Economist's View

"Tax the Wealthy to Keep US Healthy"

Robin-Hood Reich is happy:

The House: Tax the Wealthy to Keep Everyone Healthy, by Robert Reich: It's the most blatant form of Robin-Hood economics ever proposed. The universal health care bill reported by the House yesterday pays for the health insurance of the 20 percent of Americans who need help affording it with a surtax on the richest 1 percent.

I don't recall the last time Congress came up with such a direct redistribution. Occasionally Congress closes a few tax loopholes at the top and offers a refundable tax credit to workers at the bottom, or it creates a poor people's program like Medicaid, paid for out of general revenues from a progressive income tax. But to say out loud, as the House has just done, that those in our society who can most readily afford it should pay for the health insurance of those who cannot is, well, audacious.

There's another word for it: fair. According to the most recent data (for 2007), the best-off 1 percent of American households take home about 20 percent of total income -- the highest percentage since 1928. Yes, I know: Critics will charge that these are the very people who invest, innovate, and hire, and thereby keep the economy going. So raising their taxes will burden the economy and thereby hurt everyone, including those who are supposed to be helped.

But there's no reason to suppose that taking a tiny sliver of the incomes of the top 1 percent will reduce all that much of their ardor to invest, innovate, and hire in the future. Yet if this tiny sliver means affordable health care for a far larger number of Americans, who will be able to get regular checkups and thereby stay healthy and productive, the positive effect on the American economy is likely to be far greater.

Don't believe critics who say the surtax will harm small business. According to the Center for Tax Justice, it would hit only five percent of small business owners... Besides, only the profits of a small business would be taxed. ... So, for example, a couple whose income comes entirely from a small business would have to earn more than $350,000 in business profits -- after paying all their expenses, including salaries -- before the surcharge would affect them... And if they earned more, the surcharge wouldn't reduce their incentive to hire more employees because they pay employees with pre-tax income. And not even purchases of equipment ... would be affected because most small business owners can write off up to $250,000 of the costs of such equipment immediately.

A surtax is easy to administer. And the whole idea is easy to understand. Tax the wealthy to keep everyone healthy. Not even a bad bumper sticker.

I'll be very surprised if the Senate goes along with this.

Loonie Network Effects

Nick Rowe use California's IOUs and Canadian Tire money to illustrate possible outcomes when two currencies circulate side by side:

The State(s) Theory of Money: California and Canadian Tire, by Nick Rowe: I learn via [this] that there is a distinct chance that California will allow taxes to be paid in the new scrip it issued when it ran out of funds. I have no idea whether this will happen, or whether the Federal government will stop it. Let me just assume that it does happen, and that the Federal government does not stop it. I'm (almost) hoping that it does happen, and that the Fed doesn't stop it, because it would be such a fascinating experiment in monetary theory.

Assuming this experiment does go ahead, what are the chances that California scrip will circulate as a medium of exchange, and be generally acceptable, not just at banks, but in exchange for all or most goods and services?

Another way to ask this question: what's the difference between California and Canadian Tire?

For non-Canadian readers let me explain that Canadian Tire corporation is a large chain of stores selling a wide range of automotive supplies, hardware, sports and camping equipment, gasoline, etc., that has many outlets across Canada. And it issues Canadian Tire "Money". CT money consists of small paper notes, about the same size as US dollar bills, in denominations ranging from a few cents up to a couple of dollars. When you buy something at Canadian Tire, you get CT money with a face value of a couple of percent of the purchase price. Canadian Tire money is redeemable for merchandise, at par with Canadian dollars, at all Canadian Tire stores.

That last sentence is crucial. If the State of California accepts California scrip for payment of taxes, at par with US dollars, it is just like Canadian Tire. Sure, you have to pay taxes, and you don't have to shop at Canadian Tire, but most Canadians do shop at Canadian Tire, and do so more times a year than most Californians pay taxes (if we are talking about annual income taxes, at least). So the frequency with which Canadian Tire money can be redeemed at its issuer will exceed that of California scrip.

But Canadian Tire "Money" does not normally circulate as a generally accepted medium of exchange. In special circumstances, someone (other than Canadian Tire) might accept Canadian Tire money in payment for goods, but only as a favour if you have run out of "real" money, or at a discount. It is not generally used outside of Canadian Tire stores. People generally redeem it as soon as they next visit a Canadian Tire store (or just leave it stashed away until they remember to do so).

And we can understand why Canadian Tire money does not circulate as a medium of exchange. This is a case where, contrary to Gresham's Law, good money drives out bad. (Gresham's Law does not apply because there is no legal tender law saying that merchants have to accept Canadian Tire money at par, and only Canadian Tire does so).

We have known since Carl Menger that money, like language, has network effects. If the people with whom you interact are already speaking a particular language, or using a particular medium of exchange, that increases your incentive to adopt that same language or medium of exchange. Conventions can arise spontaneously, and have the force of custom. Canadian Tire money would have to be, not just as good as, but significantly better than the Loonie, in order to compete with the Loonie as a medium of exchange. It isn't. You can redeem Canadian Tire money at par in Canadian Tire stores, and below par elsewhere, so everybody just redeems it at Canadian Tire stores. It doesn't circulate.

So California scrip would end up like Canadian Tire money - being kept in the glove box until your next visit to the issuing store - except for one thing: California scrip pays 3.5% interest; Canadian Tire money pays none. In that one respect at least, California scrip is better than US dollars.

Suppose California scrip does end up circulating as a medium of exchange, being generally acceptable at par to US dollars. Is that possible? I don't think it is, because then Gresham's Law would kick in. If I hold both in my pocket, and merchants will accept both, at par, I would pay with US dollars, and hoard the California scrip, to collect the interest.

It's hard to model a stable equilibrium in which two different monies could circulate side-by-side. If one money gains any slight advantage over the other, and becomes more widely accepted, that makes people even more willing to use it, and less willing to use the other, until one money dominates. And that's what we normally see, except in "bilingual" border zones.

And I just find it hard to imagine that California scrip could ever displace the US dollar as the preferred medium of exchange, even in California. The 3.5% interest might offset any risk of default or depreciation, but the sheer force of custom should outweigh both.

"Russian Flat Tax Myth and Fact"

Do tax cuts increase productivity?:

Study separates Russian flat tax myth and fact. EurekAlert: Proponents of a flat rate income tax often point to Russia's 2001 switch to a 13 percent flat tax as nothing short of an economic miracle.

The new tax policy slashed taxes for higher-income Russians who previously paid rates of 20 and 30 percent. Despite the savings to taxpayers, real tax revenues reaped by the government increased by 25 percent in the year after the reform. The windfall, flat tax advocates say, happened because a simpler, fairer tax system leads to better compliance, and because lower taxes spur productivity.

That assessment is half right, according to a study published this month in the Journal or Political Economy. The study by economists Yuriy Gorodnichenko (University of California, Berkeley), Jorge Martinez-Vazquez and Klara Sabirianova Peter (both of Georgia State University) looked at household level data to see how tax reform influenced tax evasion and real income. The study found that tax evasion decreased under the flat tax, but the reform did little to increase real income for taxpayers.

The lesson? Where underreporting of income is widespread, a flat tax can produce a revenue increase, but don't expect massive economic productivity gains.

Tax evasion by nature is tough to quantify. To get an estimate of the extent to which Russians hide income from the tax collector, the researchers used what they call the "consumption-income gap." They gathered data from household surveys conducted in 1998 and from 2000 to 2004 by the University of North Carolina. The surveys asked respondents to catalog their monthly spending on everything from food to entertainment. The data from these surveys show that Russians generally spend 30 percent more than they report receiving in income. It's unlikely that households are getting the extra buying power by dipping into savings accounts, because most of those surveyed had little or no savings. So the gap between household consumption and reported income is largely explained by an underreporting of income.

Looking at the survey data over time, the researchers found that the consumption-income gap shrank substantially in the years after the tax reform. In other words, the amount of income Russians reported got closer to the amount they spent. This effect was strongest for households who had been in the highest tax brackets before the reform. That's a good indication that the flat tax was directly responsible for decreasing tax evasion in Russia.

The other implication in these data is that the flat tax seems to have done little to increase real income for taxpayers. If real income had increased substantially, one would expect consumption to increase as well. That wasn't the case. Taxpayers whose tax rates were cut increased their consumption net of windfall gains by less than 4 percent.

"The results of this paper have several important policy implications," the authors write.

"The adoption of a flat rate income tax is not expected to lead to significant increases in tax revenues because the productivity response is shown to be fairly small. However, if the economy is plagued by ubiquitous tax evasion, as was the case in Russia, the flat rate income tax reform can lead to substantial revenue gains via increases in voluntary compliance."

The lack of a significant productivity response undercuts the main supply-side argument that cuts in taxes produce increased growth in output that generates a partial offset (some even argue a more than full offset) to the revenue lost from the tax cut. So many supply-siders have switched to the compliance argument for the US, but I doubt this effect would be large, and certainly not large enough to pay for the tax cut, and compliance can be increased in other ways such as closing loopholes and better enforcement of existing tax law.

"VAT Time?"

Bruce Bartlett continues to advocate for a value added tax (e.g.):

VAT Time?, by Bruce Bartlett, Commentary, Forbes: According to a Washington Post report, the Obama administration and leaders on Capitol Hill are looking seriously at a value-added tax to pay for health care reform and reduce federal budget deficits. Predictably, Republicans reacted to the news with glee. They view the VAT as political poison that will destroy Obama and congressional Democrats if they dare to enact one.

The irony is that the VAT is probably the ideal tax from a conservative point of view. As a broad-based tax on consumption it creates less economic distortion per dollar of revenue than any other tax--certainly much less than the income tax. If Republicans are successful in defeating a VAT, the alternative will inevitably be significantly higher income taxes, which will do far more damage to the economy than a VAT raising the same revenue.

"Redistribution, Height Taxes, and Utilitiarianism"

I don't think I'll comment on any of the underlying philosophical issues:

Mankiw, Redistribution, Height Taxes, and Utilitiarianism, by Mathew Yglesias: Via a distraught Conor Clarke, I see that not only did Greg Mankiw once write a cheeky paper arguing that maybe we should impose a height tax, he also goes in for some odd philosophical claims. To try to reconstruct his argument, he believes:

1. The main arguments in favor of redistributive taxation are grounded in utilitarianism.
2. Utilitarian theory supports taxing tall people more heavily than short people (this is the thesis of the paper).
3. Therefore, people should either sign on for the height tax or else abandon their support for redistribution.

He concludes with this:

A moral and political philosophy is not like a smorgasbord, where you get to pick and choose the offerings you like and leave the others behind without explanation. It is more like your mother telling you to clean everything on your plate. If you are a Utilitarian redistributionist, the height tax is like that awful tasting vegetable your mother served up because it is good for you. No matter how hard you might wish it wasn’t there sitting on your plate, it just won’t go away.

I think there are a ton of mistakes being made here. This goes back to a point I was making a while ago about how dangerous it is that the public discourse is so dominated by low-quality freelance philosophy done by people with PhDs in economics. I’m fairly certain that if Mankiw were to walk over to Emerson Hall he could find some folks ... who could explain to him that there’s little grounds for the belief that a commitment to utilitarianism is the main justification for redistributive taxation.

So point one is factually wrong.

But that aside, I think the “smorgasboard” argument is a confused way of thinking about moral reasoning. A great many crucially important questions in normative ethics are easy. Is it okay to murder Greg Mankiw to steal the money in his pocket? No, it isn’t. But a lot of foundational questions in ethical theory are hard. And a lot of meta-ethical questions are hard. ... There’s a certain hyper-literal sense in which these questions all form a hierarchy. First I must decide where I stand on meta-ethics. Am I a reductive moral realist? A quasi-realist? A practical reasons theorist? An old-school “moral facts are facts too, damnit” moral realist? Are there theological issues in play? Then I need to decide if I’m a utilitarian (and if so, what kind of utilitarian!) or maybe some other kind of consequentialist or maybe I have a more Kantian view. So then depending on those answers, I can say “killing Greg Mankiw to steal the money in his pocket is wrong because…” and then lay the whole thing out.

I think what Mankiw is implying with the “smorgasboard” argument is that this is how people should actually engage in moral reasoning. ... Maybe killing Greg Mankiw really is okay? And if I’m not uncertain, if I say “the reason it’s wrong to kill Greg Mankiw and steal his money is that the murder would reduce net utility” then the murderer can counter with “well, if you believe in utilitarianism, you ought to believe in a height tax.” Then I say “well that sounds wrong!” And then, having debunked utilitarianism, Mankiw gets shot and everyone agrees that justice has been done.

Something’s gone wrong there. We don’t abandon considered convictions about normative issues that quickly. Murder is wrong. If forced to contemplate the alleged contradiction, there are a bunch of things we might want to consider. Maybe the analysis of the height issue has gotten something wrong, utility-wise. After all, though the paper is clever, it’s hardly a comprehensive review of all of the hedonic issues in play. Or maybe utilitarianism isn’t the best theoretical grounding for the conviction that murder is wrong. Or, maybe the height tax thing actually is a good idea, albeit an unrealistic one. ...

Starve the Beast (Recession Edition)

John Taylor plays Starve the Beast. First, he calls for permanent tax cuts - and only permanent tax cuts - to stimulate the economy, tax cuts that will make the long-run budget picture worse. (Paul Krugman: "You’ve got John Taylor arguing for permanent tax cuts as a response to temporary shocks, apparently oblivious to the logical problems.") Then, he tells a "scary" inflation story and argues that deficits are a bigger threat than the financial crisis and must be reduced through reductions in the size of government:

Exploding debt threatens America, by John Taylor, Commentary, Financial Times: ...Under President Barack Obama’s budget plan, the federal debt is ... is rising – and will continue to rise – much faster than ... America’s ability to service it. ...

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers..., a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. ... A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. ...

The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. ... And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. ... This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating. ...

The time for ... excuses is over. ... Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. ...[G]overnment is now the most serious source of systemic risk. ...

Funding Universal Health Care

Robert Reich says that since other alternatives to fund health care have been closed off, it's time for Obama to consider taxing employer provided health benefits:

The Only Sure Way to Fund Universal Health Care, by Robert Reich: During the presidential campaign,... Obama ... criticized John McCain for proposing to tax all employer-provided health benefits. ... I worried that Obama would come to regret the position he took.

Half a year later, it appears that the President will need to tax employer provided health benefits in order to finance universal health care. Or at least the tax-free benefits now enjoyed by higher-income employees. Many in Congress and in the White House are convinced it’s the only good option. ...

The White House is in a revenue bind. The President had intended to raise money for health care by limiting the income tax deductions that wealthy taxpayers can claim. This would have generated ... about half of Obama’s proposed “health care reserve fund.” But the proposal ran into a buzz saw of opposition from congressional Democrats. ...

With deficit vultures already circling, Obama has to come up with a far more reliable way to fund health care. That’s where employee health benefits come in. According to the Congressional Budget Office, taxing all employee health benefits would yield a whopping $246 billion every year. Even limiting the tax to higher-income employees would go a long way to funding universal health care. Employer-provided health insurance is the biggest tax break in the whole federal income tax system.

Tax-free employer-provided health care is also, in effect, the government-backed health insurance system we now have. ... Seventy percent of the 253 million Americans with health insurance receive at least some of it through their employers. ...

But, face it, it’s become a crazy system. You’re not eligible for these benefits when you and your family are likely to need them most – when you lose your job and your income plummets. And these days, as we’re witnessing, no job is safe. The system also distorts the labor market. It prevents lots of people from changing jobs for fear they’ll lose their health insurance, or won’t get the benefits they do now. And it invites employers to game the system by seeking young, healthy employees who pose low risks of ill health and will therefore keep insurance costs low... The system also encourages employers to try to push married employees onto their spouse's health insurance plan so that the spouse’s employer bears the cost.

It’s also an upside-down system. The biggest share of the $246 billion goes to upper-income people. ... Few people collecting $12 an hour at fast-food restaurants or big-box retailers see any part of the $246 billion. The higher your pay, the more health coverage you receive, and the bigger chunk of the $246 billion you get. Top executives and their families get gold-plated plans...

The good news is that a program providing universal health care doesn’t need the full $246 billion a year... Obama’s health care reserve fund needs around $650 billion over ten years. So a sensible and politically feasible alternative is to limit tax-free employer-provided health benefits to workers whose incomes are under, say, $100,000 a year, and subject those with higher incomes to progressively higher taxes on them.

It’s still not the position Obama took in the campaign. But, hey, circumstances change.

The administration has signaled that this door is not closed, but it is not their first choice.

Social Norms as Taxes on Behavior

How do social norms form?:

Scholars Create Alliance to Foster Research on Sustainability, Strategy, and Management, University of Michigan: ...Researchers ... gathered at the Ross campus ... in the first Alliance for Research on Corporate Sustainability (ARCS) conference. ...

The increasingly interdisciplinary nature of the field makes the need for an annual gathering of leading scholars more relevant today than ever, says Andy Hoffman... "Researchers in economics, strategy, and public policy need to learn to speak each others' language," Hoffman says. ...

Hoffman cited one example of an Irish government policy that neatly ties together how different lenses can be useful in studying the policy and business effects of sustainability efforts. In 2002, the Irish government tacked a 15-cent fee on plastic grocery bags. Within a year, plastic grocery bag use dropped by 94 percent.

A straight economist's view could conclude that pricing works. But Hoffman says there are other things to consider. "A price is never socially inert," he says. "A social norm formed. One person said using a plastic grocery bag is on par with wearing a fur coat or not cleaning up after your dog. How does that norm form?"

A look at the culture of Ireland shows a relatively young population, which typically makes for a good innovation test bed. There were no domestic plastic bag manufacturers in Ireland, so there was little political risk of imposing the fee. ... But unintended consequences arose. Some consumers started buying plastic trash bags to carry groceries. And so the research continues. ...

I will have to admit that if I was asked how to discourage the use of some product, my response would be to find a way to increase its price, a tax or surcharge, something like that, but I'm not sure I would think about - or even know where to begin if I did - ways to change the social norm regarding the use of the product. That's just another way to raise the price and hence discourage the use of the product, it's a form of a tax, and it's an interesting one because no money changes hands in the process. We simply have to be programmed to care what other people think about us, even strangers, something that seems to be built into our behavior.

At first I thought that might mean that social norms are preferred to taxes since the desired result is achieved without any transfer of resources, and because taxes can distort economic outcomes. But social norms can also distort outcomes since they operate like taxes. For example, a social norm supporting discrimination would lead to a less than optimal allocation of resources in an economy and hence would be counterproductive. I can even imagine cases where taxes could be used to try to offset damaging social norms, though I can't think of any concrete examples.

But it would be useful to have a better understanding of how social norms and taxes/fines interact. For example, suppose you want to discourage kids riding in cars without seat belts. Legislators could pass a law - based upon research showing its clear benefits - that imposes a fine for anyone caught allowing their kids to ride in the car without being buckled in. That would certainly have some effect on behavior, but probably not as much as if it became viewed as unnecessary endangerment by society generally (perhaps abetted by a billboard campaign, etc.). The change in the social norm would likely have a much larger effect on people's behavior. Econometrically, it would look like the imposition of the fine had a huge effect on seat belt use, but was it the fine itself that generated the change in social norms, or would the social norms have changed anyway? If the behavior had never been made illegal in the first place, would attitudes have changed as fast? Was it the change in the norm that caused the tax? When you are looking at the effect of a tax on behavior, how do you sort all of this out?

Tax Increases and Revenue: Curbing Offshore Tax Havens

One of the arguments you hear against tax increases at the upper end of the income distribution is that this group will simply find a way to avoid the taxes, legally or illegally, and therefore the revenue collected as a result of the tax increase will fall far short of what is predicted. The "tax cuts increase revenue" crowd will even argue that a tax increase can decrease revenues for this reason.

I always thought the problem was simply the will to enforce the tax increases, i.e. to take the time and effort to close whatever loopholes exist that allow this tax avoidance behavior to be rewarded, and to crack down on illegal behavior. The excuse that it's too hard, they'll just outsmart us, so why try at all always seemed like an unsatisfactory answer to me.

So it's nice to see the administration moving to make tax avoidance more difficult for both individuals and corporations, and to see efforts to broaden the tax base. This will complement their plan to raise taxes on the upper end of the income distribution. I don't know if they will be successful in the end, whether the will to clamp down on evasion and illegal activity and to broaden the base can withstand the intense pressure and resistance that is sure to come, but, unlike the previous administration, at least they are trying:

Obama Calls for New Curbs on Offshore Tax Havens, NY Times: President Obama presented a far-reaching set of proposals on Monday that are aimed at the tax benefits enjoyed by companies and wealthy individuals harboring cash in offshore accounts.

These steps, he said, would be the first in a much broader effort to fix a “broken tax system.” ... His remarks echoed the sentiment he voiced again and again during the presidential campaign, when he pledged to crack down on "illegal overseas tax evasion."

The proposed tax overhaul, which will be fully unveiled later this week..., could help raise $210 billion in revenues over 10 years...

While most Americans paid their fair share of taxes, Mr. Obama said, “there are others who are shirking theirs, and many are aided and abetted by a broken tax system.” Multinationals, he said, paid an average tax rate of just 2 percent on their foreign revenues. And some wealthy individuals hid their fortunes in foreign tax havens.

The president thus set up a frontal clash with big business over the tax advantages enjoyed by companies with extensive overseas operations. ... The president hopes to remove the competitive advantage for companies that invest and create jobs overseas, working to replace their tax advantages with incentives to produce jobs in the United States. ...

But several large businesses have opposed the proposal. About 200 companies and trade associations, including Microsoft, General Electric and the United States Chamber of Commerce, signed a letter stating that the proposed tax changes would put them at a disadvantage with their rivals. ...

Many of the tax proposals will require Congressional approval and, if passed, none would take force before 2011.

It's a start, but more is needed.

There should not be a tax advantage to moving jobs offshore, but I'm not a big fan of using tax incentives to induce firms to create jobs here either. That can quickly turn into a downward protectionist spiral as other countries follow suit. To me, this is a matter of equity. Wealth should not allow individuals or corporations to escape paying their assigned share of the tax burden.

Update: Robert Reich:

Why Obama is Taking on Corporate Tax Havens, by Robert Reich: Why, one may ask, is Obama taking on yet another huge fight by taking aim at foreign tax havens? Yes, it's unfair that multinationals pay an average tax rate of only 2 percent on their foreign revenues, and it's unfair that some wealthy Americans are avoiding taxes altogether by parking their fortunes abroad. But, hey, these have been true for decades. So why take them on now, when the President is also taking on universal health insurance and global warming, and trying to get the economy going again?

The White House says that some jobs go abroad because American companies are lured there by tax loopholes... True. But a crackdown on tax havens might also cost American jobs if companies decided that a higher tax burden here required them to cut payrolls in order to stay competitive or to simply leave the United States altogether.

Another possible explanation is that it was a campaign promise. ... But this can't be it, either. He criticized several other things as well -- such as the North American Free Trade Agreement -- which he now seems comfortable with.

So again: why this, and why now?

Two reasons, both strategic. The President needs the cooperation of many big corporations if he's going to get universal health insurance enacted... Many of these companies would benefit from lower health costs but they're reluctant to take on Big Pharma, big health insurance companies, and major health providers, all of whom are dead set against a ... government health plan. How does it help for him to take on corporate tax havens? Because the President needs as many bargaining chips with the rest of corporate America as possible. The proposed crackdown on foreign tax avoidance is one such chip. He might be willing to take it off the table if big corporations lend him active support on health insurance.

The second reason has to do with revenues. Originally the White House had planned to pay for universal health insurance by limiting tax deductions for wealthier Americans. But the Democratic leadership nixed that source. The rich Americans who take the deductions ... had enough political leverage to make it a non-starter. That means the White House has to find other sources of money. ...

The Administration figures it could raise over $100 billion over ten years by preventing companies from taking immediate deductions for overseas expenses... It could raise another $95 billion by making it harder for individuals to hide their income in offshore accounts, and harder for companies to shift income ... to ... the lowest-tax jurisdiction.

The White House is preparing to release a more detailed budget blueprint later this week. That blueprint has to contain some credible ways to pay for universal health insurance. Otherwise the measure could become vulnerable to deficit hawks who, like vultures over road kill, continue to circle ominously.

Luck and Taxes

Robert Frank:

Before Tea, Thank Your Lucky Stars, by Robert Frank, Commentary, NY Times: The link between success and luck is stronger than many people think. Analysis of this connection provides a useful framework for weighing ... recent “tea parties,” where orators ... bemoaned their “crippling” tax burdens. ...

Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success..., some people enjoy spectacular success despite having neither attribute. (Lip-synching members of boy bands?...)

Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events. ...

Malcolm Gladwell reports that a disproportionate number of pro hockey players owe their success to the accident of having been born in January, which made them the oldest, most experienced players in every youth league growing up. For that reason alone, they were more likely to make all-star teams, receive special coaching and eventually become professionals.

Although people are often quick to ascribe their own success to skill and hard work, even those qualities entail heavy elements of luck. ... People born with good genes and raised in nurturing families can claim little moral credit for their talent and industriousness. They were just lucky. ...

Even in markets where luck plays no role, minuscule differences in performance often translate into enormous differences in salaries. ... In law, consulting, investment banking, corporate management and a host of other occupations, the ablest performers are often paid hundreds or even thousands of times as much as others who perform nearly as well.

Another important message of recent research is that a person’s salary depends far more on where she is born than on her talent and effort.

For example, as a Peace Corps volunteer in Nepal long ago, I hired a cook who had no formal education but was spectacularly intelligent and resourceful. ... Yet his total lifetime earnings were less than even a very lazy, untalented American might earn in a single year. Well-paid Americans owe an enormous, if rarely acknowledged, debt to the social investments that supported their success.

The president’s proposal is modest: raising the top marginal tax rate from 35 percent to 39.5 percent, its level when Bill Clinton left office and well below the corresponding level in most other industrial countries. There has never been a shortage of talented people willing to work hard for success... And the president’s proposal would not cause such a shortage...

It would, however, promote more efficient provision of public services... For example,... when government levies higher tax rates on the wealthy, we can provide public services that the wealthy and others greatly value but that would otherwise be beyond reach. Under such a tax system, the heavier tax bill becomes payable only if we’re lucky enough to end up among life’s biggest winners.

Financially successful tax protesters seem blissfully unaware of how incredibly fortunate they are. To borrow from the late Ann Richards and her description of the first President Bush, they were born on third base and thought they’d hit a triple.

See also Hal Varian's Luck, Skill, and Progressive Taxes:

In the debate over tax policy, the power of luck shouldn't be overlooked, by Hal Varian, NY Times, 2001: President Bush's proposed tax cut has rekindled an age-old debate: how progressive or regressive should the income tax be? ...

Sachs: Paying for Government's Expanded Economic Role

Jeff Sachs says the government will need to find new sources of tax revenue:

The Costs of Expanding the Government's Economic Role [Extended version], by Jeffrey D. Sachs, Scientific American: The 10-year budget framework that President Barack Obama released ... is as much a philosophy of government as a fiscal action plan. Gone is the Ronald Reagan view that “government is not a solution to our problem; government is the problem.” Obama rightly sees an expanded role for government in allocating society’s resources as vital to meeting the 21st century challenge of sustainable development. 

The scientific discipline known as public economics describes why government is needed alongside markets to allocate resources. These reasons include: the protection of the poor through a social safety net; the correction of externalities...; the provision of “merit goods” such as health care and education that society deems to be essential for all of its members; and the financing of scientific and technological research that cannot be efficiently captured by private investors. In all these circumstances, the free-market system tends to underprovide the resource in question...

Obama’s budget plan properly focuses on areas that public economics identifies as priorities and where the U.S. discernibly lags behind many parts of Europe: health..., education..., public infrastructure... and research and development... The emphasis is on public-private partnerships (PPP), combining public financing and private sector delivery. ...

Obama’s vision of an expanded federal role is on-target and transformative, but the financing will be tricky. This year’s deficit will reach an astounding $1.75 trillion, or 12 percent of GDP...

Obama’s budget plan aims to reduce the deficit to 3 percent of GNP by 2013, and to level off till 2019..., but ... that target will be very difficult to achieve and sustain as planned. ...[T]he plan is to cut the deficit mainly through higher taxes on the rich, reduced military outlays for Iraq and Afghanistan, new revenues from auctioning carbon-emission permits and, finally, a squeeze on non-defense discretionary spending... Such a squeeze on non-defense spending seems unlikely—and indeed undesirable—at a time when government is launching several much-needed programs in education, health, energy and infrastructure.

The truth is that the U.S. ... will probably have to raise new revenues ... to carry out its vital roles in protecting the poor, promoting health and education and building a modern infrastructure with ... sustainable technology. Ending the Bush-era tax cuts on the rich certainly is merited, but further taxing the rich much beyond that will come up against political and practical limits. Within a few years, we’ll probably see the need for new broader-based taxes, perhaps a national sales or value-added tax such as those widely used in other high-income countries. If we continue to assume that we can have the expanded government that we need but without the tax revenues to pay for it, the unacceptable build-up of public debt will threaten the well-being of our children and our children’s children. ...

I doubt will see any major changes in the tax structure anytime soon, but if we do, value added taxes are regressive, but in countries where they are used, they're an important source of revenue for highly progressive tax-and-transfer systems (but not without problems). So the characteristic of these taxes overall depends upon their implementation, i.e. how the extra revenue from the tax is used.

Tax Cuts, Household Balance Sheets, and the Duration of Recessions

Greg Mankiw:

It May Be Time for the Fed to Go Negative, by N. Gregory Mankiw, Commentary, NY Times: ...What is the best way for an economy to escape a recession? Until recently, most economists relied on monetary policy. ... The problem today ... is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools...

So why ... not lower the target interest rate to, say, negative 3 percent? ... The problem with negative interest rates ... is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive. ... At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. ... Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal..., such an incentive isn’t a flaw — it’s a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. ...

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt...

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In ... the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. ...

This reminds of the the gift card idea to make sure people spend their tax cuts. Under these proposals, instead of giving people tax cuts, which they are likely to save instead of spend, the government gives them cards worth a given amount, say $1,000, and has the cards expire after, say, three months (you could stagger the issue of the cards over a three month time period so that purchases don't bunch up at the beginning and the end). The connection to the above is, of course, that the expiring gift card is just like the "expiring" money drawn through the serial number lottery (except, of course, that in one case it was a "gift" from the government, while in the other it is your savings). In both cases you are inducing people to spend rather than save through the threat that their saving will become worthless in the future (hyper-inflation does this too).

The reason for gift cards is to prevent the tax cuts from being saved. Initially, I opposed tax cuts that would mostly be saved rather than spent because it wouldn't stimulate aggregate demand, and that's what the economy needed. But I've changed my mind about that, and I think tax cuts can be an important part of the solution in a recession like this one.

Here's why. This recession has wiped out a lot of balance sheets in the financial sector, and it has also done severe damage to the balance sheets of individuals, especially those with a large proportion of their savings in financial assets or real estate (equity in their homes). Those households are not going to spend until those savings for retirement and other purposes are replenished, so how soon the end of the recession comes depends, in part, on how fast those balance sheets are repaired. Tax cuts help to do this, some types better than others. The effect of these balance sheet repairing tax cuts may not be immediately obvious since they are going toward saving, but it helps the recession end earlier than otherwise. Big ticket items, in particular, are less likely to be purchased so long as balance sheets still have big, missing pieces.

So tax cuts should be part of a recovery package, and they can be used in two ways. Some tax cuts can be used to stimulate the economy immediately by helping families who are having trouble and cannot save even if they want to, they have no choice but to consume it all, and part can be targeted at speeding up the recovery by helping households make up for losses. We have to understand, though, that this component of the package will not stimulate aggregate demand immediately, the main effect is to bring an end to the recession sooner, and other measures - increase government spending or additional tax cuts targeted at people who will spend it all - must be increased to compensate.

Recessions can be characterized by their depth and their duration, and my initial opposition to tax cuts underplayed, I think, the role they can play in reducing the duration. I still think the best and most certain way to stimulate aggregate demand is through government spending, and that government spending can itself help to end a recession sooner, but there's a role for tax cuts too. Not in every recession, at least not to the same extent, it's not always the case that a recession wipes out household balance sheets like this one did. But when that happens, household balance sheets are one of the things that must be repaired before we can fully recover.

"Tax Tea Party Time"

Bruce Bartlett says tax protesters "are not entitled to be taken seriously":

Tax Tea Party Time, Part Two, by Bruce Bartlett, Commentary, Forbes: Last week, I presented data comparing taxation in the United States to other major countries and concluded that Americans are not especially overtaxed. ... But what if we compare U.S. taxes today to those in the past? Are Americans more heavily taxed than those in earlier years, and do polls show greater dissatisfaction with taxes today? ... [I]t is hard to find evidence that taxes are rising or unusually high. ...

In response to these facts, some critics say that it is not today's taxes that concern them, but those that will have to be paid in coming years as a result of the large spending and deficits being projected. ...

I have problems with this argument as a justification for the sudden appearance of tea parties to protest taxes. First, many protesters implicitly assume that that the deficit has increased solely as a result of Barack Obama's policies. But in fact, the Congressional Budget Office was projecting a deficit of more than $1 trillion this year back in January...

It's true that projected deficits have gotten larger since January. But much of this resulted from deteriorating economic conditions that would have occurred even if John McCain were president. Moreover, it is absurd to assume that McCain would not have enacted any stimulus programs had he been elected.

More than likely, McCain would have proposed a stimulus plan of roughly the same size as that proposed by Obama. No doubt, it would have had a different composition--heavier on tax cuts, different kinds of tax cuts, less spending, different spending--but it wouldn't have been all that different from Obama's package given large Democratic majorities in the House and Senate and the pressure to act quickly.

I strongly suspect that many of those that loudly denounced the Obama stimulus package for its impact on the deficit would have cheered the McCain stimulus package even though it would have increased the deficit by about the same amount.

Proof of this proposition is that there were no tea parties during the years when George W. Bush was turning the surpluses of the Clinton years into massive deficits. ... Those protesting this week were only protesting because it is a Democrat who has increased the deficit. When a Republican did worse, it's like Emily Litella used to say, "Never mind."

Of course, people are free to protest whatever they want whenever they want, and are also free to change their minds. Maybe this week's tax protesters would have been out protesting even if McCain were president, but I don't think so. I believe this was largely a partisan exercise designed to improve the fortunes of the Republican Party, not an expression of genuine concern about taxes or our nation's fiscal future.

People should remember that while they have the right to their opinion, they are not entitled to be taken seriously. That only comes from having credibility gained by the correct presentation of facts and analysis and a willingness to be even-handed--criticizing one's own side when it is wrong and not only speaking up when the other party does the same thing.

"What Counts is the Spirit of Willingness"

An example of the claim that "many of the [G20] initiatives were more show than substance":

The world's shortest blacklist, FP Passport: I was already kind of skeptical about the G-20's pledge to crack down on tax havens, but after reading Alexander Neubacher's Der Spiegel piece on the tax haven "black list," which contains a whopping zero countries, I'm only more so:

Less than 120 hours after the close of the London summit, the ... OECD ... published the shortest blacklist of all time -- with exactly zero entries. ...

The fact that all the world's tax havens seem to have disappeared overnight is primarily the result of skillful diplomacy. Even the most notorious offshore financial centers have managed to quickly purge themselves of all suspicions of aiding and abetting tax evaders.

At one point, the OECD was vowing to expand the list to include countries like Switzerland, but now even the Cayman Islands -- a country with more registered companies than people -- managed to get itself moved to the "gray list" of countries that are supposedly working to clean up their act:

On April 1, just one day before the London summit, the Cayman Islands managed to sign seven bilateral treaties -- with the Faeroe Islands, Iceland and Greenland, for example -- to cooperate on matters of taxation. Although the specific concessions made by the Caymans, a British overseas territory, are modest, what counts is the spirit of willingness. ...

I feel like this can't have been what Sarkozy had in mind.

"Kooks, Demagogues, and Right-Wingers On Tax Day"

Robert Reich is tired of hearing complaints about taxes:

A Short Citizen's Guide to Kooks, Demagogues, and Right-Wingers On Tax Day, by Robert Reich: No one likes to pay taxes, so tax day typically attracts a range of right-wing Republicans, kooks, and demagogues, all of whom tell us how awful we have it. Herewith a short ... guide ... responding to the predictable charges:

1. "Americans pay too much in taxes." Wrong: The United States has the lowest taxes of all developed nations.

2. "The rich pay too much! The top ten percent of income earners pay over 72 percent of all income taxes!" Misleading: The main reason the rich pay such a large percent is they've become so much richer ... in recent years. If you look at what they pay as individuals ... you'll see a steady decline over the years. ...

3. "The bottom 60 percent pay only 3.3 percent of the taxes!" Misleading again. Most Americans are paying more in sales taxes than they ever have. Property taxes have also been rising at a steady clip. And Social Security taxes have also risen (thanks to the Greenspan Commission), while earnings over about $100,000 aren't subject to Social Security taxes. So-called "sin" taxes (mostly beer and cigarettes) have also skyrocketed. All of these taxes take a bigger bite out of the paychecks of people with lower incomes than they do people with higher incomes.

4. "Obama is raising your taxes!" Wrong. Obama is cutting taxes for 95 percent of Americans, by about $400 per person a year... Only the top 2 percent will have a tax increase, but even this tax increase is modest. Basically, they go back to the rates they were paying under Bill Clinton... And they won't start paying this until 2011 anyway.

5. "The huge debts we're wracking up will cause your taxes to rise!" Wrong again. When it comes to the national debt, as I've said before, the relevant statistic is the ratio of debt to the gross domestic product. The only sure way to bring that debt down and make it manageable in future years is to get the economy growing again -- which requires that, in the short term, the government spend a lot of money... In the long term, the biggest source of concern is rising health-care costs. And that's something Obama and Congress are aiming to tackle.

6. "We have a patriotic duty to stand up against Washington taxes!" Just the opposite. We have a patriotic duty to pay taxes. ... President Teddy Roosevelt made the case in 1906 when he argued in favor of continuing the inheritance tax. "The man of great wealth owes a particular obligation to the state because he derives special advantages from the mere existence of government."

An acquaintance from law school, now a partner in one of Washington's biggest and wealthiest law firms, explained to me one day over lunch how he and his partners use tax rules to create offsetting taxable gains and losses, and then allocate the gains to the firm's foreign partners who don't pay taxes in the United States. That way, they keep the losses here and shelter their income abroad. I noticed he had an American flag lapel pin. "You're supporting our troops," I said, referring to his pin. "Yup," he replied, entirely missing my point.

True patriotism isn't cheap. It's about taking on a fair share of the burden of keeping America going.

"Just How Progressive Is the Tax System?"

Catherine Rampell at Economix presents and discusses data on the progressivity of taxes (federal, state, and local, calculations from the Citizens for Tax Justice). As she notes, this comes in rebuttal to claims based upon CBO data that taxes are highly progressive, and that the wealthy pay far more than their share:

Horizontal axis shows the income group. Vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

Horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

Update: pgl follows up.

Using Inheritance Taxes to Promote Equal Opportunity

Michael Kinsley is mystified by ten Democratic senators:

Democrats for Rich Heirs?, by Michael Kinsley, Commentary, Washington Post: ...Meanwhile, the Senate is considering what to do about the estate tax. It is scheduled to be abolished next year, in one of several landmines the Bush administration set to go off after it left town. Obama proposes to reinstate the tax, at a 45 percent rate, on estates worth more than $3.5 million. Since there's no tax on what you leave to your spouse, married couples could pass on $7 million before needing to pay a dollar -- or needing to consult a lawyer who can use loopholes to save millions more.

The House has passed this measure as part of the budget. In the Senate, there's trouble. Ten Democrats have joined the Republicans in calling for a $10 million exclusion and a 35 percent rate. This is amazing. The number of people who leave estates of even $7 million is minuscule. The number leaving more than $10 million is smaller still. Yet to save these very few very wealthy people a small fraction of their estates, these senators are willing to hand their party's president an embarrassing defeat. Why on earth?

Oh, small business blah blah blah. ... To be affected by the estate tax, a business must be owned by someone of large means: at least $7 million. ...

But why the populist fury over those AIG bonuses of a few million dollars while no one seems to care much about billions being transferred through inherited wealth? The obvious answer -- that there's a difference between what people do with our hard-earned money and what they do with their own hard-earned money -- isn't actually as persuasive as it seems.

Perusing the Forbes 400 list of America's richest people, it's striking how few of them made the list by building the proverbial better mousetrap. The most common route to gargantuan wealth, like the route to smaller piles, remains inheritance. ...

Dozens of Forbes 400 fortunes derive from the rising value of land or other natural resources. These businesses are fundamentally different from mousetrap building. Land does not need to become "better" to increase in value, and that value increase doesn't produce more land. Yet other fortunes depend directly on the government. The large fortunes based on health care and pharmaceuticals would not exist if not for Medicare and Medicaid. The government hands out large fortunes even more directly in forms as varied as cable-TV franchises; cellphone licenses; drilling, mining and mineral rights; minority small-business loans; and other special treatment.

Most important, every American selling anything benefits from doing so in the world's richest market. An American doctor earns many times what the same doctor would earn in, say, India. This is not because he or she works many times harder. ... It's because we are a richer society, for reasons the American doctor had nothing to do with.

The debate over whether the estate tax should start at $7 million or $10 million is largely symbolic. That makes the push by those 10 Democratic senators for the higher amount even more mysterious.

Via Brad DeLong:

Think Progress: Lincoln’s $250 billion estate tax plan would cut taxes for only 60 ’small businesses.’: Last week, 10 Democrats in the Senate joined all 41 Republicans in voting for a $250 billion proposal to cut estate taxes... Touting the tax cut in a press release, Lincoln claimed that it was “aimed at farms and small businesses.” However, according to an analysis by the Tax Policy Center, Lincoln’s $250 billion proposal would save just 60 small businesses or farms from the estate tax:

An always charged issue is how the estate tax affects small farms and family-owned businesses. We estimate that under the Obama proposal, 100 family farms and businesses [a year] would owe tax.... The Lincoln-Kyl proposal would cut the number to 40.

According to the Congressional Budget Office, “almost all such estates are able to pay the tax bill without having to sell business assets.”

To try to overcome the political opposition, and to try to meet a worthy goal, I would increase and broaden the tax, and then earmark the revenues specifically for programs designed to promote equal opportunity, e.g. Head Start programs, funds to allow anyone to attend the college of their choice without running up large debts, or alternatively to help to start a business, and so on. To further help with the political opposition, the collected funds, or more precisely the programs the funds support, would be made available to everyone on an equal basis.

"Ricardian Equivalence in Practice"

This discussion at Brad DeLong's makes the point that Ricardian equivalence fails for deficit financed temporary changes in government spending. But what's not clear from the discussion is that there's no reason to expect Ricardian equivalence to hold in any case in practice, even for deficit financed tax cuts where it can be true in theory.

This is from the third edition of Brad's colleague David Romer's Advanced Macroeconomics text where he explains why "there is little reason to expect Ricardian equivalence to provide a good first approximation in practice":

11.3 Ricardian Equivalence in Practice

An enormous amount of research has been devoted to trying to determine how much truth there is to Ricardian equivalence. There are, of course, many reasons that Ricardian equivalence does not hold exactly. The important question, however, is whether there are large departures from it.

Class Warfare?

John Berry:

If Tax-Cut Lapsing Is Class Warfare, Let’s Fight, by John M. Berry, Commentary, Bloomberg: If letting top income-tax rates go back to where they were in 2000 is class warfare against the rich, I’m ready to snap to attention with my old M1 rifle on my shoulder.

What a ridiculous label, class warfare. It’s hardly aggression against any class to have a progressive income-tax system in which fairness and ability to pay are important considerations in setting rates for different income groups.

As far as the top tax rates are concerned,... The law already calls for today’s 33 percent rate to go to 36 percent and the 35 percent rate to rise to 39.6 percent, in 2011.

Why did a Republican Congress and President George W. Bush countenance the 2011 expiration dates in the 2001 tax-cut bill? It was one of several deceitful provisions that made rate reductions temporary to hold down estimates of revenue loss. Of course, the GOP intended all along to make the rate cuts permanent.

Obama would let the Bush rate cuts expire only for couples with incomes above $250,000 ... and raise the rates for them on capital gains and dividends to 20 percent from 15 percent.

Unfair? I don’t think so, given these earners’ relatively greater ability to bear the added burden. There’s no doubt that a larger share of the nation’s income has become concentrated at the very top of the distribution.

The extra revenue would be used to help finance the government’s necessary role in dealing with the dangers of climate change and improving access to health care and control of its costs. ...

The Obama plan would give most taxpayers small reductions in tax liabilities...

When Clinton proposed raising the top rates to 36 percent and 39.6 percent in 1993, there were plenty of predictions that the higher marginal rates would hurt Americans’ willingness to work and invest. Some economists argued that so many people would opt for leisure instead of work that the higher rates would raise no additional revenue.

Instead, a boom ensued in the latter 1990s... What did Bush’s lower rates produce? Mediocre growth, very large deficits and financial-market manipulation.

The reality is that tax rates aren’t nearly as powerful a force as some people think they are. ...

Tax Cuts and Work Effort across Income Levels

A revenue neutral change that makes taxes more progressive increases work effort. That is, when taxes on the middle class go down by a dollar and taxes on the wealthy go up by a dollar, the increase in work effort by middle class workers more than offsets and fall in work effort by the wealthy:

So, based on my research, if a need to raise some revenue means tax rates have to be increased for someone, raising them on the wealthiest will result in a smaller reduction in work effort than raising tax rates on the middle class.

That's Julie Hotchkiss reporting on her research in macroblog. There is a catch:

An additional relevant question remains: What is the implication of changing work effort for GDP growth? The relationship between work effort and value of output is not necessarily the same across income levels. In other words, one hour of high-income (higher education) labor is expected to yield a higher value of output in the economy than one hour of labor from a middle-income (lower education) worker. A complete analysis of the aggregate impact of the administration's tax plan would have to also take this into account.

However, the effect on growth is only one metric by which to judge this policy, e.g. the benefits to the household that come from one more hour of work may also differ across income levels, particularly if the additional money is used to buy necessities in one case, and luxuries in the other.

Mr. Freeze

David Brooks:

The Democratic response to the economic crisis has its problems, but let’s face it, the current Republican response is totally misguided. The House minority leader, John Boehner, has called for a federal spending freeze for the rest of the year. In other words, after a decade of profligacy, the Republicans have decided to demand a rigid fiscal straitjacket at the one moment in the past 70 years when it is completely inappropriate.

The real goal, I think, is to protect the Bush tax cuts. The tax cuts are scheduled to expire soon due to budget games the Republicans played to get the tax cuts in place, but they never intended to actually let the tax cuts be reversed. Now that they are out of power, something they didn't expect would happen, there is a possibility that the increase in taxes Bush scheduled to game the budget figures will be allowed to happen after all. However, if the political winds move against more spending - something Boehner is trying to facilitate - and the economy remains weak, the case for allowing the scheduled Bush tax hikes to occur is harder to make.

Update: Paul Krugman:

Can America be saved?: So I read this:

Boehner said Americans want government to practice the same financial restraint they have been forced to exercise: “It’s time for government to tighten their belts and show the American people that we ‘get’ it.”

and I wonder if this country can handle the crisis we’re in. Remember, John Boehner is, in effect, the second-most influential member of the GDP...

What’s insane about Boehner’s remark? He’s talking about the current economic crisis as if it were a harvest failure — as if we faced a shortage of goods, so that the more you consume the less is left for me. In reality — even most conservatives understand this, when they think about it — we’re in a world desperately short of demand. If you consume more, that’s GOOD for me, because it helps create jobs and raise incomes. It’s in my personal disinterest to have you tighten your belt — and that’s just as true if you’re “the government” as if you’re my neighbor.

Plus, who is “the government”? It’s basically us, you know — the government spends money providing services to the public. Demanding that the government tighten its belt means demanding that we, the taxpayers, get less of those services. Why is this a good thing, even aside from the state of the economy?

Again, this is what the leaders of a powerful, if minority, party think. Can this country be saved?

Bruce Bartlett: "Exposing Republican Stupidity"

Another quick hit: Republican Bruce Bartlett (budget story here):

Exposing Republican stupidity, by Bruce Bartlett, Politico: It appears from leaks about Obama’s budget that the scenario I have long envisioned will finally come to pass. Republicans will be forced to deal meaningfully with the Bush tax cuts, which Obama apparently plans to allow to expire at the end of next year.

Republicans wrote this legislation with expiration dates as a trick to avoid budget rules that make it difficult to enact permanent tax cuts. Now they are going to say that this constitutes the largest tax increase in history even though their own legislation bequeathed it.

I hope Obama stands firm; not because I want taxes to rise, but because it exposes Republican stupidity. They could have had permanent—and more effective—tax cuts in the first place if they had been willing to negotiate with Democrats. They refused to do so and deluded themselves that they could just extend their tax cuts forever. They were wrong.

"What Would Galbraith Say?"

Did JFK's decision to use tax cuts rather than government spending in an attempt to jump start a stalled economy help to cause, through a series of events, "an angry and disheartened public ... to hate the Democrats, hate liberals, and hate government," and did JFK's tax cuts therefore help to bring Richard Nixon to the White House?:

What would Galbraith say?, by Richard Parker, Commentary, Boston Globe: Dear Mr. President,
In a future two-volume work, I intend to deal with the relation of a President to economists. I will naturally urge that he listen to them attentively, and indeed with a certain respect and awe. But in times of economic challenge, the President must have a sense of what the people want. Economists only know what people should want - or sometimes what they used to want. - John Kenneth Galbraith to President Kennedy, August 1962

Treasury Secretary Timothy Geithner's debut ... of his ... rescue plan sent Wall Street into a tailspin... The Plan - clearly crafted by the Larry Summers-led economic team - had been fiercely opposed by top White House political advisers (including David Axelrod). The political people apparently feared The Plan, however sketchy, made the White House look like it was bringing back last year's arsonists to be this year's firefighters - while doing too little for the millions trapped in our still-burning economy.

To Ken Galbraith, all this would have been eerily familiar (and alarming)... John F. Kennedy ... entered office in 1961, during what was then the worst downturn since the Depression. JFK was a new, young, and untested president, uncertain in economics, a leader attuned to bipartisanship (he chose a Republican investment banker as treasury secretary). His economists were all Keynesians... But they disagreed about what to do. ...

White House chief economist Walter Heller, a tax specialist ... favored ... deep tax cuts. Ken Galbraith ... wanted spending - deficit spending - that focused on building schools, roads, and parks, and creating public jobs...

Galbraith had a ... worry:... Costs for ... war weren't in Heller's economic models. If war came in Vietnam, he knew spending would soar but that Congress would put off raising taxes to pay for it. The "wrong" stimulus strategy ... might destroy the New Frontier if the package was mismanaged, and decided only by the economists and their models.

Finally, after months of argument, Kennedy imposed a compromise: Heller's tax cuts first, then Galbraith's major public spending. JFK was unsure of his decision, but ... stimulus was clearly needed. Getting tax cuts passed first by a conservative Congress would be easier.

Kennedy['s]... tax cuts ... went into effect in 1964 under Lyndon Johnson. Initially, the economy soared - but then LBJ plunged deeper into Vietnam, and war costs soon drove heavy deficits that in turn triggered inflation. Congress dragged its feet about raising taxes quickly enough to curb inflation.

Soon enough, an angry and disheartened public began to hate the Democrats, hate liberals, and hate government. A faltering economy, along with a worsening war, brought Richard Nixon to the White House.

Galbraith's warnings had proved right, because reality had proved more complex than the economists' models.

It's an important lesson to ponder 40 years later: In times of economic crisis, presidents should listen to economists. But then they must listen to the American people, because the stakes aren't just economic.

Judd Gregg Thinks Tax Cuts Pay for Themselves

I'm really glad that someone who believes tax cuts pay for themselves - as Judd Gregg believes - won't be our next Commerce Secretary:

Bush Tax Cuts, by Judd Gregg, May 15 2007: ...I want to pick up where the Senator has left off. The Senator talks about the facts--and this is a fact--that revenues to the Federal Government have jumped dramatically in the last 3 years. In fact, in the last 3 years we have seen more revenues flowing into the Federal Government than ever in history...

Why have we gotten more revenues even though we reduced the tax burden on the American people? The answer is pretty simple. It is called human nature. When you set tax levels at a fair level ... people are willing to go out and invest. ... They are willing to work harder... That creates a stronger economy which puts more people to work, and..., of course, the more jobs you have the more tax revenues you end up getting. ...

In fact, in the area of capital gains, we have seen a dramatic increase in revenues. ... It is a huge jump in revenues we didn't expect--or at least the Congressional Budget Office didn't expect--but which we received because human nature kicked in and people were willing to sell assets, take that money and reinvest it in things that are productive, create jobs, and as a result we got those revenues. That is why today the Federal Government is actually getting more in revenues than it got under the old tax law where the rates were a lot higher. ...

I think we need to ... see what has happened as a result of reducing these tax rates. Basically, what has happened is that even with the lower tax rates today, wealthy people are paying more in revenues to the Federal Government than at any time in history. ... So even though we have cut rates, we have actually created more revenues from high-income individuals. ...

Higher taxes, actually, in many instances reduce revenues to the Federal Government... Three Presidents have proved beyond any reasonable doubt when you lower income tax rates, you generate economic expansion... President Bush has shown it once again: Cut income tax rates, expand the economy, and as a result get a fair tax level and human nature kicks in and revenues flow into the Federal Treasury. ...

Unfortunately, though, we now have the Democrats presenting to us a budget which wants to take us to the French path, which essentially is going to dramatically increase the cost to the Federal Government, to Americans, and as a result dramatically increase the tax level on Americans. We will go down that path that France has gone down.

I have to tell you, it doesn't work in France. Productivity is not up in France. Jobs are not being created in France. People don't want to go out and work harder in France. ...

I think we should reject the Democratic approach under their budget of raising taxes and stay with this tax law that is raising so much new revenue...

Who in the administration thought Gregg would be the best person available "to foster, promote, and develop the foreign and domestic commerce" when he believes ideological nonsense like this?

"Creating Jobs and Closing the Income Gap"

Can policy create jobs and reduce income inequality at the same time?:

Creating new US jobs and closing income gap, by Edward N. Wolff, Commentary, Project Syndicate: With unemployment climbing..., job creation is a key objective for policy makers. ...President Barack Obama recently proposed to increase public spending by about US$600 billion over the next two years to create an additional 4 million jobs.

But Obama is also concerned with reversing a sharp rise in income inequality, which is now at an 80-year high. Is it possible for leaders to do both at the same time? The answer is unequivocally yes, but only if they focus on government spending rather than reforming their tax systems.

America's tax system has surprisingly little redistributional punch. ... Total personal taxes are mildly progressive, increasing steadily as a share of income from 14 percent at the 10th percentile to 28 percent at the 90th percentile. But then they fall off sharply to 22 percent at the top, owing to the favorable treatment of capital gains and investment income.

On the other hand, total transfers have a much bigger equalizing effect on incomes. Cash transfers, like Social Security and unemployment insurance, are highly equalizing. When the value of non-cash government benefits, like Medicaid, Medicare, and food stamps, are also included, total transfers become extremely progressive.

Government spending on goods and services, like education, highways, police, and sanitation, has distributional consequences, too. Public consumption is just as progressive as transfer payments. ...

When you add together government transfers and public consumption and subtract taxes paid, you get a figure for net government expenditures.

This is extremely progressive. As a share of income, it declines sharply from 70 percent at the 10th percentile to -16 percent at the top (in other words, the top bracket pays more in taxes than it receives in government benefits).

The extremely progressive nature of net government expenditures comes about equally from government transfers and public spending; very little is contributed by taxes.

It is not just the poor who benefit from net governmental expenditures. The middle class is also a big beneficiary.

As Obama and other leaders around the world implement stimulus packages in the months ahead, they should recognize that the question of who benefits goes beyond the number of jobs created.

If these packages target education (very redistributive) or sanitation, fire, police, and highways (mildly redistributive), they can create jobs and reduce inequality.

This seems to take the existing tax structure and its suprisingly small "redistributional punch" as fixed, or nearly so, but I don't think we should. A revenue neutral increase in progressivity would not impede recovery, it would provide a mild stimulus as money moves from households with higher savings rates to households with lower savings rates. So the need for stimulus is not, per se, an argument against redistribution.

Sachs: A Fiscal Straitjacket

Jeff Sachs is worried that the stimulus package, especially the components involving tax cuts, will do more harm than good by starving the economy of the revenues needed to fund vital programs:

A fiscal straitjacket, by Jeffrey Sachs, Commentary, Financial Times: The US debate over the fiscal stimulus is remarkable in its neglect of the medium term – that is, the budgetary challenges over a period of five to 10 years. ... Without a sound medium-term fiscal framework, the stimulus package can easily do more harm than good...

The most obvious problem with the stimulus package is that it has been turned into a fiscal piñata – with a mad scramble for candy on the floor. We seem all too eager to rectify a generation of a nation saving too little by saving even less – this time through expanding government borrowing. ..

The White House and Congress have stated an amount – $825bn to be spent mostly over two years... Many of the details of allocating the $825bn are being left to Congress with the aim of reaching a bipartisan consensus. The result is shaping up to be an astounding mish-mash of tax cuts, public investments, transfer payments and special treats for insiders.

What we need is a medium-term fiscal framework, one that lays out an anticipated schedule of taxes and spending consistent with the needs of the economy and government functions. Rather than soundbites about ending pork-barrel projects or scouring the budget for waste, or about the relative multipliers of tax cuts versus spending increases..., we should be reflecting on certain basic fiscal facts, the most important of which is that the US government faces huge and potentially debilitating structural deficits as far as the eye can see. ...

If the present stimulus package is adopted without a medium-term plan, it will ... put the US into a fiscal straitjacket that could paralyze public sector action in critical areas for a decade or more to come. This is especially true if we allow further tax cuts during a time of fiscal hemorrhage, or give into “bipartisan” demands to make the Bush tax cuts permanent, even for the rich, as seems increasingly likely.

There are many valuable things proposed in President Barack Obama’s spending plans – such as the sums to be spent on energy, healthcare and education – but these should be incorporated into medium-term strategies rather than a grab bag of hasty short-run spending. The tax cuts that he is likely to approve..., and the extension of Bush-era tax cuts if that comes to pass, could close the door to these longer-term programs; haphazard spending on these vital programs could do the same. ...

[T]here is certainly a cyclical case for deficit- financed public spending, but accompanied by phased-in tax increases to provide proper financing of crucial government functions in the medium term.

"Righty Economists" and Ricardian Equivalence

Via email:

Has it occurred to either of you that we have Greg Mankiw approvingly posting links to Barro, and also to John Taylor arguing that a perm tax cut counts as a stimulus?

While we're at it, in quoting an abstract from Mountford & Uhlig's paper, he bolds the last sentence:

We find that deficit-financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue five years after the shock.

Multiplier of 5, 5 years later. Boy, you can't reject Ricardian equivalence much more emphatically than that. Yet Kevin Murphy, in the slides Brad posted yesterday, touts the idea.

I'm willing to give up on getting righty economists to provide a serious defense of their positions. At this point, I would settle for their

1. dividing into the camps that do and don't believe in Ricardian equivalence so the rest of us know, and

2. fighting it out among each other before they try and convince anyone else that it's simultaneously true that

(a) stimulus is unnecessary,
(b) it's impossible for a stimulus to do anything due to identities and R equivalence, and
(c) tax cuts--permanent ones!--are the best way to stimulate AD.

The 2003 "Jobs and Growth" Plan (Tax Cuts) Didn't Work

Larry Mishel on the effect, or more precisely the lack of any effect, of the 2003 tax cuts on "Jobs and Growth":

Tax cut approach has already been tried and failed as stimulus:...[The administration claimed t]he Bush tax cuts of 2003 ... would generate 1.4 million jobs on top of the 4.1 million jobs that were expected to be generated over the eighteen months following June 2003. See [here]...

EPI tracked the initiative’s effectiveness through a website, www.jobwatch.org, and found that it fell far short of its goals. Not only did the promised 1.4 million additional jobs not appear, but the 4.1 million jobs expected with no action also failed to materialize. In all, only 2.4 million jobs were created—1.7 million short of the administration’s projection without their new policy. Thus, by the Bush administration’s own metrics the tax cut program fell short by a total of 3.1 million jobs (149,000 pr month). For an analysis of how the Bush 2003 tax plan (The “Jobs and Growth" plan) fell short of its job claims see [here]...

On what basis can the conservatives who embraced those failed initiatives now claim that tax cuts are the best policy?

It seems Republicans have but one answer to every problem, get government out of the way through tax cuts and deregulation. When they are asked what caused it, whatever it might be, there is one answer, government. When asked how to fix it, whatever it might be, there is but one answer, reduce government through tax cuts and deregulation. For many, especially the politicians, it doesn't matter whether tax cuts will actually fix the economy, the goal is to reduce the size of government by any means, and they see this as an opportunity to do just that. If government is always the problem, then getting government out of the way is always the solution.

For many of the tax cut advocates on the right, this isn't really about job creation. Though job creation will get plenty of lip service, the right doesn't generally believe government intervention in any form, tax cuts or spending, is helpful as far as stabilizing the economy. They believe that cutting taxes can increase economic activity, reducing taxes gets the government out of the way and that will increase growth and jobs, but that is about the long-run and economic growth, it's not about stabilizing the economy in the short-run or about creating jobs to end a recession.

So the tax cut policy isn't really about stabilization policy. There could be jobs that are created from tax cuts, even in the short-run, but in its heart of hearts the tax cut policy is about cutting revenues at every opportunity in an attempt to reduce the size of government. If you doubt this, ask yourself what the right will argue when the economy starts to improve. Suppose we say at some point in the future, ok, now that things are better, it's time to increase taxes back where they were. What will we hear? What we'll hear is how raising taxes will kill the recovery, kill growth, cost us jobs, etc. According to this line of thinking, recessions are good times to cut taxes, but recoveries are horrible times to raise them (note, however, that this is wrong from a stabilization perspective - you should run a surplus in good times to cover deficits incurred in bad times). So once taxes ratchet down, it will be a fight to return them back where they started. That's because the real goal is not stabilization, with stabilization policy taxes would move freely in both directions, it's to reduce the size of government. And since the real goal is something besides stabilization, there's no reason to expect, and good reason not to expect, that the policy this group puts forth will be optimal (or even good) at providing short-run relief.

They already screwed this up once, the initial tax cut stimulus package put into place last spring was too small and poorly targeted, it had all sorts of problems all in the name of appeasing this same group - and here they are trying to muck up the process once again, to hold jobs hostage while they try to get tax cuts in place, even though something like 40% of the package is already devoted to tax cuts. Camel, tent, nose. I think it's time to stand up and say no, sorry, you lost the election, and not by just a little bit. You had your chance and look where we ended up - with a terrible economy, huge holes in the budget making it much harder to respond to the downturn, a financial sector wrecked by your anti-government, self-regulation philosophy, what is it about the past several years that would lead us to have any confidence at all you have the slightest clue how to manage a well-running economy instead of driving it into a ditch, let alone heal one that is broken?

"Does Stimulus Stimulate?"

Bruce Bartlett:

Does Stimulus Stimulate?, by Bruce Bartlett, Forbes.com: ...The [Great Depression] didn't really end until both monetary and fiscal policy became expansive with the onset of World War II. At that point, no one worried any more about budget deficits, and the Fed pegged interest rates to ensure that they stayed low, increasing the money supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly ended. As a consequence, economists concluded that an expansive monetary and fiscal policy, which had been advocated by economist John Maynard Keynes throughout the 1930s, was the key to getting out of a depression.

Keynes was right, but many of his followers weren't. They thought that budget deficits would stimulate growth under all circumstances, not just those of a deflationary depression. When this medicine was applied inappropriately, as it was in the 1960s and 1970s, the result was inflation.

Economists then concluded that it was a mistake to pursue countercyclical fiscal policy, and the idea of "fine-tuning" became a derogatory term. ...

In the 1980s and 1990s, economists came around to the view that only monetary policy could act quickly enough to reverse or moderate a recession. ... [But...] As we have seen, the Fed could not prevent the greatest financial downturn the world has seen since 1929. This has revived the idea that fiscal policy must be the engine that pulls us out.

Somewhat surprisingly, there has been rather heated opposition to the very principle of fiscal stimulus... We have now had several tests of the Keynesian idea--most recently with last year's $300 tax rebate... According to a new paper by University of Michigan economists Matthew Shapiro and Joel Slemrod, only a third of the money was spent, thus providing very little "bang for the buck."

The failure of rebates has shifted the focus to public works and other direct spending measures as a means of stimulating aggregate spending. A study by Obama administration economists Christina Romer and Jared Bernstein predicts that the stimulus plan being debated in Congress will raise the gross domestic product by $1.57 for every $1 spent.

Such a multiplier effect has been heavily criticized by a number of top economists, including John Taylor of Stanford, Gary Becker and Eugene Fama of the University of Chicago and Greg Mankiw and Robert Barro of Harvard. The gist of their argument is that the government cannot expand the economy through deficit spending because it has to borrow the funds in the first place, thus displacing other economic activities. In the end, the government has simply moved around economic activity without increasing it in the aggregate.

Other reputable economists have criticized this position as being no different from the pre-Keynesian view that helped make the Great Depression so long and deep. Paul Krugman of Princeton, Brad DeLong of the University of California at Berkeley and Mark Thoma of the University of Oregon have been outspoken in their belief that theory and experience show that government spending can expand the economy under conditions such as we are experiencing today.

I think the critics of an activist fiscal policy are forgetting the essential role of monetary policy as it relates to fiscal policy. As Keynes was very clear about, the whole point of fiscal stimulus is to mobilize monetary policy and inject liquidity into the economy. This is necessary when nominal interest rates get very low, as they are now, because Fed policy becomes impotent. Keynes called this a liquidity trap, and I think there is strong evidence that we are in one right now.

The problem is that fiscal stimulus needs to be injected right now to counter the liquidity trap. If that were the case, I think we might well get a very high multiplier effect this year. But if much of the stimulus doesn't come online until next year, when we are likely to be past the worst of the slowdown, then crowding out will greatly diminish the effectiveness of the stimulus, just as the critics argue. ... Thus the argument really boils down to a question of timing. ...

For this reason, I think there is a better case for stimulating the economy through tax policy than has been made. Congress can change incentives instantly by, for example, saying that new investments in machinery and equipment made after today would qualify for a 10% Investment Tax Credit...

Stimulus based on private investment also has the added virtue of establishing a foundation for future growth, whereas consumption spending does not. As economist Hal Varian of the University of California at Berkeley recently put it, "Private investment is what makes possible future increases in production and consumption. Investment tax credits or other subsidies for private sector investment are not as politically appealing as tax cuts for consumers or increases in government expenditure. But if private investment doesn't increase, where will the extra consumption come from in the future?"

I don't agree with all of this, e.g.  the "government is always the problem" emphasis in the analysis, and casting the debate as a tradeoff between private investment and private consumption rather than between private sector activity (consumption or investment) and public investment overstates the case for private sector solutions. [These arguments from yesterday apply as well.]

I've never objected to tax cuts being part of the package -- I have also argued that the desire for an immediate impact may necessitate some tax cut components in order to maximize the prospects for a faster recovery. And as tax cuts go, there are far worse choices than an investment tax credit. But just as there's a limit to the number of public sector projects that are shovel ready, there's also a limit to the number of private sector projects that are ready to go (though the planning stage does involve some spending, just not as much as when the public or private sector investment projects are going full throttle). There's also a question about how strong the reaction will be to a tax credit when the economic outlook is so gloomy, a question that doesn't arise when government is making the investments. So, sure, let's get as much out of the private sector as we can, but we shouldn't rely solely upon the private sector response to a tax credit to turn things around. It's very unlikely to be enough on its own, and it may not provide much help at all, Thus, even with tax credits, the public sector response - government spending in particular - still needs to be aggressive.

Stiglitz: Just Say No to Tax Cuts

Joseph Stiglitz on the tax cuts versus spending question:

Do not squander America’s stimulus on tax cuts, by Joseph Stiglitz, Commentary, Financial Times: As news of the US economy worsens, worries about whether a stimulus could restart the economy are growing. ...

What is clear is that tax cuts will not help much. ... It has been surprising, then, to see President George W. Bush’s former economic advisers, including Greg Mankiw, argue that tax cuts are the way forward. ...

Tax cuts have increased our national debt. They encouraged America to live beyond its means, increasing our liabilities without commensurate increases in assets. Further tax cuts would do the same. Good accounting looks at assets and liabilities. Spending on infrastructure, education and technology create assets; they increase future productivity.

Some of the spending in the stimulus serves multiple ends. Increased unemployment benefits have the largest multiplier effects – cash-strapped families spend every cent given – and meet vital social needs. It is imperative to provide health insurance to the unemployed: without that, a single serious incident can push a family into bankruptcy. Helping the unemployed meet house payments reduces foreclosures, addressing one of the underlying causes of the crisis. There are thus triple benefits.

We are in uncharted territory in this crisis. But household tax cuts, except for possibly the poorest, should have no place in the stimulus. Nor should business tax breaks, except when closely linked with additional investment. The one tax cut that should be included is a temporary incremental investment tax credit; it provides a big bang for the buck, encouraging companies to invest now when the economy needs the spending. Increased investments in infrastructure, education and technology, relief to states, and help to the unemployed need pride of place.

This is a stimulus that some Republicans will find less attractive than previous give-aways. But Americans voted for change they could believe in. I trust that that is what we will get.

There's also a video, "Conversations on the Credit Crunch," at the link above.

"Dynamic Scoring"

I was thinking about thinking about this:

Dynamic Scoring, by Andy Harless: Suppose that, at the beginning of the fiscal year, Congress appropriates $100 billion extra for infrastructure projects. At the end of the fiscal year, how much higher will the deficit turn out to be, compared to what it otherwise would have been?

The obvious answer, and the one that usually seems to be implicitly assumed by the media and the pundits, is $100 billion. But if you think about it carefully, it should become obvious that the obvious answer is the wrong answer.

The government is going to use most of that money to hire people and to buy things. Many of the people it will hire are people who were previously unemployed. Many are leaving other jobs which will subsequently be filled by people who were unemployed. These previously unemployed people, who may have been collecting benefits, will now be paying taxes. Those taxes will reduce the deficit, as will the reduced benefit payments. Moreover, for the businesses from which the government purchases, their profits will rise, and they will pay additional taxes on those additional profits. And they may expand and hire new people, or retain people that would otherwise have been laid off. And (if you believe in a multiplier effect), all the newly employed people, as well as the owners of the businesses, will spend more money, thus providing more profits and more employment for others, who will also pay taxes and stop collecting benefits. And so on. The ultimate effect of the original expenditure on the budget deficit will be considerably smaller than $100 billion.

This is called dynamic scoring. ... In the past, dynamic scoring has met with a lot of skepticism – and with good reason. Under normal economic conditions (by which I mean those that prevailed from 1953 through 2007), it's not clear that budget changes have any significant indirect effects on revenues and expenditures. Supply-siders claimed that the incentive effect of tax cuts would increase incentives for economic activity and thereby result in increased revenues. (I mean, "increased" relative to the static estimate of the revenue loss, not increased relative to what would happen without the tax cut. The latter idea had a lot of play in the popular press, but it was seldom taken very seriously by economists.) Keynesians (the old-fashioned kind) claimed that tax cuts and expenditure increases would increase demand and thereby result in increased revenues (again, relative to the static estimate). But...

Mainstream economic analysis said they were both wrong. Many economists think there are major supply-side benefits to more efficient taxation, but most such economists think those are primarily long-run benefits (faster growth over a span of time) rather than benefits that would significantly affect revenues in the short run. The Keynesian argument would make sense if monetary policy were passive, but in fact, the Fed has its own goals, and its goals don't necessarily change in response to fiscal policy. And of course the Fed takes fiscal policy into account when deciding how to accomplish those goals. So if a tax cut or an expenditure increase were expected to create, say, a million extra jobs, then, under normal economic conditions, the Fed would simply raise interest rates enough (according to its best estimate) to destroy a million jobs. (If the Fed didn't think the demand for those million jobs would be potentially inflationary, then it would already have tried to create them.)

But today's economic conditions are not normal. The Fed, like most everyone else, is expecting the recession to be a severe one, a potentially deflationary one, but the Fed is running out of options for how to deal with it. Contrary to what happens under normal conditions, the Fed will make no attempt to offset the effects of fiscal policy; indeed, it will enthusiastically welcome the help. The old-fashioned Keynesians, whose advice about dynamic scoring was (properly, in my opinion) considered wrong or irrelevant for so long, can now dust off their computers and start giving meaningful dynamic estimates of the effects of budget changes. ...

But there has never been a consensus beforehand about how dynamic scoring should be done, or even about the direction of the effects. In the past, the only conservative approach was to use static scoring – to ignore any indirect effects that budget changes might have on the ultimate deficit.

There is still no consensus about the details. But today one can hardly doubt that the indirect effects of stimulus policies on the budget will partly (if not entirely) offset their direct effects, or that the indirect effects will be large enough to be important. In today’s environment, static scoring is not just conservative, it's fundamentally unreasonable.

The details have to be negotiated... But next time you think that an $800 billion stimulus plan will add $800 billion to the national debt, think again.

I was thinking more along the lines of the traditional supply-side argument, i.e. the dynamic effects from the higher growth rate we'd have with improved infrastructure, but as noted above, these "are primarily long-run benefits."

Update: Paul Krugman:

Bang for the buck (wonkish): Mark Thoma says he was thinking about thinking about this; I was actually thinking about it. Anyway, it’s true: the cost of an effective fiscal stimulus, in terms of adding to the government’s debt, can (and should) be much less than the headline cost.

Consider an increase in government spending; assume that the interest rate is fixed (a good assumption right now, because interest rates are up against the zero lower bound). Then textbook analysis says that if the stimulus is dG, the increase in GDP is 1/(1 - c(1-t)) where c is the marginal propensity to consume out of income and t is the marginal tax rate. Suppose c is 0.5 and t is 1/3; then the multiplier is 1.5, which is more or less the conventional wisdom right now.

But if $100 billion in spending raises GDP by $150 billion, and the marginal tax rate is 1/3, $50 billion of the spending comes back in additional revenue. So bang for the buck — increase in GDP per dollar of added debt — is 3, not 1.5. Since the main concern about stimulus is that it will add to government debt, it’s this bang for the buck measure, rather than the multiplier, that’s relevant. And 3 sounds a lot better than 1.5.

Take this a bit further: $150 billion is about 1 percent of GDP, which Romer and Bernstein say means a million jobs; so this says $50,000 per job, which is a much better number than the critics have been throwing around (plus many more workers with full-time rather than part-time jobs).

Bang for the buck also heightens the contrast between effective and ineffective stimulus policies. Stay with c = 0.5, t = 1/3, and look at the effects of a tax cut; the multiplier is 0.75, half that for public investment, but bang for the buck is 1, only 1/3 that for investment.

So thinking about how stimulus comes back via revenues is important.

"Laffer-able"

Since the recession is caused by rich people deciding not to work, the solution, of course, is to cut capital gains taxes to they'll stop lounging around and do something productive:

Laffer-able, Marion Maneker, BP Cafe: ...Art Laffer ... was on Fast Money... The segment was on the proposed Obama tax cuts. Laffer didn’t think much of them. Instead, he wondered aloud, what if the government proposed a 6-month income tax moratorium: how great a stimulus would that be? After all, Laffer reasoned, freeing citizens from the undue burden of taxes would get them all out working harder and spending money.

Really? Did anyone on the panel believe that Americans of all income levels are sitting on the couch–or lounging out by the pool–instead of working because they’re unhappy with their income tax? They’re knocking off early because the marginal rates are too high and they’d prefer the leisure time to the minimal extra money? Fascinating. Unemployment moving toward double digits and the greatest white-collar restructuring in 15 years all because of onerous income taxes?

Sure, he’s a guest on the show–they’re being polite, right?–but not one of the traders said a word about this preposterous idea. They just nodded their heads in agreement and kept the bobbing up as Laffer launched into his idea that capital gains should not be taxed at all.

The slam against the Obama cuts was that the money would go into the mattress, not stimulate the economy. ... But why would the wealthy be any different? Cut their income tax or capital gains and they’ll put the money in the mattress right now too.

Not that cutting the capital gains tax would do anything to move money off the sidelines. Where would it go? What productive use would it be put to?

I’d share the segment with you but there’s no clip of his appearance on the CNBC site and the short post on the segment on Fast Money’s page is covered by an intrusive pop up. Maybe they’ve finally gotten a sense of shame for promoting this voodoo.

This tries to use a stabilization argument to implement a growth policy, which is a bad idea. We can debate whether cutting capital gains taxes is a good way to promote economic growth in the long-run, but it's clear that cutting the capital gains tax is a lousy short-run stimulus program. Even if it does promote new investment, and again that is a point that can be debated even in good times, in bad times it's hard to imagine a cut in capital gains motivating new investment when the economic outlook is so poor and so uncertain. In addition, you run into the same "are the projects shovel ready" problem you run into with public spending. For the most part, they aren't shovel ready and planning and constructing new investments, e.g. building a new production line, is not something that happens overnight. But no matter, the real goal here isn't stabilization anyway, and the long-run growth arguments are mostly a vehicle for obtaining the real goal: tax cuts for the wealthy. I hope Democrats don't give into this nonsense as they continue to compromise to get something passed.

Update: In comments to another post, where I agree that some type of tax cut may be needed as part of the stimulus package, and also say that "I am not thinking of the trickle down variety,"pgl says:

Tax cuts for the well to do - who are not borrowing constrained - will likely have NO aggregate demand stimulus effect as I have often argued (aka either Life Cycle or Ricardian Equivalence) models so if this is what the Republican Party have in mind - it is based on hogwash economics.  Tax cuts for the working poor, however, may be a good idea as these households will consume much of the tax cut.  I think this is what Obama has in mind.  If your argument is that we should go with the kind of tax cuts Obama campaigned on - I agree.  But tax cuts for Bill Gates is just stupid from a Keynesian point of view.

Update: And speaking of tax cuts of questionable value as a stimulus measure, Dean Baker:

More Money for Robert Rubin, Beat the Press: It looks like President-elect Obama is picking up President Clinton's promise to end welfare as we know it. Back in those pre-welfare reform days, welfare checks went to poor families. Welfare as we know it now seems to involve giving taxpayer dollars to Citigroup and other banks.

The media seem to have largely overlooked the Citigroup tax credit in their discussion of the latest items in President Obama's stimulus proposal. According to the Washington Post, the proposal will allow companies to write off current losses against taxes paid over the last 4-5 years, not just 2 years, as in current law.

There are relatively few companies that could benefit from this tax break since most companies will not have losses so large that they would need more than two years of tax payments to balance them against. But, really big losers, like Robert Rubin's Citigroup, and other badly failing financial institutions, are losing much more money in 2008 and 2009 than they earned in 2006 and 2007.

Did the political connections of Robert Rubin and others in the financial industry have anything to do with the decision of Obama's economic team to be so generous to them? I don't have an answer to that question, but the media should be asking it.

At best, I suppose you could argue this is a backdoor method of recapitalizing struggling financial institutions, but even then there are better ways to provide for recapitalization.

Are Taxes Progressive?

Lane Kenworthy says people should tell the full story about tax progressivity. What has been presented attempts to defend the wealthy against the charge that they don't pay their fair share, but "it doesn’t make much sense":

How Progressive Are Our Taxes?, Consider the Evidence: Steven Dubner has a post on the “Freakonomics” blog titled “The next time someone tells you that taxes are not progressive…” He relays information from a new Congressional Budget Office (CBO) report, via Greg Mankiw, which lists effective federal tax rates for households at various points in the income distribution. The rates are higher for those with larger incomes. The implication is that our tax system is quite progressive.

But it doesn’t make much sense to look only at federal taxes. State and local taxes account for about a third of total tax revenues, and they tend to be less progressive than federal taxes.

If we take into account all taxes — federal, state, and local — the effective tax rate for the well-to-do is only a bit higher than for the poor. Here is one way to see this, based on data from the CBO and the Tax Foundation.

Should Executive Pay be Capped?

Robert Frank argues against capping executive pay (with one exception). He says that a high marginal tax rate is a better option:

Should Congress Put a Cap on Executive Pay? , by Robert Frank, Commentary, NY Times: It's no wonder that voters’ outrage over exorbitant executive pay is mounting. After all, the government just had to bail out financial firms that paid big bonuses last year to many ... executives who helped precipitate the current financial crisis.

Nor is it any wonder that Congress is considering measures to limit executive pay... One popular proposal would cap the chief executive’s pay ... at 20 times its average worker’s salary. But while Congress may well have compelling reasons to limit executive pay in companies seeking bailout money, voter anger is not a good reason to extend pay caps more generally.

To be sure, executive pay in the United States is vastly higher than necessary. Executives in other countries, whose pay is often less than one-fifth that of their American counterparts, seem to work just as hard and perform just as well. ...

So why not limit executive pay? The problem is that although every company wants a talented chief executive, there are only so many to go around. Relative salaries guide job choices. If salaries were capped at, say, $2 million annually, the most talented candidates would have less reason to seek the positions that make best use of their talents.

More troubling, if C.E.O. pay were capped and pay for other jobs was not, the most talented potential managers would be more likely to become lawyers or hedge fund operators. Can anyone think that would be a good thing?

In large companies, even small differences in managerial talent can make an enormous difference. Consider a company with $10 billion in annual earnings that has narrowed its C.E.O. search to two finalists. If one would make just a handful of better decisions each year than the other, the company’s annual earnings might easily be 3 percent — or $30 million — higher...

Critics complain that executive labor markets are not really competitive — that chief executives appoint friends to their boards who approve unjustifiably large pay packages. But C.E.O.’s have always appointed friends, so that can’t explain recent trends.

One reason for these trends is that companies themselves have become bigger. ... Beyond growth in company size, executive mobility has also increased. In past decades, about the only way to become a C.E.O. was to have spent one’s entire career with the company. ... Increasingly, however, hiring committees believe that a talented executive from one industry can also deliver top performance in another. ... This new spot market for talent has affected executive salaries in much the same way that free agency affected the salaries of professional athletes.

If the market for executive talent is competitive, critics ask, why are C.E.O.’s in an industry paid about the same, regardless of performance? That’s because no one knows with certainty how a particular executive will perform. ... Executives whose record predicts good performance command a high rate. Their leash, however, has grown shorter. In the past, a C.E.O. could often stay in the job for many years despite lackluster performance. Today, a C.E.O. who fails to deliver is often dismissed after a year or two.

In short, evidence suggests that the link between pay and performance is tighter than proponents of pay caps seem to think. Since the fall of the former Soviet Union, no one has seriously challenged the wisdom of relegating a high proportion of society’s most important tasks to private markets. And the market-determined salary of a job generally offers the best — if imperfect — measure of its importance.

The financial industry, however, may be an exception. A money manager’s pay depends ... on the fund’s rate of return relative to other funds. This provides strong incentives to invest in highly leveraged risky assets, which yield higher average returns. But as recent events have shown, these complex assets also expose the rest of us to considerable systemic risk.

On balance, then, the high pay that lures talent to the financial industry may actually cause harm. So if Congress wants to cap executive pay in financial institutions receiving bailout money, well and good.

Elsewhere, however, the more prudent response to runaway salaries at the top is to raise marginal tax rates on the highest earners, irrespective of occupation. Again, relative salaries drive job choices. The jobs with the highest pretax salaries will still offer the highest post-tax salaries, just as before, so this step will not compromise the price signals that steer talented performers to the most important jobs. ...

When I look at these markets and ask if the conditions for competitive markets are satisfied, conditions like free entry, homogeneous products (as opposed to "small differences in managerial talent [that] can make an enormous difference"), perfect information about product quality (as opposed to "no one knows with certainty how a particular executive will perform"), it doesn't seem to me like they are. So even with "free agency," I don't think the market necessarily provides the correct economic incentives, i.e. the correct relative prices (of, say, executive salaries relative to the salaries of painters). If this is true across the board for high salaries whether or not they are executives, for the most part anyway, then differential treatment of high incomes is not warranted. But the fact that these salaries are "vastly higher than necessary" does mean that a high marginal tax rate can be used to overcome the distortions that the higher than necessary salaries bring about. So in this case the tax would not be creating a distortion, it would be correcting one.

Since part of the column talks about the growth in executive salaries in recent years, it's probably also useful to note that much of the change in the distribution of income recently has been driven by high salaries in the financial services industry (and the vaunted spot market spread this huge distortion to other markets by raising compensation generally). Saying that these salaries - which were based upon bubble values rather than underlying fundamentals, and which put upward pressure on executive pay generally - provide the correct economic incentives is, it seems to me, hard to defend.

"An Eisenhower Moment" for Infrastructure?

What can the incoming administration learn about infrastructure spending from Eisenhower's experience in creating the interstate highway system?:

Eisenhower's roads to prosperity, by Tom Lewis, Commentary, LA Times: ...President-elect Barack Obama vowed to "create millions of jobs by making the single largest new investment in our national infrastructure since the creation of the federal highway system..." The story of President Eisenhower's decision in 1956 to create the interstate highway system ... holds lessons that the new president and the country would do well to heed.

Eisenhower was the first Republican to occupy the White House after Herbert Hoover, who in the 1950s still wore a mantle of shame for his role in the market crash of 1929 and its aftermath. Eisenhower had an almost pathological, but healthy, fear that he might be blamed for allowing the nation to fall into another depression. When a mild recession ... pushed the unemployment rate above 5%, Eisenhower ... asked for solutions.

The highwaymen at the Bureau of Public Roads ... heeded the call. They reported that each federal dollar invested in construction generated close to one half-hour of employment. ... Workers across America, not just those who built the roadways, would benefit -- in cement and steel plants (50 tons of concrete and 20 tons of reinforcing steel go into each mile), in paint and sign manufacturers and in heavy equipment factories and oil refineries. ...

Eisenhower realized that he could not fail with highways. Americans wanted more roads for their postwar cars. Construction would prime the economic pump ... and help secure the nation's future. He signed ... the $25-billion Federal-Aid Highway Act to build a 42,000-mile interstate highway system by 1972. Ultimately the cost would escalate to more than $130 billion, and workers would not finish the roads until 1993...

Eisenhower wasn't afraid to create a huge public works program, and unlike today's presidents, he wasn't afraid of taxes. ... The 1956 highway bill levied a tax of 3 cents on each gallon of fuel -- equal to 24 cents today. The revenue went into a dedicated highway trust fund. ...

Eisenhower's interstates are an essential part of our culture. ... In 1956, Eisenhower likely didn't fully realize that he was creating not just a public works program but an economic and social blueprint for the next 50 years. Now, along with every other aspect of our infrastructure, the interstates are crumbling. Irresponsible legislators rail against the current federal highway tax of 18.4 cents a gallon -- far less in today's prices than Eisenhower's 3 cents. Seduced by easy money, governors consider leasing parts of the highway system to foreign companies.

So the lessons for Obama are clear: Don't be afraid to propose bold -- and often expensive -- programs that improve the nation's infrastructure and peoples' lives, and don't be afraid to pay for them with taxes.

It is said the 44th president is taking office at a Lincoln moment and a Roosevelt moment. True enough, but it can be an Eisenhower moment as well.

Keeping the budget in balance while the economy is struggling is not good policy. If the goal is to stimulate the economy and to create new jobs, then the "clear" lesson - the advice to pay for the spending on infrastructure by raising taxes - is wrong. The new infrastructure does need to be paid for, but the time to do that is when the economy is healthy, not when it is under performing.

"The Rising Tide Tax System"

This is one of the entries in the NY Times Magazine's annual Year in Ideas:

The Rising-Tide Tax System, by Stephen Mihm, NY Times: In the last 20-plus years, overall economic growth in the United States has come at a cost: rising income inequality, which in the past few years has hit levels not seen since the late 1920s. A more progressive income tax, introduced during the New Deal, helped mitigate the problem, and it remains a likely prescription today. Yet a team of economists that includes Robert Shiller of Yale University and Leonard Burman of the Tax Policy Center recently released a paper in which they propose another way of “spreading the wealth”...

Under the proposal, the tax code would automatically be rewritten at the end of each year to reflect any changes in the relative share of national income earned by each income bracket. For example, if one year the nation's top earners saw their share of national income rise while people at the bottom saw their share grow at a slower rate (or decline), the following year's tax rates would be automatically rewritten to compensate for the new inequality. This would keep everyone's share of after-tax income at the earlier level.

The ... proposal would work both ways: if the rich saw their share of the nation's income grow more slowly relative to people lower down the economic ladder, the tax system would become less progressive...

The name of the proposal — the Rising-Tide Tax System — is an allusion to John F. Kennedy's claim in 1962 that “a rising tide lifts all boats,” a promise that general economic growth would benefit all members of society. Shiller argues that it's still possible to turn Kennedy's vision into a reality. “It's something we can engineer,” he says.

This has attractive properties, and it may help us to avoid the concentration of bubble-inducing excess liquidity in the hands of relatively few people, but how do we know which baseline level of inequality to target?

Also, this approach leads to the idea that the only reason for progressive taxation is redistribution, but that's not the case. Concepts such as equal marginal sacrifice can be used to support a progressive structure, so even if there is no redistribution at all we may still want to have progressive taxes. Thus, before we can use this approach we'd have to decide (at least) two things - what is the level of inequality we are targeting, and what is the base level of progressiveness that we use. For example, if there is no change in inequality from previous years, does that mean taxes should be flat?

Which is Best, Monetary Policy, Government Spending, or Tax Cuts?

Keynes did not have much faith in the ability of monetary policy to lift an economy out of a recession:

The Remedist, by Robert Skidelsky, NY Times Magazine: Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission ... that the regime of deregulation he oversaw ... was based on a “flaw”... The “whole intellectual edifice,” he said, “collapsed...”

What was this “intellectual edifice”? ... Greenspan must have believed ... that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. ...

Today, [John Maynard] Keynes is justly enjoying a comeback. For the same “intellectual edifice” that Greenspan said has now collapsed was what supported the laissez-faire policies Keynes quarreled with in his times. Then, as now, economists believed that all uncertainty could be reduced to measurable risk. So asset prices always reflected fundamentals...

Keynes ... starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? ... People fall back on “conventions”.... The chief of these are ... that the future will be like the past... Above all, we run with the crowd. ...

But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

Keynes’s prescriptions were guided by his conception of money... The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” ...

It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on ... loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending..., and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must. ...

Keynes’s ... purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid.

You can take this a step further. Even if the central bank could lower the loan rate, with such a pessimistic and uncertain future outlook, will firms be induced to build new factories and install new equipment? Will consumers suddenly buy more cars and houses, or purchase new appliances on revolving credit as they worry about keeping their jobs and see their housing equity plummeting? Maybe a few, but not enough to matter much to the overall economy. Will the fall in the interest rate cause financial capital to flow out of the US in search of higher returns elsewhere thereby causing the dollar to fall and increasing net exports? Not if every other economy is suffering similar problems and hence cannot offer more attractive investment opportunities.

In short, as you go through the individual right-hand side items in AD=C+I+G+NX, it's hard to make an argument about how, in recession conditions, a fall in  the loan rate - if one can even be brought about - can generate substantial changes in C, I, or NX. That leaves G. Some people argue that we can stimulate C by changing taxes, and that may be true, but then we have to worry about getting the design right so that the tax change isn't mostly saved rather than flowing into new consumption. There is not as much uncertainty with G since it is part of aggregate demand - when the government purchases a new desk, there's no uncertainty about its effect on the demand for desks (there is some uncertainty about the total impact through the multiplier, which incorporates crowding out and crowding in, but estimates of multipliers in recessions of less than one are rare, they are often closer to two, so we can be pretty sure of at least a one-to-one impact and be fairly hopeful for an even larger effect).

Thus, the tax cuts versus government spending choice comes down to an argument about whether potential inefficiencies that are generated with government spending are more costly than the higher level of uncertainty about the impact on aggregate demand associated with tax cuts. Right now, providing a stimulus to the economy that we can count on is what is needed most, and I am willing to sacrifice any potential inefficiency associated with government spending to purchase the increased certainty in terms of stimulating aggregate demand that government spending provides (and that is true even if the multiplier is only 1.4 as in Ramey, that just advises us about how much spending is needed to be relatively sure the impact is of a particular magnitude).

One reason I am not as concerned with the efficiency aspect as others is that I believe there are a lot of public goods - goods the private sector won't invest in on its own due to market failures - that we need to repair or put into place that are crucial to our long-run growth potential. Cutting taxes won't bring these goods about, only the government can accumulate the needed funds - some of these investments are sizable - and then supply these public goods. For this reason, I don't think government spending loses to tax cuts on either the efficiency or certainty margins.

The only potential basis for tax cuts, then, as I see it, is to provide an immediate boost to spending - a cut in the payroll tax starting Monday morning would potentially do that - but that choice is mainly a consequence of waiting too long to do anything. Many of us have been saying monetary policy won't work and calling for infrastructure and other government spending for months and months now, and had that spending been put into place long ago (instead of, say, one shot tax rebates that theory says are ineffective) immediacy would not be the issue at present. But we did wait, it seems we can't be convinced to buy recession insurance in advance - we have to see the disaster in front of us before acting - and tax cuts may therefore be needed as part of the recovery package. But that does not mean that, in general, tax cuts are preferred, only that if you wait this long to act, and fierce resistance to government action until the carnage is evident may make waiting too long inevitable, you may have no other choice but to use tax policy as part of any attempt to revive the economy.

"Taxes, Bailouts and Socialism"

Is it socialism?

Taxes, Bailouts and Socialism, by James Edward Maule: ...When Senator Barack Obama replied to the question ... about his tax plan by noting that "I think when you spread the wealth around, it's good for everybody," he opened the floodgates of accusations that his tax proposals would amount to socialism. ...

Obama's tax plan is to increase taxes for individuals with incomes exceeding $250,000. Most Americans do not fall into that category, and 95 percent are unaffected by this particular proposal. Americans in that category are paying taxes at lower rates than they were paying a decade ago. The theory was that reducing rates on the rich would generate benefits not only for the rich, but also for everyone else. This "trickle down" theory turned out to be a failed experiment. All that trickled down was the economic pain inflicted on America by the casino capitalist gamblers. Technically, Obama proposes revocation of tax cuts for the wealthy. They had their chance. It failed, other than to make the wealthy wealthier, the middle class smaller, and the gap between the haves and have-nots wider. ...

Will Obama's tax plan redistribute wealth? Hardly. The additional revenue generated by the revocation of tax cuts for the wealthy very well may end up paying the interest on the national debt that was incurred because taxes were cut and kept too low during wartime. One could consider those tax cuts to have been a loan to the wealthy, and the events of the past month have demonstrated what they did with it.

But perhaps there's some wealth redistribution involved. One reasonably can argue that the revenue raised by revoking the tax cuts for the wealthy will be used to fund government programs that help only the poor or only the middle class or only the poor and middle class. Does that make it socialism? More important, does that make it bad policy? ...

Colin Powell has suggested that "Taxes are always a redistribution of money. Most of the taxes that are redistributed go back to those who pay them -- in roads and airports and hospitals and schools. And taxes are necessary for the common good, and there's nothing wrong with examining what our tax structure is or who should be paying more, who should be paying less. For us to say that makes you a socialist, I think, is an unfortunate characterization that isn't accurate." Hooray for Colin Powell. I might disagree that taxes always are a redistribution, because to the extent that they pay for services being rendered to the paying taxpayer, they do not transfer wealth. They simply represent an exchange of cash for services or property. But that articulation technicality aside, there are, and have been for decades, valid arguments for imposing higher taxes on those on whom America has bestowed better opportunities and greater fortune. Undoing the mistaken tax cuts, and fixing the problems caused by trying to fight a war without raising taxes, isn't socialism. It's an attempt to undo the problems caused by welfare for the wealthy. ...

A total ban on wealth redistribution would mean tens of millions of people in need would not get assistance, and in many instances would die. Social Security is wealth redistribution. So, too, is Medicare. So, too, are food stamps. So, too, is the program that provides breakfasts and lunches to school children who would otherwise go unfed. So, too, are all sorts of other programs. If these programs are socialism, and if support for these programs make someone a socialist, then here's some news: by that definition, America has been a socialist nation for decades, and most of its Presidents and legislators have been socialists. So what would it mean to purge "socialism" from public policy? What then would life in America be?

Will a Tax Cut Solve the Crisis?

From Economix:

With hardly anyone noticing, [Mr. Paulson] pushed through very technical and obscure changes to tax regulations that provide a “tax subsidy” for acquirers of troubled banks. Just as automakers stimulate car sales through rebate checks, the Treasury is providing a form of tax rebate to acquirers of troubled banks. Everyone can thank Hank Paulson and his stealth tax-driven fiscal stimulus for the astonishing news that Wachovia was being acquired by Wells Fargo and not Citigroup. It was Mr. Paulson’s tax subsidy to Wells Fargo that provided the fiscal grease to make this deal happen. Pundits who point to the deal and proclaim that the “free markets work without government help” don’t understand the motivating effect of several billion dollars of tax benefits to Wells Fargo.

[Note: The Wachovia deal with Wells Fargo is on hold until legal questions are resolved.]

Update: See fred, in comments.

What Does Neuroeconomics Say about Lotteries and Credit Cards?

George Lowenstein on lotteries, credit cards, and the future of neuroeconomics:

Lottery Tickets and Credit Cards: The Dangers of an Irrational Brain, by George Loewenstein, Scientific American: LEHRER: Your most recent paper looked at some of the factors that seem to influence the purchase of lottery tickets. What did you find?

LOEWENSTEIN: We [Emily Haisley, Romel Mostafa and I...] have two papers addressing the motives underlying lottery ticket purchases. All of the research was conducted with low income samples recruited at the Greyhound bus station in Pittsburgh. In all of the studies, we paid travelers $5 for completing a survey on their attitudes toward Pittsburgh, then give them the opportunity to purchase lottery tickets with the money. The variable of interest was ... the number of tickets they purchased. ... We conducted two experiments to examine whether making people feel poor makes them want to play the lottery.

We randomly assigned subjects to either feel relatively poor or relatively rich by having them complete demographic questions that included an item on annual income. ... The group made to feel poor purchased twice as many lottery tickets (an average of 1.27) than those made to feel relatively wealthier (0.67 tickets, on average).

In the second experiment, we indirectly reminded participants that, while different income groups face unequal prospects when it comes to education, employment and housing, everyone has an equal chance to win the lottery. This reminder that the lottery is a kind of “social equalizer” also increased lottery tickets purchases. The group given this reminder purchased 1.31 tickets, on average, as compared with 0.54 for those not given such a reminder.

LEHRER: Have these experiments changed how you feel about the lottery? Would you advocate any changes to the way the lottery system is run?

The Laffer Curve and Starve the Beast: "Being Mutually Exclusive Does not Prevent Them both from Being Wrong"

As a follow-up to the post below this one, from Jeff Frankel, a couple of points that have been pounded here in the past, but have not had much attention lately:

Supply-Side Economics Contradictions Live on in Washington, by Jeff Frankel: ...[I]n recent decades “conservative” presidents have enacted large tax cuts that have been anything but conservative fiscally, and have justified them by appealing to theory. In particular, they have appealed to two theories: the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit and put downward pressure on federal spending. It is insufficiently remarked that the two propositions are inconsistent with each other: reductions in tax rates can’t increase tax revenues and reduce tax revenues at the same time. But being mutually exclusive does not prevent them both from being wrong. 

The Laffer Proposition, while theoretically possible under certain conditions, does not apply to US income tax rates: a cut in those rates reduces revenue, precisely as common sense would indicate. As detailed in a new paper of mine “Snake-Oil Tax Cuts,” for the Economic Policy Institute, this conclusion was the outcome of the two big experiments of recent decades: the Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03. It is also the conclusion of more systematic scholarly studies based on more extensive data. Finally, it is the view of almost all professional economists, including the illustrious economic advisers to Presidents Reagan and Bush, even though it contradicted the views of their employers. So thorough is the discrediting of the Laffer Hypothesis, that many deny that these two presidents or their top officials could have ever believed such a thing. But abundant quotes show that they did.

"Yes, Bush's Economic Policies Are a Failure"

Tax cuts paying for themselves, or not:

Yes, Bush's Economic Policies Are a Failure, by Brad DeLong: Rex Nutting of Marketwatch:

Budget outlook worsens on war, economy - MarketWatch: With the economy weakening and spending on the war rising, the federal budget outlook has deteriorated in both the short-run and the medium-term, the Congressional Budget Office said Tuesday. In its summer budget update, the nonpartisan budget office said the federal deficit would likely double this year compared with last year, and remain at about 3% of gross domestic product for the next two years. ...

Unlike the February update, which showed the budget roughly in balance through 2018 under favorable assumptions, the September projection now sees deficits totaling $2.3 trillion over the next 10 years. Those projections assume that the 2001 and 2003 tax cuts expire and that the alternative minimum tax is not changed. If the tax cuts are extended as the White House and the McCain-Palin ticket want, the deficits over the next 10 years would be $4.2 trillion higher than now projected, CBO said.

The reason McCain-Palin want to continue these policies is that they believe suggestions that the policies haven't worked for the majority of Americans can be attributed to whining. So, if you want to continue being berated for whining about the obvious problems you face, McCain-Palin is the ticket for you.

On Dividend Taxes...

Greg Mankiw says that if your goal is to keep dividend taxes low, you should vote for Obama:

On Dividend Taxes, It’s a Post-Partisan Race, by N, Gregory Mankiw, Economic View, NY Times: ...Before 2003, when a person received dividends from his stock holdings, this income was taxed at ordinary income tax rates. That is, a dollar of dividends generated the same individual income tax liability as did a dollar of wages.

But many economists have long argued against taxing dividends this way. Dividends are a stockholder’s payment from corporate profits, and these profits have already been subject to the corporate income tax. Any tax on dividends represents a second tax on essentially the same income.

One can question whether this double taxation of income from corporate capital is fair. But fairness aside, there is also the problem of incentives. Taxing dividends twice substantially raises the overall tax burden ... and distorts various decisions. Whenever taxes, rather than true costs and benefits, drive the allocation of resources, the economy shrinks below its potential. ...

Policy wonks like me have long hoped for changes in the tax code that would eliminate, or at least mitigate, these problems. In 2003, President Bush proposed that all dividends paid out of income that had already been taxed at the corporate level should be exempt from tax at the personal level. ...

Although Congress did not give the president exactly what he sought, it gave him a large chunk of it. The top tax rate for dividends was cut to 15 percent, less than half the top rate for ordinary income. The adverse incentives of the tax ... became much smaller. ...

Senator Obama ... has not been coy about wanting to use the tax code to redistribute income... But for dividend income, Senator Obama has proposed only a modest increase in the top tax rate, to 20 percent from 15 percent. ...

In light of Senator Obama’s stand, the politics of dividend taxation may take some surprising twists. Senator John McCain wants to maintain the current tax rate of 15 percent on dividends..., but it is a good bet that if Senator McCain is elected president, while Congress remains Democratic, Congress won’t give the Republican president what he wants. They would instead let the Bush tax cuts expire, returning the dividend tax for high-income taxpayers to about 40 percent.

By contrast, if Mr. Obama is elected, Congressional Democrats will be less likely to balk at his proposed 20 percent dividend tax rate... On the issue of dividend taxation, Barack Obama may be the candidate with the best chance of preserving George Bush’s legacy.

Update from Dean Baker:

Greg Mankiw Promotes the Myth of Double Taxation, Dean Baker: There is an old myth developed by rich people at some point in the distant past that paying taxes on dividends amounts to "double-taxation." The argument is that profits are already taxed at the corporate level, so taxing money when it is paid out as dividends to shareholders is taxing the same profit a second time. Gregory Mankiw, a Harvard University professor and former top economist in the Bush administration, pushes this line in a column in the NYT.

The trick in this argument is that it ignores the enormous benefits that the government is granting by allowing a corporation to exist as a free standing legal entity. The most important of these advantages is limited liability. If a corporation produces dangerous products or emits dangerous substances that result in thousands of deaths, shareholders in the corporation cannot be held personally responsible for the damage. The corporation can go bankrupt, but beyond that point, all the shareholders are off the hook, the victims of the damage are just out of luck.

By granting corporate status, the government has allowed investors to shift risk to society as a whole. In exchange for this and other privileges of corporate status, the corporation must pay income tax on its earnings. We know that investors consider the benefits of corporate status to be worth the price in the form of the corporate income tax, because they voluntarily choose to form corporations. If investors did not consider the benefits of corporate status to outweigh the cost of the income tax, then they are free to form partnerships which are not subject to corporate income tax. In this way, the corporate income tax is a completely voluntary tax. Anyone can avoid the tax by investing in a partnership, or alternatively, any corporation can be restructured as a partnership.

The complaint about double taxation is an effort to get the benefits of corporate status for free. It is understandable that rich people would want to get benefits from the government at no cost, just like most of us would prefer not to pay our mortgage or electric bill. But, there is no reason for government to be handing out something of great value (corporate status) for free. If rich people don't like the corporate income tax, they have a very simple way to avoid it -- don't invest in corporations. The problem is that the rich are just a bunch of whiners.

Tax Cuts and Government Investment

Richard Serlin:

A dollar spent on tax cuts costs more than a dollar over the long run, a lot more., by Richard Serlin: With regard to ... "The Whole Analysis Sounds Pretty Fishy":

So the the right wing propaganda tank, Tax Foundation, claims that tax cuts recover up to 40% of their costs through so-called dynamic effects, while Bush's own Treasury Department estimated less than 10%.

Even if it actually were 40%, are tax cuts a good idea, especially tax cuts going predominantly to the rich and extremely rich? They're still costing the government 60% that can't go to many extremely high social return projects that the free market won't undertake due to market imperfections that are well established and proven in economics (real, scientific, academic economics, not screaming talk show host, propaganda tank economics), like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more available in any university introductory and intermediate economics texts.

Suppose we consider continuing Republican policies and spending another 1 trillion on tax cuts for the rich. Even if 40% were recovered (and in the long run, as opposed to just looking at short run effects, the dynamic effects go in the opposite direction -- a dollar in tax cuts ends up costing a lot more than a dollar in government revenue if that means a dollar, or even 60 cents, less in investment in high return government projects.).

The vast majority of the tax cuts, it has been shown, will eventually be spent on consumption items of little long run investment value -- leaving little to show or to grow. If instead, even just 60% of that 1 trillion were spent by the government on extremely high social return investments like infrastructure, education, basic scientific and medical research, alternative energy, etc., then 10 or 20 years from now that 600 billion could result in many trillions, or even tens of trillions more in national wealth, as opposed to having the whole 1 trillion spent on rapidly depreciating Ferraris and yachts, and ultra luxury vacations and other things for the rich that have little or no productive value.

In the long run, a dollar spent on tax cuts for the rich, instead of badly needed social investment puts us one more step closer to losing our status as the most wealthy and modern nation, and over the long run, like any other decision to increase frivolous consumption at the expense of high return investment, it costs us a lot more than a dollar, not less.

He has a follow-up post here.

"Big Misconceptions about Small Business and Taxes"

Would allowing the Bush tax cuts to expire harm small businesses?:

Big Misconceptions about Small Business and Taxes, by Chye-Ching Huang and James R. Horney, CBPP: Supporters of various tax benefits for high-income households often claim that failure to maintain them would have an undue effect on many small businesses.  ... 

This paper analyzes these claims.  It likely overestimates the number of small businesses adversely affected by changes to the top two marginal tax rates, the estate tax, and loopholes available to hedge-fund managers because it: (1) adopts an extremely generous definition of “small business” ... and (2) does not consider many valuable tax breaks that small businesses and small-business owners enjoy...  Yet it still finds that the claims typically made about small businesses and taxes are highly exaggerated, misleading, or false.

"The Whole Analysis Sounds Pretty Fishy"

An Economist for Obama says some sources of information should not be trusted:

Tax Foundation is NOT a Credible Source, Economists for Obama: As I explained here, it is a right-wing think tank, part of the billionaire-funded Republican propaganda machine. Here's another post describing some of the misinformation they produce.

Greg Mankiw today links to a brief from the Tax Foundation which tries to claim that tax cuts recover up to 40% of their costs through so-called dynamic effects. Although this is still a long, long way from McCain's deluded claim that tax cuts pay for themselves, it is a much bigger effect than Bush's own Treasury Department estimated (less than 10%). This is an effort to argue that McCain's tax proposal wouldn't create deficits quite as massive as the Tax Policy Center's analysis shows.

Where does the TF figure come from? From yet-to-be-published research, which conveniently makes it impossible to fully critique it. It says it is based on a "large sample of tax returns filed by the same taxpayers between 1998 and 2005 and "examined the change in taxpayers' taxable income as reported on their tax forms and the change in their tax rates, after controlling for a variety of non-tax factors." Immediately, one can see the econometric issues, starting with what is the right lag structure and what is the right set of covariates? The whole analysis sounds pretty fishy. If the data is as juicy as it sounds, why didn't the authors just estimate the direct behavioral effects of the 2001 tax changes, treating them as a natural experiment? The fact that they did not makes me suspect that they massaged the analysis to get the results they wanted. Without seeing the paper, I can only speculate.

My big question is, where on Earth did they get such great data? I have never heard of a publicly available panel data on tax returns, although admittedly, this is not my research area. Will this data be released to other researchers so that they can try to replicate the analysis and examine how fragile the results are? (This has become the research standard for major journals.) I am going to hazard a guess that the researchers will say that the data is confidential, so that we'll just have to trust them. But the Tax Foundation doesn't deserve that kind of trust from anyone, Greg Mankiw included.

Update: The author of the post, in comments:

I want to point out that one of the author's took strong issue with the post in comments on our blog and offered to send me the paper (which I hope to get soon). So I may revise my opinion of the paper and even retract my criticisms after further reflection!

But I stand by the fundamental point that outfits like the Tax Foundation don't get the benefit of the doubt when publicizing results based on unpublished research.

Statutory versus Effective Tax Rates

Greg Mankiw posts this graph from the Tax Foundation:

But it's not clear why he would post a graph showing statutory rather than effective tax rates, and why he would post a graph that combines the data in a way that just happens to exaggerate differences between the US and other countries. As Paul Krugman says:

The Tax Foundation is not a reliable source

and he links to this evidence detailing why the graph is misleading. As he explains:

What they don’t make clear is that:

1. The graph shows the “statutory” tax rate, which is the maximum rate a corporation can pay in principle. But because corporate tax rules allow all kinds of deductions and exclusions, the statutory rate is a poor guide to the actual disincentives the corporate tax creates.

2. Even more important, while they don’t explain how they calculate the “average” tax rate, the fact that their own data show that all the big economies have tax rates above 30%, while their graph shows an average rate of about 27%, seems to indicated that they’re showing us an unweighted average — that is, one that makes small economies like Ireland and Greece seem as important as big economies like Japan and Germany. And whaddya know, corporate taxes in big economies tend to be similar to those in the United States, a point made by the Congressional Budget Office in the study from which the chart above is drawn. (Yes Germany cut rates this year. Big deal.)

And, as Linda Beale notes:

[T]he US is actually a corporate tax haven, with the lowest effective corporate tax rates of almost all the countries that participate in the OECD. That's a little fact that the Tax Foundation apparently doesn't want the American public to understand, since all its hype is in terms of statutory rates and not in terms of effective tax rates.

Paul Krugman: Now That's Rich

Will Barack Obama raise taxes on the middle class? Nope:

Now That’s Rich, by Paul Krugman, Commentary, NY Times: ...Barack Obama wants to put tax rates on higher-income Americans more or less back to what they were under Bill Clinton; John McCain ... says that means raising taxes on the middle class. ...

When we think about the middle class, we tend to think of Americans whose lives are decent but not luxurious: they have houses, cars and health insurance, but they still worry about making ends meet, especially when the time comes to send the kids to college.

Meanwhile, when we think about the rich, we tend to think about the handful of people who are really, really rich — people with servants, people with so much money that, like Mr. McCain, they don’t know how many houses they own. (Remember how Republicans jeered at John Kerry for being too rich?)...

[T]o imply that everyone except the poor belongs to one of these two categories: either you’re clearly rich, or you’re an ordinary member of the middle class ...[is] just wrong.

In his entertaining book “Richistan,” Robert Frank ... declares that the rich aren’t just different from you and me, they live in a different, parallel country. But that country is divided into levels, and only the inhabitants of upper Richistan live like aristocrats; the inhabitants of middle Richistan lead ample but not gilded lives; and lower Richistanis live in McMansions, drive around in S.U.V.’s, and are likely to think of themselves as “affluent” rather than rich.

Even these arguably not-rich, however, live in a different financial universe from ... ordinary members of the middle class: they have lots of disposable income after paying for the essentials, and they don’t lose sleep over expenses, like insurance co-pays and tuition bills, that can seem daunting to many working American families.

Which brings us to the dispute about tax policy.

Mr. McCain wants to preserve almost all the Bush tax cuts, and add to them by cutting taxes on corporations. Mr. Obama wants to roll back the ... cuts in tax rates on the top two income brackets and ... on income from dividends and capital gains — and use some of that money to reduce taxes lower down the scale.

According to ... the nonpartisan Tax Policy Center, those Obama tax increases would fall overwhelmingly on people with incomes of more than $200,000 a year. Are such people rich? Well, maybe not: some of those Mr. Obama proposes taxing are only denizens of lower Richistan, although the really big tax increases would fall on upper Richistan. But one thing’s for sure: Mr. Obama isn’t planning to raise taxes on the middle class, by any reasonable definition — even that of the Bush administration. ...

[I]n May, the Treasury Department — which used to do serious tax studies, but these days just churns out Bush administration propaganda — released a report purporting to show, by looking at the tax bills of four hypothetical families, how the middle and working class would be hurt if the Bush tax cuts aren’t made permanent. ...

It turns out that Treasury’s hypothetical families got all their gains from the so-called middle-class provisions of the Bush tax cuts: the Child Tax Credit, the reduced tax bracket for lower incomes and marriage penalty relief. ... In other words, the Bush administration itself implicitly defines the middle class as ... people making too little to end up paying additional taxes under the Obama plan.

Of course, all the evidence in the world won’t stop Republicans from claiming, as they always do, that Democrats are going to impose a crippling tax burden on ordinary hard-working Americans. But it just ain’t so.

"The Greek Menace"

Some responses to the Tax Foundation's announcement of a new campaign called Compete USA which claims high corporate tax rates are hurting US competitiveness. First, Paul Krugman:

The Greek menace, by Paul Krugman: ...All our corporate investment are belong to … Greece?

Run for the hills! Excessive taxes on corporations are threatening American prosperity, because we can’t match the low, low taxes of other advanced countries. Or so says the Tax Foundation, which is rolling out a new campaign called Compete USA. John McCain has already made big cuts in corporate taxes a big part of his agenda.

There’s a lot to say about this stuff, but right now I’d just like to mention one aspect. The Tax Foundation people start off with a graph that’s supposed to be terrifying, with the headline “Europe cuts rates while U.S. stands still”; the graph shows European tax rates dropping far below the US rate.

What they don’t make clear is that:

1. The graph shows the “statutory” tax rate, which is the maximum rate a corporation can pay in principle. But because corporate tax rules allow all kinds of deductions and exclusions, the statutory rate is a poor guide to the actual disincentives the corporate tax creates.

2. Even more important, while they don’t explain how they calculate the “average” tax rate, the fact that their own data show that all the big economies have tax rates above 30%, while their graph shows an average rate of about 27%, seems to indicated that they’re showing us an unweighted average — that is, one that makes small economies like Ireland and Greece seem as important as big economies like Japan and Germany. And whaddya know, corporate taxes in big economies tend to be similar to those in the United States, a point made by the Congressional Budget Office in the study from which the chart above is drawn. (Yes Germany cut rates this year. Big deal.)

So basically, the Tax Foundation wants us to be frightened of the Greek menace. How can American business survive in a world in which Greek corporations have a big tax advantage?

Next, from Linda Beale:

Tax Foundation and Competitive Environments: more bunk!, by ataxingmatter: The Tax Foundation is busy again pushing its latest propaganda idea--that the US has such high corporate taxes that it stifles competition and hurts our economy--with a new "competeusa.com" organization.

Wrong. Fact is, though our tax laws include statutory rates that are fairly high (35% for corporations earning about $18 million or more annually) but generally in the same ballpark as those of other developed western nations, the actual tax rates paid by US corporations are extraordinarily low, around 6%. Remember the latest GAO report (reported elsewhere on ataxingmatter) that shows that two-thirds of US corporations pay no federal income tax. That's not just the ones that are losing money, but also many corporations that have record high profits (including some Big Oil companies) that end up paying next to nothing in taxes.

That's because the statutory rate of 35% is only on paper. Corporations engage in aggressive tax planning that cheats the system, and they take advantage of a bountiful number of lucrative loopholes built into the system under the four decades of Reagan-style corporate favoritism and deregulation, including items such as accelerated depreciation, various expensing provisions that let corporations deduct before they really have an economic cost, and the lucrative research & development credit that lowers taxes dollar-for-dollar for R&D expenditures that corporations have to do anyway (so they do not serve as an incentive to greater development) and that corporations have often already done prior to the enactment of the one-year "extensions" of the credit that have been taking place as transitions to no-credit for years.

As a result, the US is actually a corporate tax haven, with the lowest effective corporate tax rates of almost all the countries that participate in the OECD. That's a little fact that the Tax Foundation apparently doesn't want the American public to understand, since all its hype is in terms of statutory rates and not in terms of effective tax rates.

"Fuel Subsidies Drag Down a Nation"

Why lump-sum transfers are better than fuel subsidies:

How Fuel Subsidies Drag Down a Nation, by Robert H. Frank, Ecponomic View, NY Times: ...[M]any emerging economies employ subsidies that keep domestic fuel prices far below the world price. As a result, these countries consume far more fuel than they would otherwise.

By one estimate, countries with fuel subsidies accounted for virtually the entire increase in worldwide oil consumption last year. Without this artificial demand stimulus, world oil prices would have been significantly lower. ...

It would surely be unrealistic to expect other governments to abandon subsidies just so Americans who drive S.U.V.’s and live in big houses could benefit from lower world energy prices. But those governments might want to reconsider their policy in the light of overwhelming economic evidence that the subsidies create net losses even for their ostensible beneficiaries. ...

The problem is that when the price of a good is below its cost, people use it wastefully. In the case of a gallon of gasoline, the cost ... includes not just the price of buying the gallon in the world market — say, $4 — but also external costs, like dirtier air and increased congestion. The external costs are ... substantial. With reasonable estimates factored in for them, the true cost of using a gallon is clearly greater than $4. By contrast, the price of gasoline to users is simply the amount they pay at the pump. With a $2-a-gallon subsidy in effect, gasoline bought in the world market at $4 would sell for $2...

Consider how this difference might affect a trucker’s decision about whether to accept a hauling job. ... Suppose the job... requires 1,000 gallons of fuel, available at the subsidized price of $2 a gallon, for a total fuel outlay of $2,000. If the cost of the trucker’s time and equipment are, say, $1,000 for the trip, his narrow interests dictate accepting the job if the shipper is willing to pay at least $3,000. Suppose the shipper is willing to pay that amount but not more.

The problem is that if the trucker accepts the job at that price, the country as a whole will be worse off by more than $2,000. Although the $3,000 fee would cover his own costs, the government would end up paying $2,000 in additional subsidies for the 1,000 gallons consumed. On top of that, the trip would generate additional pollution and congestion costs. So the fact that the subsidy encouraged him to accept the job means that its net effect is equivalent to throwing more than $2,000 onto a bonfire.

Waste is always bad. ... Subsidy proponents cite the firestorm of political protest that would erupt if fuel were to sell at the international market price. That fuel subsidies are wasteful, however, implies that there must be less costly ways to keep the peace.

Consider again our trucker... Instead of paying $2,000 to subsidize his fuel, the government could give him a tax cut of, say, $1,000, and use the remaining $1,000 to help pay for public services. Because the trucker’s earnings from the hauling job were only enough to cover his costs at the subsidized fuel price, he would be $1,000 better off with the tax cut alone than with the fuel subsidy. The additional support for public services would augment this benefit. In short, a tax cut is always a better way to keep political protest at bay because ... it does not encourage shipments whose costs exceed their benefits.

If a United States president urged developing economies to eliminate fuel subsidies because they result in higher energy prices for Americans, the conversation would probably end very quickly. But this conversation might be reframed.

A good place to start would be to heed the same advice we’d like others to follow. Emerging economies are not the only ones in which prices at the pump substantially understate the true social cost of fuel. ... Adopting some variant of a tax on carbon ... would help eliminate this discrepancy.

That would set the stage for our next president to explain to other leaders why eliminating fuel subsidies would make the overall economic pie larger. Because the resulting efficiency gains can be redistributed so that everyone gets a bigger slice than before, the idea should be fairly easy to sell.