In the U.S., Selectively Applied Capitalism

The New York Times recently called the government’s role in propping up Fannie Mae and Freddie Mac “a strange coda” to an era in which U.S. officials, investors and economists often pressed foreign countries to free their own financial institutions from government interference and manipulation even as we turned a blind eye to the growing power and influence of our own quasi-government lending institutions.

In truth, there is nothing strange about it. The U.S. has become a purveyor of what might best be described as selectively applied capitalism, in which we urge free markets and growth policies on the rest of the world but increasingly do not practice what we preach. Today, if you were building a country from scratch you would hardly look to the U.S. as a model of how to tax your businesses and residents, how to regulate your financial systems, or how to use markets and incentives to organize and run government most efficiently.

Fannie Mae and Freddie Mac, for instance, didn’t become too big to fail by happenstance. Although the Roosevelt administration created Fannie Mae during the Depression to add liquidity to the mortgage market after lending had dried up, Fannie Mae continued to dominate the secondary market for mortgages long after the credit crisis of the Depression had passed. Rather than wind down Fannie Mae’s role in the mortgage market, in 1970 Congress created Freddie Mac, another government sponsored entity, to compete with Fannie Mae, which had been spun off two years earlier into a quasi-government lender.

Nothing illustrates how difficult it is to end a government initiative, even when its raison d’etre has long passed, than the persistence of Fannie and Freddie. Several studies have estimated that today what Fannie Mae and Freddie Mac give us through their giant borrowing power and implicit government backing (which has recently become explicit) is a reduction in the interest rate on mortgages of about 25 basis points. In other words, the federal government has remained our biggest player in the home mortgage market through these two quasi-public entities for the sake of knocking a quarter of a percentage point off your mortgage.

But this is nothing new and not confined to the mortgage market. Several years ago I attended a conference in Israel on reforming that country’s heavily regulated economy, where I heard a succession of speakers present models of how to reorganize everything from taxes to market regulation. Interestingly, none of the models were based on what we do here in the United States, and I could understand why. Our personal and corporate tax systems and our regulatory regimes are too intricate and burdensome to produce the kind of nimble economy that reformers were seeking.

Our corporate tax rate is now so high and uncompetitive that even re-destributive types like Charlie Rangel, chair of the House Ways and Means Committee, think it should be lowered. Our adjusted federal and average state corporate tax rate, at 39.27 percent, is higher than 28 out of 29 Organisation of Economic Co-operation and Development (OECD) members. In 24 states, including California, New Jersey, Massachusetts, Pennsylvania and New York, the combined federal-local tax rate is higher than in any other OECD country (in 22 OECD countries--including France, Italy, Spain, United Kingdom, Poland and Ireland--there are no state or provincial corporate taxes on top of the federal rate).

Meanwhile, our federal government and the states increasingly see our personal income tax system as a vehicle for achieving social goals instead of principally a method of raising revenue. That has given us a tax system that is not only more progressive but also much more complex than many countries. The country’s top 1 percent of households now earns 21 percent of U.S. income and pays 39 percent of income taxes, according to the Internal Revenue Service. When all income and all taxes are included in the equation, including payroll taxes and the share of corporate taxes paid by individuals, the top 1 percent earns 15.6 percent of income and pays 27.6 percent of taxes, according to the nonpartisan Congressional Budget Office. To achieve these numbers, our federal tax code alone now stretches to more than one million words designed to help politicians underwrite and subsidize everything from mortgages to energy efficiency to college education.

By contrast, 24 countries around the world have now gone in the opposite direction, employing simple flat-tax schemes with no loopholes for special interests and no double taxation in the form of capital gains or estate taxes. Significantly, many of these are former Soviet bloc countries which had a unique opportunity after the fall of the Iron Curtain to design tax systems from scratch. None chose anything remotely like our system, not surprisingly, though many were inspired by ideas they learned here in the U.S., where we talk a good game.

The fall of the Soviet Union has helped spark other free-market changes that have left the United States behind. As markets opened up in many former Soviet bloc countries, our officials, economists and business leaders urged the countries to free their state-controlled enterprises from public control, prompting a wave of privatizations around the world. Looking to rebuild their neglected infrastructures, countries also tapped private markets to finance and operate roads, bridges, airports, water systems and the like. Our Wall Street firms, with the financial expertise to manage these transactions, were happy to lend a hand. In the transportation field alone, some 1,100 privatization deals valued at some $360 billion have taken place over the last two decades--though most were overseas.

Here in the U.S., public sector unions have been effective at fighting privatization and competition for the delivery of public services. Another impediment to free-market reform has been our massive and increasingly corrupt and inefficient system of allowing states to raise money through the use of tax-free municipal bonds. The muni market has been a valuable enabler of corrupt pols, who have plunged states into billions of dollars of debt by using munis to finance pork-barrel projects, non-essential construction like publicly financed stadiums and sports arenas, and public authorities that are managed (and mostly mismanaged) by their patronage appointments. Why tap the private sector when you can ride on the taxpayers’ backs?

This has produced a sharp contrast between how public work is done here and in many other places. In the 1980s, for instance, the Thatcher administration in Britain began a program of contracting with private firms to build and operate toll roads, work continued by the Blair government. A 2002 study in Britain found that whereas 70 percent of publicly managed construction was completed late, and 73 percent came in over budget, only 24 percent of construction managed for government by private firms was late, and 20 percent was over budget. Compare that with the boondoggles produced in places like New York and New Jersey, where giant publicly financed construction authorities, fueled by muni bond offerings, have squandered billions of dollars through fraud, waste and mismanagement.

These days, in other words, we seem to lead only in the amount of energy we expend urging others to do what we don’t do ourselves.