Skin in the Game

A couple of recent articles on taxes and health care reminded me how important it is to create "skin in the game" for stakeholders.  The tax article builds on an op-ed from a few months ago on the "tax tipping point"... the point where a minority of people actually pay taxes and tax policy is by definition driven by the majority.  In effect, representation without taxation.

What happens when the voter in the exact middle of the earnings spectrum receives more in benefits from Washington than he pays in taxes? Economists Allan Meltzer and Scott Richard posed this question 27 years ago. We may soon enough know the answer. 

In 2006, the latest year for which we have Census data, 220 million Americans were eligible to vote and 89 million -- 40% -- paid no income taxes. According to the Tax Policy Center (a joint venture of the Brookings Institution and the Urban Institute), this will jump to 49% when Mr. Obama's cash credits remove 18 million more voters from the tax rolls. In all, three out of every five voters will pay little or nothing in income taxes under Mr. Obama's plans and gain when taxes rise on the 40% that already pays 95% of income tax revenues.

The recent article takes it a step further.

If you thought Bernard Madoff's Ponzi scheme was bad, wait until you hear about the inverted pyramid scheme the federal government is working on. While Mr. Madoff preyed on people who trusted him with their money, the federal government has everyone's money, and the implications of its actions are worse.

Picture an upside-down pyramid with its narrow tip at the bottom and its base on top. The only way the pyramid can stand is by spinning fast enough or by having a wide enough tip so it won't fall down. The federal version of this spinning top is the tax code; the government collects its money almost entirely from the people at the narrow tip and then gives it to the people at the wider side. So long as the pyramid spins, the system can work. If it slows down enough, it falls.

A very small number of taxpayers -- the 10% of the country that makes more than $92,400 a year -- pay 72.4% of the nation's income taxes. They're the tip of the triangle that's supporting virtually everyone and everything.

He goes on to discuss income redistribution and such, but I won't touch that third rail this time.  That's not my point.

Mr. Obama is adding to this trend with his "Make Work Pay" tax cut that means almost 50% of the country will no longer pay any income taxes, up from a little over 40% today. A certain amount of income redistribution in a capitalistic society is healthy, but this goes too far. The economic and moral problem is that when 50% of the country gets benefits without paying for them and an increasingly smaller number of taxpayers foot the bill, the spinning triangle will no longer be able to support itself.

His solution is to create skin in the game... everyone pays.  Not equally; very few people dispute that taxes should be progressive with the more successful paying more... to a point. 

I favor the abolition of all Social Security, Medicare and estate taxes. In their place, we should create a simple income tax system that has no deductions or credits at all. The result would be a progressive, multitiered income tax in which everyone pays. The bottom 50% won't be excused from paying the cost of government and top earners will no longer have the loopholes they're used to.

One letter responding to the article pretty much nailed it.

What could be fairer or more equal than requiring everyone to equally share the tax burden or, to paraphrase Vice President Joe Biden, to allow everyone equal opportunity to participate in the "patriotic duty" to pay taxes. Imagine the demand for government accountability, fiscal responsibility and spending limits if everyone's wallet were equally at risk. Perhaps this is what politicians are trying to avoid.

Revising and clarifying the tax code, closing loopholes, decreasing or eliminating politicized deductions is long overdue. A simplified tax code so straightforward that it could enable senators, congressmen, even U.S. Treasury secretaries to comply would be a welcome change.

Indeed.  Perhaps a few cabinet nominees could even figure it out.

Now on to health care, which has a very similar problem.  Costs are going up, and some portion of that is due to inefficiency.  Once again I won't touch the third rail discussion of whether that's due to insurance companies and such.  But a portion, a very significant portion, is due to the increased marginal cost of improved care technology.  Tiny improvements can cost much, much more... but who's to say they shouldn't be paid for?

There's nothing I've seen so far, however, that will fundamentally address the core issue, and that is that medical care costs are simply going up. Increasing access is great for various social reasons, but it's not going to have a big impact on increasing costs unless we actually start making some hard choices. Some of those hard choices are going to be very unpopular, especially when you start to ration care.

But the second approach is more of a long term approach, where you have to make people sensitive to how much... they spend on health care. That's the core problem: People always want the very best, even if the marginal benefit is much less than the marginal costs, because they don't bear the cost. In Medicare, the government bears the cost. And so people don't have any type of trade off between spending and benefits. They always want the very best. And... the innovators always come up with the better pill even though its efficacy may be just marginally better than the generic drug; or the better operation, even though its efficacy will be just marginally better than the cheaper operation.

How do you do that?  We like insurance that basically pays for everything, perhaps aside from a $20 co-pay.  Universal or single-payer would just make it easier.  What a great deal!  Or is it?

There are only really two things you can do. The first is you say, "Well, people still aren't sensitized to cost and benefits. We'll keep on paying for it." And in that case the government then has to say, "You know what, we'll keep on paying but for only some stuff." And now the government is the one in charge of deciding who gets what. The second approach is to actually make people directly sensitized to it. And you do that with things like health savings accounts in which people have to pre-fund some of their future medical care. They have to pay out the first several dollars of that care, and the government's only a back stop on a catastrophic case.

That second option is the only one that would really work.  Everyone has to have skin, at least some skin, in the game.  With some modification for income and ability to pay.

Ultimately, the best package is some type of hybrid where you have people being sensitized to health care costs for routine care. For catastrophic care you probably have a government back stop, but more of minimal back stop than we now have. It's not always wise to pay for the best device that's out there. It's really about taking into account cost benefits.

Medicare, by the way, will claim that it take costs and benefits into account. But in effect they do not. They will approve almost anything that has some type of marginal benefit and not really think very hard about the costs.

I learned the lesson about having skin in the game when I owned my own manufacturing company.  I had to pay all the various fees and taxes, including the employer side of employee taxes.  These days I still pay my taxes quarterly, but cutting a real live check.  It hurts, and I really feel what I am paying for roads and schools and bridges to nowhere.  Many are good things, many aren't, and I have become very sensitive to the difference.

It would be a bureaucratic nightmare, but what if income taxes weren't deducted from payroll checks?  What if everyone (well, those few that still have to pay!) had to actually sit down a write a check to the government every few weeks?  What if gas taxes weren't simply included in the price of gas but were added on afterwards, like other sales taxes?  Ouch!  I bet people would be looking at those roads and bridges a bit differently.

And perhaps even volunteering to pay more.  Yes, really.

Think about the tip you give when going out to dinner.  Remember when it was typically 15%?  Most of us as we move into higher income brackets get a new appreciation for the amount of work it takes to provide good service at a dining establishment, and we slowly increase the standard tip to 20% or more.  Or perhaps it's just easier to calculate.  Compare that to some other countries where a standard tip is just included.

And finally, yes finally, think about your business or organization.  Do employees have skin in the game?  Profit-sharing or gain-sharing tied to real goals?  Goals that improve the value delivered to customers and thereby creating more return to the stakeholders?

Everyone needs skin in the game to feel a part of, and accountable to, the value creation process.

Comments

[Eric Wade]

Great post. If anyone can find a way to get those who do not pay taxes to begin to care about how much we are taxed, I will be forever grateful!

[Andy Wagner]

Much of what you described here tax-wise is proposed by the Hall-Rabushka Flat tax, one rate, one standard deduction, no loopholes for anything, no withholdings. The code prescribed is so lean, you can pay quarterly without having to buy special computer software or pay somebody to fill out the forms for you.