The Road to Cyprus

There is plenty of public commentary about the banking crisis in Cyprus; there is far more privately. The public discourse is about debt, deficits, politics and Europe. The private inquiries are more in the nature of, “what does this mean for me, could our government simply place a 20% tax on my bank deposits?” The short answer is of course the Federal government has the power to impose taxes on financial assets. They already do. The longer answer is that while we do have a very serious political economic crisis, we are a long way from the drastic measures being taken in Cyprus.

Governments in the US impose a broad range of taxes. Federal, state and, even some municipalities, tax income. Municipalities rely heavily on property taxes for funding. Property taxes are levied on a particular type of asset; real estate. Estate taxes are imposed on all assets at the time of death. Sales taxes are imposed on consumption. Value added taxes fall on production. On balance, the US tax burden falls far more heavily on earnings than it does on wealth.

There are also a variety of other mandates and programs that represent a tax without being called such. For example, FDIC insurance is essentially a tax imposed on bank owners and customers. FDIC insurance is calculated as a percentage of bank assets and is collected from the bank on a quarterly basis. Bank depositors don’t experience this as a tax because they don’t pay for it directly. There are only three places that the money can come from; lower deposit rates, higher borrowing rates or lower returns to bank equity holders. I can’t really calculate who bears what part of the cost of FDIC insurance, but I can assure you that it is not ultimately all born by equity holders. FDIC insurance is a special purpose tax levied to fund the cost of closing bankrupt banks. That is exactly what the measures being taken in Cyprus are, simply on a larger and more direct scale.

Social Security taxes are imposed through payroll deduction and matched dollar for dollar through the employer. The employee doesn’t experience the employer portion directly as a tax, but the impact of the employer portion of the tax is also partially born by  employees (in the form of lower wages) as well as by the customers, owners and suppliers of the employer.

Mandating that health insurance plans must carry the children of employees up to 26 years of age is also a tax. It is imposed on the plan sponsor, but the cost is ultimately born by some combination of the sponsors, customers, owners, suppliers and employees. The Affordable Care Act avoids direct taxation by simply ordering a massive redirection of costs and revenues among providers, insurers and patients.

The heavy handed federal policies imposing negative real interest rates effectively represent a tax on savings. Borrowers are benefiting at the expense of savers. The largest borrower is, of course, the US government. In effect bank depositors and other liquid instrument investors are already paying a special deficit reduction tax. Events in Cyprus largely represent a proxy war between Germans and Russians, both marvelous cultures not noted for subtlety. Our crisis is not as deep as theirs and our methods for taxing financial assets will remain more subtle for the foreseeable future.

Amidst all this complexity, these are some basic observations that can help us understand what Cyprus means for us.

1. Governments within the US already impose broad methods of taxation through income taxes, consumption taxes, asset taxes and mandates. They acknowledge no fundamental limitations to the level and type of taxes they may impose. As pressure for revenue grows, new forms of taxation will come under more serious consideration. Politicians naturally prefer indirect taxation and they are getting frighteningly good at it. We are long way from having the political environment necessary for direct taxes on financial assets.

2. The President’s rhetoric on taxing the rich has impacted high income earners, but had no bearing on the ultra-wealthy, who live on capital gains, dividends and accumulated assets rather than wages. The net burden of taxation in the US rests far more heavily on earnings than on wealth. I am not a fan of the class warfare rhetoric, but the President’s verbal warfare has impacted the wannabes far more than the real rich. The President has therefore earned his unpopularity with small business people. He continues to earn his popularity with plutocrats.

3. There is broad public support for maintaining and increasing the scope of the social safety net. In practice, the public has largely accepted the notion that governmental expenditures need not be matched by current tax revenues. People are voting for benefits they expect others to pay for. The result is that we are borrowing 40% of everything spent at a federal level and we show no meaningful inclination to actually reduce expenses. The right talks about a preference for expense cuts and the left talks about a need for additional taxes. Other than the largely symbolic proxy war about tax rates for the rich, no one is actually reducing actual federal spending or meaningfully increasing direct tax revenues.

4. The resulting deficits and unfunded liabilities themselves represent massive future taxes that will be levied on someone, somehow, someday. We have simply chosen to borrow the money rather than specifying through what taxes we will repay the debt and by whom these will be paid. Both parties are mumbling about economic growth as the painless way to reduce deficits. Meanwhile the growth environment is being adversely affected by the deficits themselves and, more importantly, by the aging demography and stagnant population growth that is causing entitlement-driven deficits.

5. The interplay between entitlement spending growth, aging and even declining population is the root of the rolling European crisis. The focus on Europe and the Euro is more pronounced because they are further down the same political and demographic road we are on. The political, economic and demographic strength of the US is greater than that of Europe but the trend lines are the same.

6. The main difference between the US and Cyprus is that the dollar remains the world’s reserve currency. For all of our problems, we look a lot better than Europe and while China is large, investors rightly look at our political institutions as more trustworthy than China’s. The world supports our appetite for debt because there simply isn’t a less unattractive alternative. Being the international benchmark of relative political economic stability gives us more road to kick the can down.

7. When the crisis comes, all solutions will be on the table. As shocking as the notion of Cyprus simply taking a percentage of bank deposits was, it came under consideration because Russian plutocrats represent such a high percentage of Cyprian bank deposits.

The fundamental issues in play in Cyprus, Greece, Italy, Spain and the rest of Europe also exist here. They are simply less advanced. We should not expect to see direct taxation of bank deposits any time soon for two reasons.

The first reason is that Cyprus happens when investors lose confidence in the ability of a government to manage its political and economic affairs. The US remains, by default, the benchmark of relative political and economic strength. Our Cyprus moment will not come unless and until a better benchmark of stability is available.  In the meantime, if you are losing confidence in the ability of the US to maintain the political and economic confidence of investors, ask yourself who you really like better.  Our greatest advantage in funding large deficits cheaply is our status as the world’s reserve currency. Our greatest disadvantage in solving our deficits is our status as the world’s reserve currency. How can we summon the political will to stop deficit spending when we seem to have unlimited credit availability at negative real interest rates? Global investors are so scared that they are willing to pay us to use their money to fund our deficit.

The second reason is that we are doing a pretty good job of taxing deposits already through the dramatic suppression of interest rates. This largely taxes savers to the benefit of all borrowers, the largest of which is the Federal government. We could refer to the current rate environment as Deficit Funding Assistance (or DeficAid).

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