The taxes portion of the fiscal cliff discussions have brought to light issues on which not just politicians, but economists, private equity and other financial professionals, vehemently disagree. To elected officials, the fiscal cliff issue comes down to votes and the benefits of reducing the costs associated with government (i.e. reducing government spending) and the risks associated with increasing the costs associated with government spending (i.e. increasing the tax burden). To the private equity world, economists, and other financial professionals, who supposedly are more level headed with less personal attachment to the politics of the issue, the matter comes down to evaluating the numbers.
Not surprisingly, the numbers give conflicting advice. The Obama administration and the Congressional Research Service, among others, have been arguing for some time that increasing the cost of government has little effect on overall economic activity. On the other hand, professional analysts with access to the same information easily come to completely different conclusions.
So, who’s right? Well, the answer is – it depends. In all, it would require volumes of analysis to even begin to address the tax issues of the fiscal cliff, and even then the issue likely wouldn’t even begin to be settled.
With the background in mind, there appears to be at least one major aspect of the debate that’s missing – signals. In theoretical and empirical economics and contract theory, signaling refers to information one party to a contract conveys to the other party (see, for instance, Michael Spence’s well known work on signaling in the job market). In the current issue of the fiscal cliff, the matter is the signal the government as a whole is sending to the other party to the contract – the public or the rich (in this case the “government” includes Republicans, Democrats, Independents, and so forth; the “public” includes anyone from the lowly moochers to the deserving unemployed to the rich covering the costs of the programs).
Within the signaling context, the signal from certain key government officials is that tax rates, or at least the overall tax burden, are in all likelihood going up not just in the near term, but over a longer horizon. It’s the long term signal mismanagement that’s likely to cause the most harm (and the most difficult to prove empirically).
Why does the signal matter? Simple. Because it changes expectations, and in a world driven, or at least influenced, by investment and consumption expectations, non-material expectations – in a very real sense – affect such things as material construction, material spending, and material profit. And, although the effects of tax policy are generally felt more strongly over a longer term horizon, the effects certainly begin to show up immediately.
What does all this really mean? Well, it means that elected officials should spend some time managing expectations. It means that individuals with some ability to influence public policy should signal that the tax burden does not need to be permanent and that long term cost management is also part of the U.S.’s federal government’s budget solution.
Almost everyone is aware that once a reputation is established, it’s difficult to change. The same applies generally to tax burden expectations. Once the federal government establishes the reputation that it wants the costs of government to expand, it’s going to take some time reverse that trend. That is unless certain federal officials with the ability to manage expectations take some time actually doing that.
In all, elected officials should learn from the masters of expectations and signaling management – private equity and other high level investment professionals – and address the signals being sent.
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