Sunday, July 5, 2009

California Is Still Leading The Way

For years, California has led the way in so many aspects. The state boasts the eighth largest economy in the world – all by itself. And the residents of the state have long prided themselves on their sensitivity to social issues such as the environment, gay marriage, and immigration laws.

Now, California is leading the way in another important category – state bankruptcy. Instead of checks, the state will be issuing IOUs this week to state vendors who are owed money and also to many of the elderly, the disabled, and the college students who receive aid from the state. Once again – these people are expecting a check from their state government and they are going to open the mail and find an IOU slip instead. California’s credit rating is now the worst of all fifty states, and creditors are considering taking it even lower. The effect of this will worsen the crisis, as it will cost the state even more in borrowing costs than they currently pay on the existing debt. By all counts, this is a “death spiral” from which it will be very hard to recover.

How did this happen? I believe it all starts with the arrogance of a government that thinks it should insert itself into every aspect of people’s lives. By claiming such an interventionist role, a cycle of bankruptcy is started - 1) more government programs are instituted to “help” the poor, needy, or those groups who have well-paid lobbyists– and these programs cost a lot of money, 2) taxes are raised to bring in revenue for these programs, 3) taxpayers grow disenchanted with the tax burden under which they live, so they either leave the state for a lower-tax state, or the state economy becomes so bad that businesses start to go under – taxpayers make less money and businesses collect less sales tax revenue, leaving less overall tax revenue collected by the government. Simply put, the spending went up by the government, but the influx of tax revenue went down.

This phenomenon is called the Laffer curve. Think of it in this way – if the government set a tax rate of 0%, then it follows that the government’s tax revenue income would be zero. But, if the government set our tax rate at 100% of our income, it’s likely that their revenue income would also be near zero, since none of us would have much incentive to work for money that we cannot keep. The curve rises between these points, and it must peak at some tax rate – at that point where people still feel an incentive to work and pay their taxes. The lesson to learn is that at some point, raising taxes will actually decrease the total revenue brought in by the government. Higher tax rates will then begin driving people away or out of business entirely.

The state of California is going out of business, too. Their only hope is to either get help from the federal government (who has so far refused to get involved) or else start cutting back on government programs and tax rates. This last choice is an extremely difficult one. Cutting back on government services will cause jobs to be lost – unemployment will rise, at least temporarily, until workers are able to shift from the government sector back to the private sector. And lowering tax rates is a fearful action, too, because tax revenues will temporarily go down along with them – at least until the economy turns around. This is tough medicine to swallow, especially for a state that prides itself on its standard of living and cutting-edge social awareness. This combination of events in the state has even led certain people within the state to propose the legalization of marijuana or same-sex marriage as methods to solve the budget crisis (they make dubious arguments as to how this will happen, but hey, it’s California).

Unfortunately, it seems that our federal government is now proceeding to make the very same mistake. Government programs and government’s intrusion into the private sector are increasing at a dramatic rate. All of this will cost money. So the federal government will propose to raise taxes. And the federal government has one more option that the states do not – they can print more money (and they do). But both of these actions will ultimately result in economic failure. In terms of federal taxation, we are likely already over the peak of the Laffer curve when it comes to tax rates, and inflating the money supply will only weaken the overall buying power of every dollar bill. Will the federal government foresee this, based on California’s example, and make the right decisions now?

Wait and see.

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