Higher taxes are a sign of desperation before the end

Tax reform is causing uproar around the world. From Australia to the UK, tax rates are suddenly rising. Wealth taxes, capital gains taxes and inheritance taxes have investors in a panic.

It feels like an onslaught. Especially if you follow the news or pay taxes in more than one country.

But it’s all a sideshow. Because taxes are merely the symptom, not the cause.

The economist Milton Frieman warned us not to focus on taxes: ‘Keep your eye on one thing and one thing only: how much government is spending, because that’s the true tax.’

His point was that all government spending must be paid for somehow.

The government can use inflation in the form of printed money. It can borrow money. Or it can tax.

Each imposes a different cost on the economy. But all three are merely a consequence of too much government spending in the first place. That is what matters.

Of the three, at least taxes are the most honest. People feel the burden of higher governments spending directly.

In fact, I’d like to propose a tax reform that makes this even more explicit. What if tax rates adjusted at the end of the year to make the budget balance?

Then everyone clamouring for more spending would also be clamouring for higher taxes, by definition.

By connecting spending and tax rates, the incentive to be frugal emerges within the political system. People would actually vote for it.

Instead, we have two ways to hide the burden of too much spending…

Borrowing money is selling your future

Saving money allows you to spend it in the future. It is therefore an intertemporal transaction. You shift consumption power from today to a future date.

Borrowing is the reverse. You pull consumption out of the future in order to have it today. But you must then repay it in the future by consuming less as you pay off the debt.

One interesting thing to point out is that the savers and borrowers in an economy must balance.

For you to consume something today that you didn’t produce (borrow), someone else has to forgo consuming what they produced (save and lend).

The lenders’ incentive is that, in the future, they will be able to consume without producing.

What balances borrowers and savers is the interest rate. It is the incentive of to save and the price borrowing. So it is a market price.

That’s why the interest rate is referred to as ‘the price of time.’

Sadly, the way we manage our economic system today masks this simple truth. Banks and central banks can create money out of thin air by lending it. They appear to conjure up consumption without needing savings first.

But beneath the mirage, the same truth still applies.

Unfortunately, government borrowing is a little different…

Government debt is rarely paid off. New debt is simply borrowed to repay the old.

Government debt is rarely invested in things that produce a future income. That makes it harder to repay.

Government debt is not paid by the same group of people that borrowed it. It is passed down to subsequent generations of taxpayers.

And, last but not least, government debt is denominated in a currency that the government can create via the central bank.

Imagine borrowing something you can print into existence! But we’ll get back to that.

First consider that massive government debts around the world are a claim on future taxpayers.

Do you expect them to honour this claim?

Do you think taxpayers will accept inheriting vast government debts incurred for past welfare recipients?

I doubt it.

Instead, they’ll…

Print their way out of trouble

Governments can print the money they need. So why don’t they?

Well, we’ve learned the hard way that politicians cannot be trusted with this power. They overdo it, causing inflation.

And so most of the world separated out the power to create money and handed it to independent central banks. This is, however, quite a new experiment. And it hasn’t really worked.

Once governments get into financial trouble by borrowing too much, central banks are willing to print money to bail them out. Because the alternative is too terrifying – a major sovereign debt crisis.

So, these days, the money-printing solution is delayed until things are desperate. But it is still there.

And the result is still the same too: inflation.

For decades, investors benefitted from this. The government’s money printing inflated asset prices more than consumer prices.

Housing bubbles made us look rich. Stock market bubbles delivered absurd paper gains. Gold outperformed everything – the giveaway that it was all just asset price inflation.

Because the inflation showed up in asset markets instead of consumer prices, central banks could simply ignore it. They just claimed their money creating wasn’t causing inflation, even as house prices spiralled higher…

But in 2022, that changed. Consumer prices spiked instead of asset prices. Suddenly, inflation made investors poorer too.

We didn’t like that…

So now creating money to cover the budget deficit is off the table. And politicians are back to raising taxes.

Friedman was right

The important thing to notice is that all government spending has a costr. Hiding this away by borrowing the money or printing it doesn’t make the pain go away.

Now that inflation has become unpopular and government debt is already dangerously high in many countries, politicians are having to turn back to taxation.

This is a turning point because taxation is unpopular. It is hard to hide in a democracy.

Most people wouldn’t know if their government debt is dangerously high. And few understand inflation is caused by governments having to print money because they don’t want to borrow or tax.

But we all know what a tax is. And we all associate it with government spending.

The fact that so many governments are having to raise taxes right now is a signal that politicians are desperate. Because people will not put up with taxes. Especially taxes being used to pay for past borrowing.

Soon, the political system will discover the Laffer Curve. And the disappointing amounts of tax revenue raised from taxing the rich.

Then we will face a choice. Radical spending cuts like Greece in 2012. Print the money like Argentina used to. Or risk even more debt, like Japan.

Investors need to figure out which way their government will go. Because it’ll determine which investments are best positioned to profit.

Australia’s choice will be fascinating to watch because we are still a few steps behind the ‘pioneers’ in Japan, the UK and Europe. Let’s watch closely.

Australia also has a natural advantage over its competitors in this race to the bottom. Truly vast natural resources. These are famously generous to the tax office.

So it won’t come as a surprise to see this happen soon.