Politics & Policy

Two Americas?

Try two economic visions.

John McCain made a very interesting point on the opening night of the Republican convention in New York. He essentially argued that both political parties have the same objectives: peace and prosperity. What sets the two parties apart, he said, are the methods they are willing to employ to achieve these goals.

But McCain must have been making this assessment only in terms of foreign policy. Were he to say the same about the domestic policy of the candidates he would be very wrong indeed.

Reading through the economic platforms of each party, it is apparent that the candidates vying for the presidency not only disagree on the methods, but also on the results. President Bush’s vision is one of an ownership society; Senator Kerry’s is one of an America where government clout is used to produce benefits for the general population. While each proposal promises to deliver the goods, it is obvious that each will take the economy on a different path.

Let’s begin with the incumbent’s vision and see where it leads us.

During his first term, President Bush’s tax-policy objective was the reduction of the double-taxation of income. If reelected, he will upgrade this to his long-term objective: the complete elimination of any double-taxation of income. This comes with an added (and significant) nuance — the idea of an “ownership society,” which the president underscored in his acceptance speech at the Republican convention.

The president’s ownership-society programs — retirement savings accounts (RSAs), lifetime savings accounts (LSAs), and health savings accounts (HSAs) — will not only further reduce the double-taxation of income, but will strengthen the link between reward and effort. Americans, in other words, will have a greater chance of capturing the full benefits of their actions if the Bush plan plays out.

An ownership-society concept has all the elements of a defined-contribution plan. Simply, when people own something, they take better care of it. And when people take better care of their assets, they (most likely) will make better decisions.

A good way to understand this is to look at a precursor of the ownership society — the tax treatment of residential real estate. Much is being said about the recent recession and how real estate was not adversely affected. People always mention low interest rates as the reason for this. But those who do are mistaken.

There have been other recessions with low interest rates and real estate declines. The difference this time around rests in how real estate is taxed. Real estate today is highly tax advantaged. First, it is a levered investment — most people do not own their homes outright. Second, the interest on mortgage payments is deductible from income taxes. Third, if the gains are less than $500,000 every two years, they are tax-free.

These characteristics make real estate very attractive. With a 20 percent down payment, investors enjoy a 4 to 1 leverage factor. This means that a 2 percent gain in the value of a property produces double-digit after-tax rates of return. That’s much better than most mutual funds offer. To make it even better, homeowners can borrow against the equity of their homes without penalty.

The tax treatment of real estate explains in part the increased attractiveness of real estate as an investment vehicle. The 1997 tax law effectively eliminated the double taxation of income by making gains up to $500,000 tax-free. The parallels with the Roth-IRA are evident: You invest in after-tax income and get to keep the gains. This is the essence of the ownership society.

As mentioned, George W. Bush’s plan for health savings accounts is a new piece in the ownership-society puzzle. HSAs, as proposed, would be funded with after-tax income. The account holder would at the end of a year be able to keep any cash in his account and transfer it to heirs or invest it. As with real estate tax treatment and/or the Roth IRA, the gains would be tax-free.

So far there is nothing special about this. However, if the dollar amount allowed under HSAs is meaningful, both personal behavior and the nature of the health care industry will change dramatically.

Let’s say that someone can put away $10,000 a year per family in an HSA. That cash, of course, can be used to pay for medical services. But if it’s your “own” money, will you go to the doctor for a minor ache or a common cold? In most cases, no. And when your doctor orders multiple redundant tests, will you question him? Of course you will.

Why? As an HSA owner you will get to keep any cash left over in your account at the end of the year.

Also, as a cash patient, you will bypass the need for all the burdensome paper work and insurance forms currently found in your doctor’s office. The regulatory burden on doctors will also decline. And most important, once you are a cash patient, your doctor will have to be nice to you. Patients, in effect, will become clients.

How soon before ownership programs such as the HSA take hold? The analogy here is that of the IRA program that existed prior to Ronald Reagan’s election. Back then it was seldom used. But the changes made during Reagan’s first term created an environment that fostered defined-contribution plans.

Once again, there must be a catalyst to push people into many of the programs of the ownership society that already exist. In the case of housing, tax treatment and the magnitude of the gains did the job. But what’s needed now is a bold initiative that produces some generous allowances for the amounts to be invested in the various ownership-society programs. Bush has opened a dialogue on the ownership society. Now he must be a champion for it.

Now to John Kerry.

In his acceptance speech, the senator hinted at using government buying power to lower health care costs. The measures he proposed have all the trappings of a defined-benefit plan. Workers would own some amorphous portion of the benefit pie secured by government buying power. Workers would pay for these benefits in terms of higher taxes or contributions.

In a defined-benefit scheme the link between benefits and contributions is at best a weak one. The approach is amenable to collective bargaining; in this case it’s a government-negotiated arrangement. Someone other than the workers who make the contributions will decide how the benefits are apportioned. And the amount of benefits received need not be related to the amounts contributed. Since the government would set the eligibility criteria for benefits, it is clear that what one would put in may not be what one would get out. It’s just like Social Security in its current form.

The defined-benefit aspect of the Kerry plan suggests that there is no exit strategy for the government. As long as the government intervenes there will be differential taxation and resource waste. To see this, consider the case of a taxpayer facing a 33 percent marginal tax rate. A dollar worth of income nets that taxpayer 67 cents of after-tax income. In contrast, $1 worth of benefits nets the taxpayer $1 worth of income. So, the worker is much better off receiving his income in the form of benefits. It’s tax-free.

In this scheme, the employer doesn’t care either way — he still pays out $1. Incentives only tilt the balance in favor of fringe benefits. So, would a worker be willing to tolerate some efficiency loss in the provision of the fringe benefits? Sure, as long as he came out ahead. For instance, if there were a 32 percent efficiency loss a worker would still net 68 cents on $1. That is one penny better than 67 cents worth of after-tax income generated by an additional $1 in salary.

But this calculation also shows the potential amount of marginal resource waste generated by the differential tax treatment of fringe benefits and salaries. Put another way, there is no escaping the disincentive effects under the Kerry approach. Given the likely expansion of these types of programs in a Kerry presidency, it follows that the amount of resource waste and the levels of distortion in the U.S. economy are likely to increase.

Two Americas? No, what we have here are two distinct economic visions (that would certainly lead us to different Americas). Among other things, Kerry’s vision will lead to more government waste and an efficiency loss, while Bush’s will lead to less waste and efficiency gains. Again, Americans always prove discerning with their own assets.

The emergence of the investor class has emphasized this. As the penalties on investment have decreased, the investor class has been able to make the connection between how a person votes, policy actions of the president and the Federal Reserve, and the value of a portfolio. Bush’s ownership society has similar potential.

– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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