then dialed the number he gave me, and, bingo, someone answered the call, saying: “Good evening, this is the Hotel Tamanaco, how may I help you?”

As I started to walk away, the tourist mumbled something to the effect that this time I had gotten lucky, but that I shouldn’t always count on luck bailing me out of difficult situations.

EPISODE #10

This is the shortest, and by far the best, incident in the local culture category.

In the mid-1970s, I was very lucky to receive an attractive offer from a tour company. I could join a five-day, all inclusive Hawaiian vacation tour for $1,000, airfare from Detroit included. The only condition was that, at the end of the tour, I and the other tour members had to provide the tour company with a written description of our tour experience. I couldn’t wait to get on the plane.

After we arrived in Honolulu, we took another short flight to Maui, where we checked in to a hotel for the night. We were informed that our sightseeing tour would begin early the next morning, promptly after breakfast.

Unfortunately, our tour guide that day insisted on overwhelming us non-stop with details about the Hawaiian culture. Since we were all Americans, much of what he described was already known to us, and his constant commentaary was a distraction that we couldn’t do anything about. But the following conversation was so funny that I still crack up thinking about it.

Tour Guide (TG): “Let me share with you a custom that is unique to Hawaii.  On these islands, flowers in a lady’s hair indicate whether she is married or available.”

Tourist: “What do you mean?”

TG: “Ladies who are unmarried and available wear flowers in the hair on the right side of their head.”

Tourist: “What about married ladies?”

TG: “They wear flowers in the hair on the left side of their head, indicating that they are married.”

Tourist: “That puzzles me. I have seen a few ladies with flowers in the hair on the middle of their head.”

TG: “I’m glad you noticed that.  These ladies are married, but still actively looking.”

BOTTOM LINE

I hope you enjoy this blog as much as I did writing it. But p-l-e-a-s-e do not get used to such a theme. Remember, my speciality is finance and economics, and that’s all I usually write about. With that in mind, look forward to my next blog, which will be about some esoteric finance topic. Yuck!

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog. ­­

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Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

_________________________________________________________________________

Sid Mittra
Ph.D., Economics
Emeritus Professor, OU, Michigan

It is reported that, in the U.S., there are 4.35 radios per household. If you are currently listening to one of your radios, please turn it off so you can concentrate on the important concepts in this blog. Thank you.  

These days we can’t avoid being bombarded with news about the consequences resulting from high inflation and declining unemployment. And, as if that were not enough, the good news about declining unemployment is actually not such good news. I hope this blog helps you understand this apparent paradox because, at least for me, this complicated problem is making it hard for me to enjoy these beautiful summer days.   

PART I

BASIC UNDERSTANDING OF INFLATION AND UNEMPLOYMENT

Let me begin by describing some basics of inflation and unemployment, the twin economic evils.  

Basic Definition

Simply stated, inflation is the rise in the prices of commonly purchased goods and services, such as food, clothing, housing, recreation, transportation, and consumer staples. Expressed as a percentage, inflation measures the average price change in a basket of goods and services over time.

Unemployment occurs when people are without work while actively searching for employment. The unemployment rate is a percentage, calculated by dividing the number of unemployed individuals by the number of all currently employed individuals in the labor force.  Over time, high rates of unemployment can significantly reduce family income, destroy purchasing power and have a negative impact on the growth of our economy’s gross domestic product. 

Causes and Cures of Inflation

Inflation occurs when prices rise due to wage increases and increases in the cost of raw materials. A significant increase in the demand for goods and services also leads to inflation because consumers are willing to pay higher prices for the goods and services.

Actions the Federal Reserve can take in an attempt to curb inflation are to increase the interest rate, reduce the money supply, and sell government bonds. The government can also take measures to curb inflation, such as reducing spending and increasing taxes.

Causes and Cures of Unemployment

Many types of unemployment exist today, including cyclical, frictional, and structural. Cyclical unemployment is associated with business cycles, such as recessions and economic booms. Frictional unemployment is unrelated to economic factors and occurs when individuals are voluntarily searching for work, such as when they wish to change jobs or have just graduated from college and are seeking their first job. Structural unemployment is a type of long-term unemployment caused when there is a decline in certain industries or there are unemployed workers who are unqualified for available jobs. There is a fourth type of unemployment – voluntary unemployment – that is rarely mentioned and occurs when unemployed workers choose not to accept employment at the going wage rate or do not seek employment because they are receiving temporary stimulus package unemployment benefits.

Cyclical Unemployment

The most common type of unemployment is cyclical unemployment, which is caused by a lack of demand for goods and services when the economy enters a recession. There are two policies that are generally used to reduce cyclical unemployment. 

          A. Monetary Policy. During an economic downturn, there is less money flowing through the economy. As such, this money supply shortage causes the unemployment rate to go up. In response, the Federal Reserve lowers the federal funds interest rate. That, in turn, reduces the cost of borrowing by the private sector and results in an increase in the money supply as more credit is extended to borrowers. Ultimately, this action is intended to cure the money supply shortage and, over time, reverse the economic downturn.

          B. Fiscal Policy. If changes in monetary policy do not fully reduce cyclical unemployment, the government can provide additional financial assistance by enacting a stimulus package, implementing tax cuts, financing infrastructure projects, and providing unemployment benefits.   

Frictional Unemployment

Changes in monetary and fiscal policy are ineffective in addressing frictional unemployment, and it is the passage of time, not government action, that is required to solve it. 

Structural Unemployment

Long-lasting structural unemployment occurs when there are fundamental changes in the economy. These changes create a mismatch between what skills employers need and what skills available workers have.  As a result, there are jobs available, but not enough qualified workers to fill them. Structural unemployment also occurs when new technology requires workers with a set of advanced skills that those seeking employment do not have.

Voluntary Unemployment

Tejvan Pettinger defines it as a situation where the unemployed choose not to accept a job at the going wage rate.

Reasons for voluntary unemployment include the following:

• Generous unemployment benefits, which make accepting a job less attractive.
• High marginal tax rates, which reduce effective take home pay.
• Unemployed hoping to find a job more suited to skills/qualifications.
• Some jobs are seen as ‘demeaning’ or too tedious. For example, fruit picking/security guard.
• Preference for ‘leisure’ (not working) over working.

Further discussion of this type of unemployment is out of bounds for us. However, relevant information is readily available on Google.  

PART II

UNEMPLOYMENT VS. INFLATION: THE ETERNAL CONFLICT

The Phillips Curve

In 1958, Bill Phillips developed the concept of the Phillips Curve, which documented that inflation and unemployment have a stable and inverse relationship. Intuitively, this inverse relationship between inflation and unemployment makes sense. When the prices of goods and services fall, this usually indicates lower demand and lower sales. As a result, employers are forced to start laying off workers to maintain their profit margin – and unemployment increases. Conversely, when unemployment is low, employers offer higher wages and other attractive benefits, all of which leads to renewed inflation.

The Phillips Curve concept highlights two essential components of economic policymaking. First, reducing inflation requires paying a price in terms of higher unemployment. Conversely, reducing unemployment requires paying a price in terms of terms of higher inflation. Long-term statistics confirm this relationship. Second, except under extremely rare circumstances, it is virtually impossible for the rate of inflation and the rate of unemployment simultaneously to reach a point of equilibrium, and implementing the economic policymaking tools referred to above are unlikely to aid in reaching that goal.

For example, the economic conditions that prevailed during the 1990s demonstrated that the inverse relationship between unemployment and inflation can be the desired objective as long as both levels are low. Multiple research studies have shown that the late 1990s featured a combination of unemployment below 5% and inflation below 2.5%. Contributing to that low unemployment rate was a technology and Internet revolution that created many employment opportunities. Simultaneously, inexpensive gas prices thanks to new oil discoveries and increased efficiency helped keep inflation low. From 2000 to 2019, we saw more of the same. While the U.S. experienced two periods of painful economic decline along the way, the long-term averages over the two decades saw continued low inflation and low unemployment

Phillips Curve and the Prevailing Economic System

In May 2021, employment rose by 559,000, and the unemployment rate declined to 5.8%. Equally important, that month’s inflation rate rose by 0.3% to 2.9%. For the long term, the goal should be to achieve 5.0-5.2% unemployment and 2-3% inflation. It appears that the Phillips Curve is generally applicable to our current economy, but only in the short term. For the long term, it is hard to predict what combination of unemployment and inflation rates will be desirable in the post-pandemic era.

In addition, there is the paradox of the current relatively low unemployment rate being not such good news because many employers are finding it difficult to fill open positions – particularly unskilled positions.

Current Policy Actions

Policymaking in the current economic environment is a difficult issue to address. The fact that post-lockdown demand is strong and that we are seeing increases in prices should not be surprising. But the $64 question is whether this current inflation is temporary or more pervasive. If it is a short-term phenomenon, then drastic monetary and fiscal policy measures that could disturb the natural growth of the U.S. economy should not be taken at this time. If, however, this trend continues and results in a higher-than-desired inflation rate, then both the Federal Reserve and the government should take appropriate actions to address the issue.  

To the best of my knowledge, the experts believe that the current unemployment rate and spike in inflation are the direct result of the pandemic, and hence are, by definition, short-term.

Bottom Line

Thank you for turning off your radio and joining this important discussion.

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Travis Smith provided technical support for this article. Charles Gauck professionally edited this blog and made valuable suggestions for improvement. However, the author takes full responsibility for the contents of this blog. 

Feedback

If you’re enjoying what you’re reading, please consider recommending it to friends you like (and also to those you don’t like). They can sign up at sid.mittra1@gmail.com. If you want to share your thoughts on this or any other blog, or on my blogs in general, please email me at sid.mittra1@gmail.com.

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THOUGHTS FOR THE DAY

You have been formed of three parts—body, breadth, and mind. Of these, the first two are yours insofar as they are only in your care. The third alone is truly yours.

                                                                 Marcus Aurelius, Meditations, 12.3

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