Practical analysis for investment professionals
28 May 2015

Book Review: We Are Better Than This

Posted In: Economics

We Are Better Than This: How Government Should Spend Our Money. 2014. Edward D. Kleinbard.

Reviewed by Matthew D. Gelfand, CFA

Fiscal policy — government spending and tax revenue policy — affects every aspect of the economy. Edward Kleinbard, author of We Are Better Than This: How Government Should Spend Our Money, is an ace mechanic who conveys a deep appreciation of the workings of the US fiscal machine. He comes to this task with skills honed during a career at the US Congress’s Joint Committee on Taxation, where he served as chief of staff, and in his current role of law and business professor at the University of Southern California.

Kleinbard has written two books in one. The first is a philosophical road map of the progressive case for economic policies on income distribution, infrastructure spending, and social insurance, among others. This discussion is of less utility to financial analysts but — despite Kleinbard’s clear philosophical leanings — is worth mentioning here because his comments on the topic establish that he is a nonideological student of fiscal policy.

The second book-within-a-book will be of interest to financial analysts who want to understand the mechanics of fiscal policy. It is an informed instruction manual that draws on a large body of data and insightful analysis yet drives forward in layman’s terms rather than economic jargon. The chapter “An Overweight Government?” reviews spending on US military, health care, and major retirement programs (Social Security and Medicare) and assesses US government spending vis-à-vis similar programs of other major, developed economies (i.e., OECD countries). “Are High Taxes Killing Us?” pores over many useful statistics to distinguish true tax rates from “sticker” rates, to find out who really pays the taxes (incidence, as economists call it), and, importantly, to gauge effective (or average) and marginal tax rates. Of course, marginal tax rates are ultimately the rates that affect taxpayers’ — and investors’ — incremental decisions, so a better understanding of our tax structure is one of Kleinbard’s key contributions. “The Hidden Hand of Government Spending” reviews in detail the panoply of the federal government’s so-called tax expenditures — that is, in common parlance, the “loopholes” and subsidies that many taxpayers utilize and that skew behavior significantly.

Here is where Kleinbard’s experience and expertise offer particular insight, because tax expenditures are large and yet obscured, unmanaged, and perhaps unmanageable. The dollar value of such implicit expenditures is huge — some $1.2 trillion a year — comparable in magnitude to all explicit federal discretionary expenditures, according to Kleinbard. Yet,

because of Congress’s pervasive use of tax expenditures, we cannot determine by inspection of our budget how much support the federal government provides to different sectors of the private economy. . . . We cannot debate fairly the efficiency costs of a system in which spending and revenues are disguised. . . . Congress’s consistent use of tax expenditures to achieve . . . an “allocative agenda” . . . means that words like “spending” and “taxing” lose their significance. . . . Congress relies on the low visibility . . . of tax subsidies to increase spending on favored policies, by decreasing the visibility of those benefits to most observers . . . and simultaneously decreasing the visibility of the tax costs incurred to finance those spending policies.

To make matters worse, Congress also fails to monitor these subsidies over time:

Tax subsidies are not subject to any sort of review or oversight by the Congressional committees charged with substance matter expertise, and no comprehensive Congressional review of tax expenditures exists.

Having laid out the design flaws in the current federal fiscal machine, Kleinbard proposes correctives for how the nation should decide the amount to spend on infrastructure and education (human capital), for the design of its social insurance schemes (Social Security, Medicare, other health care insurance and services, and disaster relief), and for the progressive (i.e., graduated) income tax rate schedule.

Relying mainly on procedural, administrative, or legal arguments to support his positions, Kleinbard unfortunately omits economic analysis, which would have provided stronger support. The chapter “The Better Base Case” summarizes his policy prescriptions. Devoid of any mention of economics, this chapter might have been more appropriate as a newspaper op-ed or as an article in a public affairs periodical. The “better base case” is specific to current circumstances and controversies and thus misses an opportunity for prescribing general principles for more efficient fiscal policy, which would have made this important book more timeless.

At times, Kleinbard gets the economics wrong or merely asserts the merits of his policy prescriptions without providing much support. For example, he lists a series of facts about federal health care and insurance programs, including the newest ones under the Affordable Care Act, as if that list by itself were sufficient to justify those programs. He never uses cost–benefit analysis to establish whether the programs are worthy or rightsized. In another case, he proposes a structure for taxing capital income (corporate profits, capital gains, dividends, interest, and the like) at rates different from those for labor income, using a “labor–capital income centrifuge.” But he never makes the economic case for such an approach. He relies only on the fact that several OECD countries, including the United States, tax labor and capital differently and argues that the United States should thus continue to do so. In fact, the broad consensus among economists is that efficient, nondistorting tax rules would tax all types of income—properly measured—at the same rate, although perhaps using progressive rates on higher incomes. In most circumstances, the vast majority of economists would not endorse favoring one type of income over another through differential tax rates.

In his favor, Kleinbard’s writing style is generally engaging. Discussing the demerits of tax loopholes, he fantasizes about repealing them all in “a sort of tax expenditure mass extinction event.” His wry humor pervades the text, making it more accessible and compelling, although at times he is derisive of the other side of the aisle. In summary, despite a few shortcomings, We Are Better Than This is a useful guide to the structure and effects of the US fiscal machine.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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2 thoughts on “Book Review: We Are Better Than This”

  1. DougT says:

    “The broad consensus among economists is that efficient, nondistorting tax rules would tax all types of income—properly measured—at the same rate.” Really?

    I can think of Glenn Hubbard (Columbia), Greg Mankiw (Harvard), Gene Fama (Chicago), Jude Wanniski (Polyconomics) and several other major economists who support preferential tax treatment for capital gains. At a minimum, it seems unfair to tax people for any inflation-based asset appreciation. As Mankiw noted in an article in the NY Times: “Throughout almost the entire history of the United States income tax, the tax rate on capital gains has been lower than that on ordinary income.”

    There’s a good, economic reason for this. If we encourage capital investment, we are more likely to enjoy capital-based productivity gains which will lead to greater real income growth. At least, that’s the supply-side argument (as outlined in Gwartney and Stroup, a CFA-curriculum text).

    For a critique based on the economics of fiscal policy, it seems the reviewer dismissed a major school of economic thought. Even so, I liked the review–it gives me a good sense of what the book offers, and where its policy recommendations are likely to tend towards.

    1. Matthew Gelfand says:

      Doug T, thank you for your comment. You are quite right in mentioning several “major economists who support preferential tax treatment for capital gains,” which was implicit in my mentioning “all types of income” with an emphasis on the phrase “properly measured.” A short book review didn’t leave room to elaborate on that point, so I can elaborate a bit more here. The view of capital gains taxes that you rightly mentioned is in the context of the practicalities of political science rather than a necessity in economic analysis. Among other measurement issues, properly measured capital gains would account for inflation (a point to which you alluded) and thus obviate the need to treat real, or inflation-adjusted, capital income any differently from other forms of income. Indeed, some draft tax reform proposals in the early 1980s from the Reagan Administration attempted to put capital gains on an even playing field in exactly this way. I imagine that careful analysts such as Hubbard and Mankiw – and I would importantly add Martin Feldstein to this list – might have supported such reforms back then. Unfortunately, the formulation of inflation adjustment also might’ve been too complicated to sell politically or for Congress to appreciate.

      The argument that capital gains should receive special treatment also rests on the idea that doing so in the face of faulty income measurement would induce a better level of investment and hence support economic growth. Perhaps it would if we could get the second-best adjustments right. Starting from neutral, the economy would generate more of any activity that is taxed less than before or less than other activities. Mine was a more theoretical point: why favor investment in physical and intangible capital — if one could measure the income it generates properly? Human capital is also important for economic growth and, while such investment now receives a lot of subsidies (free public education, subsidized colleges, etc.), there is much human capital investment that is disfavored relative to physical investment. On-the-job training and spending one’s leisure time to learn new skills are two examples. Moreover, it is quite plausible, if unusual in the history of the U.S. economy, that one could have too much investment in physical capital, witness the technology and real estate bubbles of recent decades. While hardly an example of a market economy, the overinvestment in the last decade or so in China also has run into the economic laws of growth – too much of a good thing to be sustainable or efficient. My point isn’t to favor one or another form of capital, or to favor them in different ways, but to favor neither relative to other types of income generation. If we could have an efficient tax system, I’d prefer to let the economy decide on the proper mix of human and physical capital, land, research and innovation, and materials and labor needed to produce our gross domestic product efficiently without artificially supporting any one class of inputs.

      Finally, and this point is a matter of nomenclature, so I quibble, I wouldn’t characterize favoring the tax treatment of capital gains as a “school of economic thought,” no less a major one. Rather, it is a specialty within the field of public finance, one that has thankfully attracted the efforts of some very accomplished economists.

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