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Has America become irrational? Not since the 1930s have politics been so polarized, from the Tea Party movement on one side of the spectrum to the Occupy Wall Street protesters on the other. Why does the right object so vehemently to government spending? And why does the left attack private capital with parallel passion? The answer lies not in the American psyche, but in the statistics.
America is engaged in class war, but not of the sort one reads about in the mainstream press. The truly indigent – young African-American men, for example, most of whom are now unemployed – have little to do in this war. Large corporations for the most part are bystanders as well; they will make their peace with the victor. This is a war of survival between the productive middle class on one hand, and the dependents of the state on the other.
The Tea Party’s aversion to government spending is as pure an expression of rational self-interest as we have seen in American history. Like any new movement, it attracts more than its fair share of oddballs. The fact that a movement led by amateurs continues to wield so much power proves that it has good reason to be there.
The Tea Party is a middle-class movement, older, better educated and wealthier than average, but it is not a party of the very wealthy, who are conspicuously absent among its activists. They know from personal or family experience that taxation is destroying the American middle class. They are approaching retirement, and most of their wealth is in the family home, as it is for the great majority of Americans:
Exhibit 1: Home equity as a percentage of net worth, by income (2004)
The American tax burden has shifted drastically away from the federal government, and on to states and localities. And property taxes are bearing an increasing share of the total burden. That is killing the residential property market.
Federal tax revenues remain about 10% below the pre-crisis peak, but state and local tax collections continue to rise. In part, that is because states and localities cannot run budget deficits, unlike the federal government, and must raise taxes to cover their expenses, even while they cut spending. State and local employment has fallen by more than half a million since August 1998, and the layoffs continue.
But a great deal of state and local spending is tied to federal entitlement programs, especially in health care. States receive block grants from the federal government and, in return, take on responsibility for funding public health care and other programs in return. Unfunded mandates push states further into fiscal trouble.
Exhibit 2: Federal vs local tax collections
With income and sales depressed, state and local governments rely on property tax revenues more than ever.
Exhibit 3: Property taxes as percentage of total state and local revenues
Property tax collections have continued to rise, even while home prices have collapsed. Local property assessments lagged behind actual prices during the bubble years, but have not fallen to reflect the 40% decline in home prices.
Exhibit 4: Property tax revenues vs home prices
Property taxes have risen so far that a prospective homebuyer today will pay as much in real estate taxes as on mortgage interest.
Exhibit 5: Property taxes vs home mortgage interest (mortgage debt outstanding multiplied by current mortgage rate), in $US billions
The average homebuyer today, the chart shows, will pay almost as much in property taxes as in mortgage interest. (Mortgage interest is calculated on the basis of the current mortgage rate, reflecting the costs to prospective homebuyers rather than existing homeowners).
That is an astonishing outcome; in the past, mortgage interest typically was two or three times the property tax bill. Put another way, the combined cost of mortgage interest and property taxes is close to a trillion dollars a year today, about the same as at the peak of the housing bubble. Rising property taxes have just about wiped out the impact of lower interest rates and lower home prices on households. The property tax data include commercial as well as residential taxes, to be sure, but more than two-thirds of total property tax collections are from households.
That explains why the middle class compares its revolt to the American revolutionaries who dumped East India Company tea into Boston Harbor. Their modest wealth embedded in household equity and prospective retirement are at risk. Tea Party activists seem amateurish because they are newcomers to politics. For the most part they are the kind of people who lived their lives quietly before the crisis came to their front door. Many things radicalized this part of the political spectrum, but taxation pushed them out of the front door.
On the other side of the spectrum we have the dependents of the state. Not all of them are poor. As a 2011 Heritage Foundation study  showed, the federal government is paying much higher wages for construction workers on projects funded by the 2009 economic stimulus package than prevail in the marketplace. The Davis-Bacon act sets an arbitrary floor under union wages, and the Obama administration paid between 30% and 60% more than the reported market rate as a favor to its trade-union backers.
Exhibit 6: Federal government pays 30% to 60% above market for construction work
The swelling of state and local budgets has created a new kind of pseudo-middle class, that is workers who earn more than $100,000 year with a bit of overtime. The generosity of government pensions has become a scandal; the California Foundation for Fiscal Responsibility claims that more than 6,000 retired California government workers receive pensions in excess of $100,000 a year; about half were policemen, firemen, and prison guards. States cannot afford this largesse. The American Enterprise Institute calculated American states’ excess pension liabilities amount to $2.8 trillion, given the present return on investments.
Public sector employees unions rode the real estate bubble along with homeowners, and local governments awarded them unsustainable concessions in the form of pay, pensions and health benefits. Their political power waxed with state and local spending power. Today the public sector unions are the backbone of the Democratic Party. They man the phone banks, staff polling stations, and round up voters to the polls.
The prospect of default on state debt has increased borrowing costs for errant states. Europe has Greece, Ireland and Portugal; America has 11 states whose budget deficit exceeds 16% of the total budget.
Exhibit 7: Worst US state budget deficits
Bonds issued by American states and cities bear the widest risk premium on record. Their yield is not taxed by the federal government, so that the tax-adjusted yield is usually reckoned at 28% below that of comparable Treasuries. After tax adjustment, the Bond Buyer Index of 20-year US municipal bonds paid just 35 basis points (0.35%) above the 20-year Treasury bond. Today it pays 230 basis points more.
Exhibit 8: Yield on 20-Year Municipal Bonds vs. 20-year Treasury
At the peak of the debt crisis in early 2009, the tax-adjusted spread was about 400 basis points, roughly the difference today between German and Italian government debt. American states have to cut their deficits, or the market will refuse to finance them.
State and local governments, though, have exhausted their tax base, and the continuous rise in property taxes through the crash in property prices has kept the real estate market more depressed than economic conditions otherwise might indicate. A further increase in tax rates would yield less revenue. In effect, the government would have to proceed from taxing private capital to expropriating it, de facto or de jure – for example, nationalizing banks and directing them to make loans to politically-favored projects, after the fashion of Latin American banana republics.
The alternative is to renegotiate pension and health benefits already promised to public sector unions.
In either case, households that considered themselves comfortably middle class, and looked forward to a comfortable and secure retirement, find themselves on the edge of calamity. During the bubble years of 1998-2007, when America imported $6 trillion of overseas capital, the ride was easy.
When the whole world brought its savings to the United States, people of mediocre skills and slack work habits could afford big houses, expensive vacations, and (at taxpayer expense) generous pensions. Why Americans expected to live well indefinitely on the largesse of foreign investors is a question for the psychiatrists, not the economists.
The crisis has called into being a political movement of the exasperated middle class, namely the Tea Party. It has erased the image of the government unions as champions of progressive causes, and exposed them as an “aristocracy of labor” (in Marx’s phrase) parasitizing the public revenue.
The outcome inherently favors the Republicans. Debt – the catchall name for the crushing tax burden – has become a hot button issue even for many Democrats. But this election will be fought more desperately, and nastily, than any other that comes to mind during the past century. This is an existential struggle, a political war of survival for the American middle class. If the government unions go down in the fight, the Democratic Party of Barack Obama will cease to exist in its present form – and that would be a beneficial outcome for the United States.
1. See here.