Wednesday, August 24, 2011

Taxes and the Principal-Agent Problem


Government gets its revenues by taxing its citizens. Nothing complicated about that.

As individual citizens we are likely to spend our money (MOM) more wisely and with more care than government officials will spend what starts out as our money, but after being transferred to government, then in effect becomes other people's money (OPM). Nothing complicated about that either.

Through its taxing power, the government takes our money away from us and spends it as it sees fit. To repeat, this OPM will be spent more ineffectively, inefficiently and with more waste than had we kept it and spent it ourselves.

When we then factor in the intermediary costs (commission or handling costs) of government acting in its capacity as middleman, the cost of spending the original MOM, which next becomes OPM, and then is ultimately spent by the "middleman", becomes quite high indeed.


As an example, in economics the principal-agent problem arises when the individual employee's interests aren't properly aligned with those of the owner, the owner being the principal and the employee being the agent. Thus, a principal is always well advised to see to it that the interests of his employees are aligned with his own.

Here are a few illustrations of the principal-agent problem at work. When employees don't work harder than the minimum required, or retail workers are tempted to steal from the cash register, or CEOs don't act in the long term best interests of the company's owners, or officials of various organizations don't act in a fiduciary or stewardship manner with the resources and funds entrusted to them, these all serve as good examples of the principal-agent problem. Of course, there are countless others as well.

As a simple matter of fact, whenever there is a principal and an agent, there is a potential problem of not properly aligning their interests. If such a misalignment occurs, the result will generally be ineffective and inefficient (let alone optimal) results for the costs incurred, whether those costs be stated in terms of money, time, effort or judgment.


Now let's move back to two specific questions concerning taxes. (1) Should the so-called "millionaires and billionaires", aka the 3% of the people earning more than $200,000 and who pay ~50% of the total income taxes already, pay even more in income taxes, as advocated by our president and Warren Buffett? (2) Or is that even the right question to ask, at least initially?

My Response To Buffett And Obama is an editorial commentary by the retired CEO of American Express. Therein he disagrees strongly with Buffett's and Obama's assertion that taxes on him or any other citizens should be raised any time soon.

In the editorial, Mr. Golub makes some broader points about taxation and asks some pointed questions as well. I hope you will take the time to read and reflect on what he has to say about taxes, government and citizenship.

Here's part of what bothers him about our current tax collection system and the way our taxes are subsequently spent, "....the unfair way taxes are collected, and the violation of the implicit social contract between me and my government that my taxes will be spent---effectively and efficiently---on purposes that support the general needs of the country."

Here are additional problems that he has with our present chaotic mess of a tax system: (1) Gifts to charities are deductible but gifts to grandchildren are not. (2) Mortgage interest deductions support the private housing industry at the expense of renters. (3) Generous fringe benefits are not taxed at all, in order to support union and government workers at the expense of people who buy their own insurance with after-tax dollars. He describes many others of a similar nature.

With respect to taxes, Golub defines both the duty and track record of government this way, "Governments have an obligation to spend our tax money on programs that work. They fail at this fundamental task."


As citizens who pay taxes, what exactly is the nature of our relationship with the government? Should we be willing to pay more in taxes, based on how these monies are currently managed and spent? That brings us directly to the principal-agent problem.

The principal-agent problem is front and center in the tax and spend relationship between citizens and our elected representatives. We citizens are the principals and government officials are the agents.

Here's my exact point. If we individually are likely to do a better job when deciding how to spend our own money than government officials will, we should be reluctant to turn it over to government without compelling evidence that it's the right thing to do.

Why give our money to our agents to spend as they see fit? In my opinion, MOM thinking trumps OPM wasting every time. All taxes begin as MOM and end up as OPM, with a government commission in the middle.

So let's be careful about what we do with our money. In the case of taxes, how much government are we all willing to pay for, regardless of where the money comes from? And how much money are we willing to waste? And how willing are we to substitute the judgment of OPM thinking for MOM?

Can't we be a little more self-reliant? Can't we trust ourselves to try to do the right thing?

So we should always require the government to commit to act responsibly with what we entrust to them. And even with such a commitment, we need a strong monitoring device to ensure that promises made are in fact promises kept. After all, their track record isn't so good.

If we adopt a starve the beast attitude and approach toward government spending, thereby requiring our "stewards" or "agents" in government to spend both wisely and transparently, we will begin to reverse the ever growing tendency toward government growth.

That would be a great start toward sanity and fiscal responsibility. MOMs everywhere would like the result.

We hear a lot about how much more we need in taxes. Why not discuss instead how much federal government spending has grown since the Depression years? In that regard, here's something you may not know and which the politicians aren't likely to volunteer anytime soon.

Government spending was ~4% of our GDP (gross domestic product) in 1930 and grew to ~10% by 1940 by the end of the Depression years. Now it's ~25%.

Republicans want to bring it down to what they call a "historical and normal" ~18%-20%, but why stop there? Why not something closer to 15% over time? That would be a 40% reduction from current levels. MOM advocates would really like that.

Admittedly, moving methodically along the way toward fiscal sanity would require a radical change in our entitlement programs and related spending. Medicare, medicaid and social security, deductibility of charitable contributions, mortgage interest deductibility and other subsidies would all come under scrutiny, for sure.

But all that government spending starts out as MOM. It makes no sense, at least to me, to willingly convert MOM into OPM without a very good reason. History teaches that we have no such reason to perpetuate our wasteful OPM ways of today.

Thanks. Bob.

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