Over the weekend the Obama Administration effectively fired the CEO of GM, Rick Wagoner, and much of the GM board.  This would not be much to report had the common stockholders of GM voted to replace members of the board and those new members then voted to terminate Mr. Wagoner; it would actually be almost expected and applauded by most.  However, this story becomes very newsworthy as it is the first time that the United States Government, namely the Obama Administration, has effectively fired a member of the private sector.

Due to TARP, the United States Government owns a large share of a number of major U.S. corporations, a gigantic leap in the direction of Socialism.  However, until recently the Government has led us (the citizens) to believe that it would not meddle in the affairs of these private organizations, but rather it would simply be a silent investor in them in some horrible attempt to calm the economic volatility.  The Government’s stance as a silent investor, however, has rapidly eroded and developed into the role of an activist investor that even Carl Icahn would envy.  The United States Government has capped executive income ($500k per annum), capped executive bonuses (1/3 of annual salary or $167k), is attempting to tax any bonus paid to a family earning more than $250k per annum at a 90% rate, restricted the marketing practices of a number of companies (most notably not allowing Bank of America to sponsor the new Yankees Stadium), and now deciding who should is worthy or unworthy to be a CEO or board member of private companies.

The members of Congress and the Obama Administration seem to believe that they are more fit to run private companies than anyone else in this nation.  A few months ago we were led to believe that we must bailout the domestic automobile manufacturers in order for them to avoid bankruptcy (see my article on this topic).  The Government, in all its wisdom, has now decided that the only way out for these very companies to restructure and survive is to go the route of bankruptcy — this only after handing them billions upon billions of dollars in tax payer cash!

We are on a collision course with socialism at an incredible rate.  I’d usually offer a relatively simple solution here, but given the above absurdities offered to us by our Government, I think that the solution is more than apparent.

Update:

It should be noted that President Obama has explicitly given GM sixty days to completely restructure and Chrysler thirty days or both firms will be forced into bankruptcy by the United States Government.  Obama has demanded, as an activist investor/chairman of the board might, that Chrysler merge with European automobile manufacturer, Fiat, within the next thirty days.  In addition, the Obama Administration is now insisting that members of the United Auto Workers Union give bigger concessions than they had previously been willing to give and that holders of GM debt agree to take a steep discount on that debt and could be required to convert it to GM stock.

Again, this would be fine and well if a private equity group purchased a good chunk of one of these companies then demanded changes be made – it is the legal way of doing things in this nation.  However, in this circumstance we have the Federal Government not only intervening in the private markets, but completely controlling them.  President Obama commandeered complete control of General Motors and Chrysler and that should not sit well with the American people.  What happened to our guarantee of Life, Liberty, and the Pursuit of Happiness?

Sources: WSJ1, WSJ2, Reuters

Recently the House of Representatives passed a bill that would require a tax of 90% on any bonus received by an employee whose household earns more than $250k per year.  This tax applies to any employee of any company that received at least $5 billion in federal aid via TARP.  This includes twelve of the largest companies in the United States and hundreds of thousands of employees.

The bill was in response to AIG giving retention bonuses that had been contractually agreed upon AFTER the United States provided “bailout” money to the insurer.  In fact, language in the bill explicitly allowed AIG to provide such retention bonuses to their employees.  The bonuses were given in an attempt to keep the company’s best employees on board while AIG tried to restructure to become a going concern.  The United States government believed that these bonuses were absolutely egregious, even though the United States government owned most of AIG when these bonuses were agreed upon between the company and the employees.

There are very serious problems associated with the United States essentially disregarding contract law and property rights by taxing these bonuses at a 90% rate, but there is another serious problem that is not as easily seen.  This new bill, should it pass the Senate, which it likely will with the help of President Obama, would make it so that no employee of these twelve gigantic, struggling corporations can ever receive a bonus that puts his/her household income over $250k.  As such, if a Citi secretary who is married to a successful surgeon makes $35,000 per year and is bonused $5,000 at the end of that year, she will have to pay a 90% tax on her $5,000 bonus.  This means that an overwhelming number of employees at these struggling corporations are likely to leave their posts for an occupation where they are entitled to more than 10% of their hard earned bonuses.  Those employees that stick around at these companies will likely be the people that will never have a chance of having a household income of over $250,000.  In other words, the employees with the most talent and capability of turning around these companies will leave said companies.

The United States government entered this “crisis” by stating that we, as tax-paying Americans, were to bailout out these giant corporations to “save” them because they were “too big to fail.”  True to form, our representatives have taken it upon themselves to wreck any chance of recovery for these companies by forcing any employee capable of “saving” these companies to leave.  This would be the equivalent of a baseball team telling its fans that it must increase ticket prices to improve the team, but they refuse to pay any player anything over $250k, and if that player’s wife makes an income then that income will be deducted from what the player will be paid.  The odds of such a baseball team improving are extremely limited — essentially zero.  This is the same ludicrous situation that our politicians have presented to us today.  They want to charge us money to save companies by effectively refusing to hire any capable employee.

Bravo, United States government, you have done it again.

Imagine an America where contracts were only valid so long as the political winds out of the District of Columbia blew in the right direction: a world where the government could circumvent any contract that attracted the ire of politicians, or that politicians could use to redirect attention from their own failings. In such an uncertain world, who among us would put any faith in contracts, and who among us would be willing to put our livelihoods at risk on the basis that the government would protect our interests?

As uncertain as free markets may seem, certainty is one of the bedrocks of a free market system. A free market can only thrive in a moral society (note: “moral” here not necessarily in the sense of a religious morality), governed by a legal framework which establishes certainty in economic transactions. Certainty is then derived from the laws being enforced by a governing body with the authority to use force in order to enforce the rule of law, which ideally is a direct reflection of agreed upon social mores. As long as outcomes within the rule of law are known, a free market economy can then function, and market participants are able to speculate about the unknown, with known legal outcomes upon the outcome of the unknown.

We speculate every day. One such speculation that we all experience in our lives is the speculation about our worth in the workplace. As employees, we believe that our services have value, and we demand to be paid for the value of our services. We know that we will do our best and that we will provide value to the company, but the prospective employer can’t possibly know what type of employee we will turn out to be. When we agree to work for a company, we take on some amount of risk: what if the person offering us a job has lied to us about how much we will be paid? What if our job will be different than described during the interview process? On the flip side, the employer also has risks: What if the employee doesn’t work the full time for which he is paid? What if the employee is dishonest and steals from the company?

To solve these issues and to help mitigate risks associated with employment, the employer and employee enter into a contract. The employer specifies salary and job requirements, and the employee agrees to perform services in a manner as defined by the employer. Both sides gain some amount of certainty from having agreed to a contract.

Employment, like all contracts, can only exist in a moral society with a well-defined rule of law, and here is why: If no social mores exist by which the majority of people function, neither party will trust that the other party will perform on the contract, yielding the contract ineffective on its face. A rule of law cannot compensate for a lack of social mores, because adjudicating contracts is not costless – someone must pay for attorneys, judges, court clerks, courthouses, officers of the court to enforce judgments, etc. At the margins, people will not enter into contracts if they believe they will have to resort to the legal system to resolve a dispute, because they cannot afford the very real costs of having an issue adjudicated. Without morality, the odds of reliance on the legal system increase. However, in a moral society, the rule of law ensures that the few who do not abide by social mores will be forced to comply, and, thus, odds are that contracts will be honored sans adjudication. Both morality and rule of law are necessary, but individually insufficient conditions to ensure a proper framework for contracts to exist.

Recently, there has been much ado about the bonuses given to AIG executives: bonuses that were contractually agreed upon by both AIG and the individuals who were given bonuses. These were not, by all accounts, discretionary bonuses that AIG lavished upon these executives, but contractually owed bonuses of a specified amount, which AIG could not legally alter. To be sure, AIG didn’t pay these executives in excess of what surely was a guaranteed minimum bonus. Most likely, AIG had discretion to pay these executives more than the minimum, but, given the performance of the company, AIG did not pay in excess of the bare minimum.

For the past few days, the news media has not been able to stop covering these bonuses. In fact, the news media continues to beat the war drum against these “greedy” executives, all but demanding that something be done about these “outrageous” bonuses. Fox News’ Greta Van Susteren, who is… ahem … a lawyer, vows to “get to the bottom” of how we let these bonuses be paid. I guess the fact that these are contractually owed bonuses eludes this lawyer.

It is our own greed and envy that outrages us about these bonuses. What’s worse is that, because we, as taxpayers, have taken 80% ownership in AIG, we feel that we have the right to control the company and demand that these bonuses not be paid. We feel a certain amount, and rightfully so, of righteous indignation that our tax dollars are going to pay the bonuses of people who were involved in running AIG into the ground, but our greed and envy are distracting our attention from the people who are truly deserving of our ire. In fact, one might think that politicians are intentionally calling our attention to these trivial bonuses, which account for less than one-tenth of one percent of the money allotted to AIG, so that we will not focus on the fact that the government is busily spending us into debt and circumventing laws that were established to keep us all safe from the government intervening in our lives.

We should be angry at the politicians who bailed out a company so wrought with mismanagement, not at the company or at the executives who received these bonuses. The free market allows for failure: in fact, failure is like a disease that causes illness but eventually is fought off by the body, which then has antibodies to fight the disease in the future. When the government intervenes, it causes the same problems caused by the over-prescription of antibiotics, which causes the disease to mutate such that fighting it off in the future becomes ever more difficult. Our anger should be focused on the very politicians who are distracting us by pointing to some trivial amount of money given out as bonuses.

We should be even more angry at politicians who speak of finding “legal avenues” to circumvent the rule of law. If even one private contract is circumvented by the government, then all contracts are at risk of being impaired by the government. Our greed and envy may lead us to believe that it’s right to punish these few individuals who received more money than most Americans will see in a lifetime as a bonus for a single year’s work, especially when that work resulted in laying the groundwork for the company’s failure, but we must remember that the rule of law is essential to a properly functioning economy, and that we wouldn’t want the government interfering in our contracts.

What if, for example, the government decided that non-hybrid vehicles are not being sold at a price that politicians feel accounts for the social costs of those cars and increases the amount you, as a non-hybrid car owner, owe for the car? “Absurd!” you say “The government can’t do that!”

Oh, but they can. What if anyone who owns a non-hybrid car suddenly becomes subject to a new tax for non-hybrid car ownership – even if you purchased the car 10 years ago? You might think this was unfair; that had you known this when you were purchasing a car, you might not have purchased the car. You’d probably think it was unfair that the government passed this law after you purchased the car.

You’d be right to be upset, because this is exactly what the Constitution attempts to avoid in Article I, Section 9 where it states, “No bill of attainder or ex post facto Law shall be passed.” Such a tax would, de facto, be an ex post facto law. Such laws are unconstitutional.

Well, what of the solution that Congress is discussing to “rectify” the AIG situation? Senate Banking Committee Chairman Chris Dodd (D-Conn.) has recommended levying a draconian and confiscatory tax aimed at only AIG executives who received this bonus. Such a tax, so directed at these specific individuals for the sole purpose of circumventing a legally valid and binding contract is, de facto, and ex post facto law. We, as Americans, no matter how disgusted we are by the fact that we are bailing out AIG, cannot stand for the government violating the Constitution to enforce some notion of cosmic justice, because it undermines the very principles upon which the country was founded, and which allow our free market economy to function.

We are moving toward living in an ex post facto world: a world where we address symptoms rather than illnesses; a world where the rule of law changes on a daily basis based on how we feel about outcomes rather than a world where we enforce a rule of law established to make sure everyone plays by the same rules. Such a world is not only an ex post facto world, but an ad hoc world, malleable by the political process, changing daily, and wholly unstable to support a free market economy.

We are being persuaded, both by our politicians and the media, to focus on outcomes, which are mere symptoms of the underlying illnesses causing them. Too often the conversation about “equality” focuses on equality of outcomes, rather than equality of opportunity. We look at those things we see that make us feel wronged, and try to right them, instead of understanding what caused them in the first place. In AIG’s case, it was government intervention that allowed these bonuses to be made. Had the government allowed the rule of law – the system that ensures we all play by the same rules – to solve AIG’s financial woes, AIG would have entered into bankruptcy, ruled by bankruptcy law, and a judge could have legally invalidated the contracts for guaranteed bonuses, in favor of paying AIG’s debt holders and shareholders. Problem solved.

It is precisely government intervention in the free market that has caused this problem. Allowing the government to fix the problem by circumventing private contracts and directly violating the Constitution only creates systemic problems that will certainly cause more problems in the future, because it will create an ex post facto world, and an ex post facto economy.

In an article entitled “A War You Can Stop”, David Frum a resident at the American Enterprise Institute argues that drug users are to blame for gang violence and the devastation that is currently ongoing in Mexico and in border states such as Arizona, whose capital city, Phoenix, was second in the world last year in kidnappings, second only to Mexico City.

Frum says: “Every time a North American indulges in illegal drug use, that user subsidizes and incentivizes the gangsters who dump charred, decapitated bodies in Mexico’s cities. It’s our buying that creates the profits for which the gangsters kill. An estimated 2.8% of American adults and 2.3% of Canadians use cocaine at least once a year. If they quit, they’d put the gangsters out of business. This is one war that ordinary individuals have the power to stop. So here’s a challenge next time you meet a campus peace activist. Ask them: What are you doing to put an end to this murderous trade?”

I agree with Frum that if Americans would stop using drugs, the drug lords in Mexico would stop making drugs for export to the United States, and there would be less drug related killings in the United States.

Realistically, can we expect that Americans stop using drugs? For anyone who truly believes that drugs can be successfully eradicated in the United States, I ask you this one question: How can we possibly keep drugs out of the hands of free men and women when inmates (who have very limited rights and freedom) can get drugs in prisons?

I doubt there’s much debate among the well educated that drugs are detrimental to a drug user’s health, but can we stop drug use any better than we can stop people from over eating, over exercising, bulimia, gambling, or any number of behaviors which are detrimental to physical and mental well being? If someone wants drugs, they will get drugs: End of story. Until we find a way to affect free will, we must accept that some people will want to use drugs.

What if instead of fighting the drug war by trying to end demand and throw suppliers in prison, we allowed Americans to produce and sell drugs? What if we used good old fashioned competition to drive Mexican drug lords out of business?

Today, drug s are sold at a massive premium to cost of production in order to cover the costs of drug seizures, death squads like the ones mentioned in Frum’s article, and other risks associated with dealing in an illicit industry. That premium makes drugs a desirable business to nefarious people: people who would stop at nothing – not even murder – in order to sell their products and protect their business.

If drugs were decriminalized in the United States, the prices would drop, the quality of drugs would increase, and the war on drugs would no longer exist. Best of all, nefarious people who currently run the drug businesses couldn’t afford to carry on as they do now, and they couldn’t fund the death squads and purchase of government officials that currently wreak havoc on civil societies around the world.

The single quickest way to end the war on drugs is to simply end the war on drugs: decriminalize drug use/production, tax the sale of drugs, and allow Americans the freedom to choose what they do with their bodies. If we really wanted to, we could take all the profits from taxing drugs and put those monies towards drug prevention and education programs.

If we end the war on drugs, we’re still faced with the same education and prevention problems that we face today; however, we don’t have to expend the resources on the drug war: Our prisons would not be overrun with criminals whose only crime is drug use; Our law enforcement officers would not die in gunfights with drug lords, gangs would have to find other means of funding their violence; Drug-related kidnappings would decrease; and, most of all, we’d be allowing people to choose for themselves if they wanted to use drugs.

Frum and I both agree this is a war to be fought economically – a war to be fought using the power of economics and incentives. Where we disagree is on which incentives to use in the fight. Frum wants to essentially guilt people into ending their drug use. I want to unleash the power of the free market on drugs, so that every individual has an incentive to start a business selling drugs, until competition has reduced the profit of the drug business such that the extraordinary profits that buy off our law enforcement agencies and corrupt our country cease to exist. We can always fight to win the hearts and minds of those prone to drug use, but wouldn’t that be easier to do if we weren’t squandering our resources and the lives lost in the drug war fighting a war that has no end?

See Frum’s full article here:

http://www.aei.org/publications/filter.all,pubID.29542/pub_detail.asp

One of the greatest lessons of economics that is simple, yet so often misunderstood, is something that Art Laffer put to me very succinctly: “Whatever you tax, you get less of.”

In general, people seem to understand this.

We tax cigarettes because, at the margins, less people will smoke if smoking costs more. We, as a society, recognize that smoking will cause death; however, even though we know that every cigarette marginally diminishes the smoker’s health, we don’t criminalize smoking. Instead, we just tax cigarettes in hopes that this “sin tax” will help to influence some people not to smoke. Of course, economists also recognize that the demand for cigarettes, especially to a nicotine-addicted person, is relatively inelastic, and therefore a cigarette tax is a good source of government revenue. However, demand elasticity aside, we do recognize that when we tax cigarettes, less cigarettes are smoked. Whatever you tax, you get less of.

When it comes to income, it would seem that people understand the concept, but their application of the concept isn’t well thought out.

Given the class warfare that seems to dominate today’s political conversations – and, with 5% of the population paying the bulk of the taxes, it’s politically expedient for politicians to promise the other 95% benefits at no cost to them, but for which the other 5% will be forced to pay – I think it’s safe to say that there is a fair amount of the “have nots” thinking that there are too few “haves” and too many “have nots” and that by increasing taxes on the “haves” we will simply get less “haves” and we will, to quote Barrack Obama, “level the playing field.” Oh, but that were true.

Here’s the problem with that line of thinking: Remember, whatever you tax, you get less of. What, exactly, are we taxing when we tax those “rich” people? Are we taxing their assets, or are we taxing their current year income? We tax current year income. So, what do we get less of? We get less high income earners.

In the short term, we get less high income earners because the government takes some of their earnings and redistributes it (through direct redistribution and indirect redistribution in the form of government operations and projects) to those who earned less income, giving a whole new definition to the term “unearned income”, as defined by the IRS currently anyway.

In the long term, we get less high income earners because people substitute away from those activities that earn higher incomes. Earning a lot of money is hard work: there’s greater responsibility, greater stress, greater risk, and more years of hard work on the front end to be able to take on everything that comes along with activities that generate more income. It’s far easier to earn less money: anyone can flip a burger. Also, dual income families where income is roughly equal between the husband and wife may decide that if they are going to lose 50% of their income to taxes, they would be better off having one of the two stay home, thus decreasing the output of the economy as a whole because less people are producing goods and services.

Now, the question is do we really want to have less high income earners? Is that really what those who want to level the playing field want? I posit that those who vote to level the playing field often think of people like Warren Buffet and Bill Gates as those who should contribute more in order to level the playing field.

I’ve got news for you: Warren Buffet and Bill Gates could both not earn a dime for the rest of their lives, not pay any income taxes, and live perfectly comfortable lives. In fact, they could not earn another dime and be wealthier the day they die than almost any other American. Why? Because they are wealthy today. What’s worse is that if we enacted high taxes, we would probably find that their wealth would increase compared to the rest of the population. If their relative wealth were to increase, that would be precisely the opposite of the “level the playing field” crowd’s goal. This is what we in economics refer to as secondary effects, or unintended consequences.

When we tax income, we just ensure that we have less high income earners. Let’s think about what that means; let’s examine the secondary effects.

Average Joe is a hardworking American. He has been working at a fast food chain since he was 16, and has worked his way up to a district manager. He’s 40 years old, making $65,000.00 per year, has a decent amount of debt like a lot of Americans, and he desperately wants to take his experience to open his own restaurant, but he needs to save around $250,000.00. Given that Joe is carrying about $30,000.00 of credit card debt, trying to save that money is difficult, and taking on even more debt in loans is a substantial risk at his age.

Joe has worked so hard over the years, and distinguished himself as such a stand-out in the organization, that he’s asked to take on a vice president role in the company. Joe will be paid a salary of $150,000.00 per year, with a bonus potential of 200% of his salary, depending on company performance. In his first year, Joe earns a 100% bonus, but is let go because of budget cutbacks in the organization.

Guess what: Joe is now rich. That’s right, according to the tax code, Joe is in the top 5% of income earners, and we’re going to tax him to level the playing field. Joe will probably pay well over $100,000.00 in taxes. Joe was finally getting to a point in life when he unloaded the burden of credit card debt that straps so many Americans, and he could have established a base of savings that would have begun to accrue interest so that interest was finally working for him. Joe could have used that savings towards starting his own restaurant, which would have employed more people and brought more diversity of restaurants to the community.

Joe’s hard work could have finally made him just barely self-sustaining and finally put him in the black, but because he’s now “rich”, he’s going to have to give a substantial amount of his earnings to Uncle Sam. So much for leveling the playing field. Now that he was finally getting to a point where he could start caching up to the truly wealthy, his tax burden is making it more difficult for him. We’re leveling the playing field by keeping Joe in relative poverty.

Meanwhile, Warren Buffet and Bill Gates will pay roughly $45,000.00 per $300,000.00 of income because their incomes come predominately in the form of dividends, interest, and long-term capital gains.

That’s right: the “income gap” between Average Joe and the Warren Buffets (net of tax) of the world is actually widening. The wealth gap is widening at an even faster pace because of the power of compounding interest. And, to make matters worse, people like Average Joe have an even more difficult time attaining the level of wealth of Buffet and Gates because the government classifies them as “rich” the second they actually are in a position to make their lives better and earn their way out of relative poverty.

By taxing the “rich”, so long as we classify rich as those who earn a lot of W-2 or 1099 income (for those not familiar with the tax system, these are “earned income” or wages as opposed to “unearned income” such as interest, dividends, and capital gains), we actually ensure that we get less rich people in the future. Those with wealth continue to have wealth, and those who aspire to become wealthy by working hard will be kept down by the tax system.

In the long term, less people will work towards the American Dream, because we will have taxed away the opportunity for those who would only be moderately successful in comparison to the few notables such as Henry Ford, Sam Walton, Bill Gates, Warren Buffet, and those whose work commands compensation on the order of magnitude the likes of which most Americans will likely never achieve. So, not only will we have made it more difficult to become wealthy, we will, at the margins, reduce the number of people who put in the necessary work to become wealthy, and that only reduces our production as a whole.

Whatever you tax, you get less of. If you tax high income, you’ll get less high income, and that will keep the wealthy wealthy, and the poor poor. Do we really want to level the playing field by forcing poverty on future generations?

I will be organizing a group of people to meet in the Phoenix, AZ area on March 18th to simply drink wine and discuss economics and politics.  If you would be interested in attending please join the facebook group here or comment on this post.