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November 13, 2012

(Fiscal) Cliff Notes

Since it is indisputably the policy question of the moment, here are a few of my own observations regarding the "fiscal cliff." Throughout, I will rely on the analysis of the Congressional Budget Office (CBO), as reported in the CBO reports titled An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022 and Economic Effects of Policies Contributing to Fiscal Tightening in 2013.

Since the CBO analysis and definitions of the fiscal cliff are familiar to many, I will forgo a rehash of the details. However, in case you haven't been following the conversation closely or are in the mood for a refresher, you can go here first for a quick summary. This "appendix" also includes a description of the CBO's alternative scenario, which amounts to renewing most expiring tax provisions and rescinding the automatic budget cuts to be implemented under the provisions of last year's debt-ceiling extension.

On, then, to a few facts about the fiscal cliff scenario that have caught my attention.

1. Going over the cliff would put the federal budget on the path to sustainability.

If reducing the level of federal debt relative to gross domestic (GDP) is your goal, the fiscal cliff would indeed do the trick. According to the CBO:

Budget deficits are projected to continue to shrink for several years—to 2.4 percent of GDP in 2014 and 0.4 percent by 2018—before rising again to 0.9 percent by 2022. With deficits small relative to the size of the economy, debt held by the public is also projected to drop relative to GDP—from about 77 percent in 2014 to about 58 percent in 2022. Even with that decline, however, debt would represent a larger share of GDP in 2022 than in any year between 1955 and 2009.

Such would not be the case should the status quo of the CBO's alternative scenario prevail. Under (more or less) status quo policy, the debt-to-GDP ratio would rise to a hair under 90 percent by 2022:


The current debt-to-GDP ratio of 67 percent is already nearly double the 2007 level, which checked in at about 36 percent. However, though the increase in the debt-to-GDP ratio over the past five years is smaller in percentage terms, a jump to 90 percent from where we are today may be more problematic. There is some evidence of "threshold effects" that associate negative effects on growth with debt levels that exceed a critical upper bound relative to the size of the economy. At the Federal Reserve Bank of Kansas City's 2011 Economic Symposium, Steve Cecchetti offered the following observation, based on his research with M.S. Mohanty and Fabrizio Zampolli:

Using a new dataset on debt levels in 18 Organisation for Economic Co-operation and Development (OECD) countries from 1980 to 2010 (based primarily on flow of funds data), we examine the impact of debt on economic growth....

Our results support the view that, beyond a certain level, debt is bad for growth. For government debt, the number is about 85 percent of GDP.

Of course, causation is always a tricky thing to establish, and Cecchetti et al. are clear that their estimates are subject to considerable uncertainty. Still, it is clear that the fiscal cliff moves the level of debt in the right direction. The status quo does not.

2. The fiscal cliff moves in the direction of budget balance really fast.

By the CBO's estimates, over the next three years the fiscal cliff would reduce deficits relative to GDP by about 6 percentage points, from the current ratio of 7.3 percent to the projected 2015 level of 1.2 percent.

Deficit reduction of this magnitude is not unprecedented. A comparable decline occurred in the 1990s, when the federal budget moved from deficits that were 4.7 percent of GDP to a surplus equal to 1.4 percent of GDP. However, that 6 percentage point change in deficits relative to GDP happened over an eight-year span, from 1992 to 1999.

It is probably also worth noting that the average annual rate of GDP growth over the 1993–99 period was 4 percent. The CBO projects real growth rates over the next three years at 2.7 percent, which incorporates two years of growth in excess of 4 percent following negative growth in 2013.

The upshot is that, though the fiscal cliff would move the federal budget in the right direction vis à vis sustainability, it does so at an extremely rapid pace. I'm not sure speed kills in this case, but it sounds pretty risky.

3. The fiscal cliff heavily weights deficit reduction in the direction of higher taxation.

Over the first five years off the cliff, almost three-quarters of the deficit reduction relative to the CBO's no-cliff alternative would be accounted for by revenue increases. Only 28 percent would be a result of lower outlays:


The balance shifts only slightly over the full 10-year horizon of the CBO projections, with outlays increasing to 34 percent of the total and revenues falling to 66 percent.

Particularly for the nearer-term horizon, there is at least some evidence that this revenue/outlay mix may not be optimal. A few months back, Greg Mankiw highlighted this, from new research by Alberto Alesina, Carlo Favero, and Francesco Giavazzi:

This paper studies whether fiscal corrections cause large output losses. We find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions.

Of course, that in the end is a relatively short-run impact. It does not directly confront the growth aspects of the policy mix associated with fiscal reform. Controversy on the growth-maximizing size of government and the best growth-supporting mix of spending and tax policies is longstanding. The dustup on a Congressional Research Services report questioning the relationship between top marginal tax rates and growth is but a recent installment of this debate.

Here's what I think we know, in theory anyway: Government spending can be growth-enhancing. Tax increases can be growth-retarding. It's all about the tradeoffs, the details matter, and unqualified statements about the "right" thing to do should be treated with suspicion. (If you are an advanced student of economics or otherwise tolerant of a bit of a math slog, you can find an excellent summary of the whole issue here.)

In other words, there are lots of decisions to be made—and it would probably be better if those decisions are not made by default.

Dave AltigBy Dave Altig, executive vice president and research director at the Atlanta Fed

 


November 13, 2012 in Federal Debt and Deficits, Fiscal Policy, Taxes | Permalink

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"Tax increases can be growth-retarding." That has yet to be demonstrated. On the other hand, we do know that tax increases can be growth-enhancing. This has been demonstrated repeatedly.

Posted by: Kaleberg | November 14, 2012 at 10:46 PM

We could make it sustainable by moving revenue to 20% of GDP and reducing spending to 18% GDP. That would leave a 2% surplus as far as the eye could see and pay off the national debt in 45 years.

Fiscal Cliff is half of the solution that we need. Entitlement reform is the other half.

Posted by: John | November 15, 2012 at 09:10 AM

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October 17, 2011

State and local fiscal fortunes: Follow the money (collected)

Last week, we found ourselves in conversation with some colleagues discussing the issue of state and local fiscal conditions, which by pure coincidence coincided with the announcement that the city of Harrisburg, Pa., filed for bankruptcy. In the course of conversation, our attention was drawn to an interesting fact. Prior to 2000, according to U.S. Census Bureau data through 2008, annual growth of total revenues at the state and local level was closely aligned with direct expenditures at the same level. Since 2000, however, this pattern has decidedly changed. The main reason is the dramatic volatility of total revenue:

Revenues at the state and local level come from many sources. Taxes from income, sales, and property, of course, but also from various fees and charges associated from education, utilities, ports and airports, and so on. In addition, revenues come from transfers from the federal government and, importantly, asset income from trust fund portfolios.

In fact, the primary source of the increased volatility in state and local government revenues since 2000 is large swings in revenue going into insurance trust funds to finance compulsory or voluntary social insurance programs operated by the public sector.

Insurance trust revenue is derived from contributions, assessments, premiums, or payroll "taxes" required of employers and employees. It also includes any earnings on assets held or invested by such funds. Not surprisingly then, the volatility of insurance trust revenue is partly tied to volatility in financial markets, as the chart below clearly illustrates.

Though fluctuations in insurance fund revenues have been the largest source of fluctuations in overall state and local revenues over the past decade or so, volatility in general revenue is still an issue. Ups and downs in income tax revenues have been particularly sharp since 2000.

Interestingly, Census Bureau data for state government finances show tax revenue growth turned negative in 2009.

In research that focuses specifically on revenue variability at the state level, UCLA law professor Kirk Stark notes the possibility that state revenues have too much reliance on the same income-centric tax base that characterizes the federal revenue code:

"Perhaps the most obvious (yet little discussed) federal inducement for the design of state and local tax systems is the fact that Congress has established an elaborate and detailed legal framework for certain taxes—including, most notably, the individual and corporate income taxes—but not for others. The very existence of the Code, Treasury Regulations, IRS administrative guidance, and federal judicial case law creates an almost irresistible incentive for the states to adopt individual and corporate income taxes. The availability of the federal income tax base as a starting point in calculating state tax liability is an unqualified benefit. …

"At the same time, however, there are potentially significant costs associated with having states piggyback on the federal income tax. Taxes that might be suitable for use by a central level of government are not necessarily appropriate for use by state or local governments. Some of the most volatile state revenue sources are those upon which states rely by virtue of piggybacking on the federal income tax."

The theme of Professor Stark's article is the role that federal policy might play in generating revenue volatility at the state level:

"Through various inducements and limitations embedded in federal law, the federal government has stacked the deck in favor of state revenue volatility, unwittingly exacerbating the subnational fiscal crises that it is then called upon to mitigate through bailouts and general fiscal relief."

Some other examples of how federal tax policy can have an impact on state and local policy according to Stark include "differential treatment of alternative tax sources within the federal income tax deduction for state and local taxes" and "various specific provisions in federal law that limit state taxing authority."
Professor Stark is clear on the point that the research in this area has defied simple generic conclusions about how state and local tax codes can be constructed to minimize revenue volatility. And the work is largely silent on how the volatility question fits into the broader question of optimal tax-system design. But it is hard to argue with this conclusion:

"If the federal government is interested in reducing the likelihood and severity of future state fiscal crises, it should consider changes to federal law that would eliminate the current bias in favor of volatile state tax systems."

David Altig By Dave Altig, senior vice president and research director at the Atlanta Fed



and

John Robertson John Robertson, vice president and senior economist in the Atlanta Fed's research department

October 17, 2011 in Economic Growth and Development, Fiscal Policy, Taxes | Permalink

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Very good blog! Always an interesting read!

This article as well. It's title might be somewhat misleading, however.

To assess the fortunes of States and Cities, spending, or more precisely, what they *should* be spending, appears more relevant than the variance of income.

It is hard to make the numbers work when future pension obligations are included in the liabilities, volatility of earnings notwithstanding (e.g. Illinois).

Again, keep up with the good work!
SamK

Posted by: SamK | October 19, 2011 at 10:01 AM

But volatility of some of local revenues seems to me a good idea because it is anti-cyclical, just like for the Union budget: taxes go down when incomes go down. Since the USA includes a fiscal Union supposedly if a locality has a sudden drop in revenues the Union budget should support distressed localities (with safeguards).

The alternative would be for local taxes to rise sharply as a percentage of income when local economic activity is depressed, which sounds mad to me.

Unless the idea is to shift most of the local taxation burden to low income residents, via taxes on transactions that are largely independent of income and on expenditures that have very little elasticity to price; for example by replacing local taxes on income with local taxes on food sales, or rents, and with masses increases in fees on services like water supply and garbage collection and public transport.

Also, the "insurance fund" story is simply the old accounting strategy: to book "estimated" gigantic expected capital gains and impossibly high returns on the insurance fund, and cut income taxes on wealthy residents with the resulting "savings", and then when the insurance fund investments as expected fail to deliver during a recession, recommend a massive cut in services or a switch from income related to consumption related taxes to cover the shortfall.

Both strategies are not mad, just politics of a very specific sort.

Posted by: Blissex | October 20, 2011 at 05:45 PM

«Not surprisingly then, the volatility of insurance trust revenue is partly tied to volatility in financial markets, as the chart below clearly illustrates.»

There is another note as to this: why ever is there *any* volatility in these insurance funds? USA treasuries have not been that volatile.

Comparing insurance fund assets with stock market valuations seems crazy to me, as it seems to imply that local government insurance funds are invested speculatively instead of prudently, and from the graph it seems that they volatility is even greater than that of the S&P500, which means that they haven't even been invested in index funds, but in stock-picking speculative strategies.

The graph actually seems to suggest a massive breakdown in the fiduciary duties of local government investment managers, as if their goal was not just to book massive gains to justify cutting local taxes, but also to push up stock market prices via extremely leveraged speculation to pursue a further set of political goals. That would be madness.

Posted by: Blissex | October 20, 2011 at 05:57 PM

That the volatility of investment funds is much higher than that of the S&P seems to imply that the funds contain a significant amount of highly speculative leveraged instruments, for example stock derivatives.

I personally think that there is no reason whatever to invest local government funds in anything other than treasuries (like OASDI does) on both prudential and return grounds.

But it seems that politicians of many local governments instead thought that Orange County was a laudable model and Mr. Citron a hero prophet.

Posted by: Blissex | October 21, 2011 at 05:50 AM

I think the biggest inducement to states having income taxes is the federal deduction for state income taxes paid. The deduction causes part of the state's tax burden to be shifted to the federal government. If a small state like Hawaii can impose and administer a highly successful broad-based gross receipts tax, I don't think the mere existence of tax code is enough by itself to attract a state to the net income tax. After all, one state could also copy another's code. Just keeping up with changes in the federal income tax imposes a burden on tax administrators.

Posted by: don | October 27, 2011 at 06:30 PM

The U.S. Census Bureau released 2009 state and local government data on October 31: http://www.census.gov/govs/estimate/

Posted by: Jeff | November 01, 2011 at 10:34 AM

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May 19, 2011

The long and short (runs) of tax reform

In an earlier part of my career, I spent a fair amount of time thinking about fiscal policy issues. The evolution of my responsibilities eventually moved my attentions in a somewhat different direction, but you never really forget your first research love. With questions of debt, government spending, and taxes at the top of the news, it isn't hard for my old fondness for the topic to reemerge.

So, in that context, I had a somewhat nostalgic response to an item at Angry Bear, written by contributor Dan Crawford. In essence, the Crawford post formally (through statistical analysis) asks the question "How is GDP growth related to marginal tax rates (that is, the tax rate applied to your last dollar of income)?" More specifically, Crawford analyzes how gross domestic product (GDP) growth next year is related to the marginal tax rate faced by the average individual and the marginal tax rate faced by the highest-income taxpayers.

I don't intend to quibble with the specifics of that experiment per se but rather highlight an aspect of taxation and tax reform that I think should not be forgotten. That is, the short run is no place for a decent discussion of tax policy to be hanging out. To say that more formally, the largest effects of tax policy accrue over time, and it is probably not a good idea to be too focused on the immediate—say, next year's—effects of any given policy or change in policy.

The following chart is based on tax reform experiments in a paper I co-authored over a decade ago with Alan Auerbach, Larry Kotlikoff, Kent Smetters, and Jan Walliser. (Note that the chart does not appear in the paper, but I created it using data from the paper—a publicly available version of the paper can be found here.) The chart depicts the cumulative percentage increases in national income that would be realized (in our model) in the years following three different tax reforms.

The three experiments depicted in this chart were as follows:

"[The clean income tax] replaces the progressive taxation of wage income with a single rate that is also applied to capital income. In addition, the clean income tax eliminates the major federal tax-base reductions including the standard deduction, personal and dependent exemptions, itemized deductions, the deductibility of state income taxes at the federal level, and preferential tax treatment of fringe benefits...


"Our flat tax experiment modifies the clean consumption tax by including a standard deduction of $9500. In addition, housing wealth, which equals about half of the capital stock, is entirely exempt from taxation."


Parenthetically, the "clean consumption tax"

"...differs from the clean income tax by including full expensing of investment expenditures. This produces a consumption-tax structure. Formally, we specify the system as a combination of a labor-income tax and a business cash-flow tax."


Finally,

"Our [flat tax with transition relief] experiment adds transition relief to the flat tax by extending pre-reform depreciation rules for capital in place at the time of the tax reform."


Here's what I want to emphasize in all of this. If the change in policy you might be considering involves a reduction in effective marginal tax rates (implemented via a combination of changes in statutory rates and adjustments in deductions and exemptions), the approach taken by Crawford in his Angry Bear piece is probably acceptable. The clean income tax reform is in the spirit of Crawford's calculations, and in our results the long-run impact on output is realized almost immediately. If, however, the tax reform involves changing the tax base in a fundamental way (in both versions of our flat tax experiments the base shifts from income to consumption), then the ultimate effects are felt only gradually. In our flat tax experiments, the longer-run effects on income are in the neighborhood of three times as large as the near-term effects.

All of the experiments described were done under the assumption of revenue neutrality, so questions of the right policy for budget balancing exercises weren't explicitly addressed. (Nor is it the nature of the experiment contemplated in the Angry Bear post.) Nonetheless, they do suggest that deficit reduction exercises that involve changes in tax rates and the tax base will have differential effects over time, and realizing the full benefits of tax reform may require a modicum of patience.

Note: A user-friendly description of the paper that the chart above is based on appeared in an Economic Commentary article published by the Cleveland Fed.

Update: Though the item at Angry Bear was posted by Dan Crawford, Mike Kimel actually wrote it. I apologize for the mistake and draw your attention to Kimel's follow-up post.


Dave Altig By Dave Altig
senior vice president and research director at the Atlanta Fed

May 19, 2011 in Deficits, Fiscal Policy, Taxes | Permalink

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Dan Crawford posted the analysis. Mike Kimmel wrote it. Just thought I should mention it.

Posted by: kharris | May 20, 2011 at 10:39 AM

So when does your theoretical chart reflect the dramatic plunge that has occurred in real nations with flat taxes (e.g. Iceland)? Must be in year 14, right?

Posted by: Devin | May 20, 2011 at 11:36 AM

Minor correction: Dan posted it, but Mike Kimel actually wrote it.

Posted by: Ken Houghton | May 20, 2011 at 12:20 PM

Dave,

Hi. Thanks for mentioning the post. I modified it to take into account some of your comments. (New version here: http://www.angrybearblog.com/2011/05/tax-rates-and-economic-growth-over-ten.html)

Now I use the tax rates in any given year to explain annualized growth rates over the subsequent ten years. Additionally, I've included quadratic forms of both the top and bottom rates, which allows me to compute growth maximizing rates at both ends of the scale.

It turns out that the growth maximizing top marginal rate isn't much changed from the first post (i.e., 67%), but the optimal bottom marginal rate is zero. I think that indicates that using historical US data at least, a flat tax is a bad idea, as the top and bottom marginal rates would be identical if rates were flat.

With respect, given the choice between the outcomes predicted by a simulation, and historical outcomes, I'd go with the historical outcomes.

Best regards.

Posted by: Mike Kimel | May 24, 2011 at 07:23 PM

Dave, I would be interested is learning more as to why this is the case...i.e. why would a change into a flat tax have minimal short-term effects (yet meaningful long-term effects)?

Posted by: Chris | May 26, 2011 at 07:45 PM

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October 27, 2010

Real estate and municipal revenue

In September, the Federal Reserve Bank of Atlanta's Center for Real Estate Analytics sponsored a conference to examine the impact the real estate downturn is having on public sector finances.

It's no secret that state and local governments are currently experiencing substantial revenue declines. One popular explanation is that deteriorating local real estate conditions are responsible for a portion of that decline, but it turns out that this explanation is not the main cause, at least not yet. One of the sessions in the conference featured attempts by three economists from the Federal Reserve Board of Governors (Lutz, Molloy, and Shan) and two from Florida State University (Doerner and Ihlanfeldt) to estimate the direct impact of the decline in real estate values on local tax revenues. Both papers examined the multiple channels of influence between the decline in real estate values and local revenues.

The largest channel, of course, is the decline in property tax income related to declining assessed property values. Of course, property owners don't pay property taxes based on the current value of their home. They pay based on an assessment that is at least a year old. Thus, the decline in property values takes considerable time to work its way through the assessment process and into property tax revenues. Consequently, declines in property values have only more recently started to be reflected in lower property tax revenues. Experts expect the decline in those revenues to continue for another couple of years, with the worst shortfall two or three years out. Some of the assessments are fairly gloomy.

To illustrate that point, I've pulled a few charts from the Lutz, Molloy, and Shan paper. The first chart illustrates the decline in revenues led by individual and sales taxes. Notably, property tax collections grew at an increasing rate in 2009 over 2008.

102610a
(enlarge)

The next chart directly depicts the relationship (or the short-run lack thereof) between housing price growth changes and property tax revenue. Lags in changes in assessments and the ability of local governments to change property tax rates can go a long way in explaining why overall property tax revenue continues to grow.

102610b
(enlarge)

Finally, Lutz, Molloy, and Shan broke down the data by some states, and I include the case of Georgia below. (The Ihlanfeldt and Doerner paper does something similar—and in great detail for the state of Florida.) The Georgia case clearly shows the effect of the lags: property values rose through the first part of the last decade and, even though tax rates were falling, overall tax revenue rose. Post-2007, however, market values of homes declined while the aggregate assessed values continued to rise through 2009 (along with property tax revenue).

102610c
(enlarge)

It is hard to imagine the trend of aggregate increased assessed valuation continuing. If the assessed values begin to track the market values, pressures will emerge on the government entities that depend on property taxes. The picture suggests that tax rates and/or spending on programs are likely to change notably during the coming few years.

By Tom Cunningham, vice president and associate director of research and acting director of the Center for Real Estate Analytics at the Federal Reserve Bank of Atlanta

October 27, 2010 in Economic Growth and Development, Fiscal Policy, Taxes | Permalink

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I think many, if not all, munincipalities change the mill rate of the tax assessment to collect the tax revenue needed. As in, they take their budget and divide THAT by the new lower total property values in the district to arrive at the new (higher) rate of individual parcel tax liability, so a lower property value does not necessarily mean lower taxes! Lower tax revenues are the result of income, sales, and other taxes, not property taxes.

Posted by: Thrill | November 01, 2010 at 01:22 PM

I disagree Thrill. I think that this is a fantastic post. In Illinois, virtually all property tax revenue goes to pay for local schools.

When a house is valued at 500k and resells at 300k, the property tax won't remain the same. Government revenue should decrease.

Posted by: Jeff | November 04, 2010 at 07:53 PM

You would only get a 3 BR if there were one male and one female child. Bear in mind, as well, that you may not get any voucher at all, if your area has a waiting list. The funding for Sec 8 is not unlimited, and it's generally a 'first come, first served' situation. There are many Sec 8 areas of the country in which the lists are so lengthy that they aren't even accepting applications.

Posted by: Poplar Bluff Real Estate | November 08, 2010 at 06:59 AM

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March 11, 2009

Another side of the administration’s tax plan

While discussions of the Obama administration's tax plan focus on the expected impact on consumer spending and the federal deficit, not much attention has been given to the incentives of the plan for work effort. Different tax rates, deductions, and rebates provide varying degrees of incentives to work less or work more, and those incentives differ across income groups. Here I want to focus on just one of the proposed changes: the reinstatement of the 39.6 percent marginal tax rate for the wealthy.

Supply side economists tout low tax rates across the board as a way to provide incentives for people to work harder and thus for the economy to grow faster; with this thinking, people work harder because they get to keep more of the money they're working for.

Results in a recent working paper, with coauthor Robert Moore, confirm these predictions by finding that work effort increased across all income levels when tax rates were cut (among other things) in the 2001 Bush administration tax reform. But work effort increased much less among the more educated (higher income) families.

031009a

The administration's current budget plan includes a reversion of the marginal tax rate among the wealthiest to the pre-Bush tax rates—an increase from 35 to 39.6 percent. This tax rate increase is equivalent to reducing a worker's wage by 7 percent. The chart shows what the impact on work effort would be across education/income groups if wages were decreased for both groups by 7 percent; education and income are very highly correlated. The analysis found that husbands with a high school degree only would reduce their hours worked by about 63 hours per year (about 2.9 percent), whereas husbands with a college degree or more would reduce their work hours by only 42 hours per year (about 1.8 percent). Working wives in these families would also reduce their hours of work.

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.

The calculations here use results obtained from estimating a joint labor supply model for dual-earner families with different levels of education for the year 2000. A complete analysis of the work effort implications from the administration's tax plan would require accounting for all the changes to marginal tax rates, phase-outs of deductions, and tax credits simultaneously, as well as considering the impact on decisions of family members to enter or exit the labor market in response to the tax changes.

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.

By Julie Hotchkiss, research economist and policy adviser at the Atlanta Fed

March 11, 2009 in Labor Markets, Taxes | Permalink

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"an increase from 35 to 39.6 percent. This tax rate increase is equivalent to reducing a worker's wage by 7 percent."

This is misleading. The increase is an increase in marginal rates only: only on the income above a set level. Therefore moving from 35% to 39.6% marginal tax rate is NOT like a 7% reduction in worker's wage. It is only a reduction of 7% in the marginal wage. Statements like this that say "it's equivalent to a reduced wage of 7%" obfuscate the debate.

Further, workers' incentives are no doubt in response to marginal total taxation, not just marginal Fed Income tax. The brackets for which margina Fed income tax is actually increasing from 35-39.6% are those brackets that pay a lower marginal tax (0%) on SS/Medicare taxes, while lower income brackets face a steep additional approx 7% marginal tax on top of marginal fed income tax rates.

Posted by: EconProph | March 11, 2009 at 01:37 PM

But why is there no mention of the income and substitution effects, and the backward bending labor supply curve? As income gets higher, at some point the income effect outweighs the substitution effect, and the resulting labor supply curve bends back, implying that people at that income level and above would work more when their taxes are raised because of the strong income effect, because they have to to maintain their current lifestyle. Last I checked, research implied that the backward bend began at about the upper middle class level.

And, of course, sadly, the pink elephant of economics, positional/context/prestige externalities (see Cornell Economist Robert Frank's article: http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf) is almost never mentioned. Cut taxes on the very wealthy and the spending is overwhelmingly on zero sum game positional/context/prestige externality goods that add very little total utils to society, especially relative to the basically non-positional things that money could have been spent on like basic medical and scientific research, alternative energy, education, public health and safety, etc.

Posted by: Richard H. Serlin | March 11, 2009 at 03:21 PM

For an excellent brief article on the income and substitution effects and the backward bending labor supply curve, and the historically weak relationship between income, taxes, and hours worked, see Cornell Economist Robert Frank's article:

http://www.nytimes.com/2007/04/12/business/12scene.html?partner=rssnyt&emc=rss

Posted by: Richard H. Serlin | March 11, 2009 at 03:24 PM

Richard Serlin makes very good points.

In fact, I think we can speculate on some of the positional/prestige/context spending that occurred in the upper income brackets in the past 8 years as the marginal rates were lowered to 35%. Actually the rate for some has been 16% since for many of these people they were were given a loophole that let them claim that being paid to manage a fund (labor) was actually capital gains (investment of capital) when they had nothing at risk.

What did high income folks do with their lower-marginal tax rate enhanced take-home pay? It appears that more than a few bought second homes (and third homes and more). They bought real estate assets. They "invested" the money, but unlike in past cycles the investments were in hedge funds and derivatives. Financial devices that added relatively little to the real stock of capital goods and productive capability in the economy. As for the additional homes, I don't think that's worked out too well for us, has it?

Posted by: EconProph | March 11, 2009 at 05:10 PM

Your analysis is in a vacuum. What if the hours that the wealthy work are more productive than the hours the middle class work?

The other issue in the Obama tax plan is the increase in not only marginal tax rates, but increases in FICA tax rates, reductions in the ability to deduct to charities and mortgages, and the other increases in the federal bureaucracy that will explode entitlement spending.

I have hearsay anecdotes that say that if you collect welfare under the Obama plan it is more than working 8 hours a day for a minimum wage job. This will certainly also decrease production.

Posted by: jeff | March 11, 2009 at 09:29 PM

Obama would do well to leave the current brackets and marginal rates as they are, and instead add new brackets and higher marginal rates on top of that structure. There is no reason for a progressive income tax system to stop being progressive at $357k of income. He could easily add a 39.6% bracket at 500K or so and a second, even higher bracket at 1M or 2M. Furthermore, why not make the rates on dividends and capital gains progressive?

Posted by: RueTheDay | March 12, 2009 at 08:39 AM

I took a look at your paper. As is common, there are potential problems with the model and paper. It only looks at 2001 changes in taxes; how would it do out of sample. The groupings are course, and there are other issues I won't get into now. But I would like to note that the other research appears to go against your implication (at least many could interpret it this way) that these tax cuts would induce a widespread increase in hours worked.

This is from a survey of the labor supply elasticity literature by Harvard Labor Economist George Borjas, from his 2008 text, "Labor Economics", 4th ed.

Few topics in applied economics have been as thoroughly researched as the empirical relationship between hours of work and wages (pg. 45)...The neoclassical model of labor-leisure choice implies that the sign of the coefficient beta depends on whether income or substitution effects dominate (pg.s 45-6)...There are almost as many estimates of labor supply elasticity as there are empirical studies in the literature. As a result, the variation in the estimates is enormous. Some studies report the elasticity to be zero; other studies report it to be large and negative; still others report it to be large and positive. There have been some attempts to determine which studies are most credible. These surveys conclude that the elasticity of male labor supply is roughly around -0.1. In other words a 10% increase in the wage leads to a 1% decrease in hours of work for men. The dominance of income effects is often used to explain the decline in hours of work between 1900 and 2000 (pg. 46, emphasis added)...Labor supply elasticities in the United States are small: Hours of work do not respond much to wage changes. Moreover income effects tend to dominate (at least for working men). The available evidence, therefore, does not support the argument that income tax cuts could increase tax revenues in the United States. (pg. 51)

Posted by: Richard H. Serlin | March 12, 2009 at 11:57 PM

As a comment on the paper, I was a little bothered by the mention of the dual income model and then a sentence or two about low-income families but nothing clearly stated about the numbers of dual income families at the various economic levels, nor what was done with single parent families, etc. Taking the work at its face, I found the data source fairly weak and the implications then weakened by the paucity of discussion (lack of data?) about exactly which actual group in numbers in society might fit this model.

I would also like to agree generally with the first comment above. A better statement is there would be a 4.96% increase in the marginal tax on income above $x - which I believe is something like $370k for a joint return.

Posted by: jonathan | March 18, 2009 at 06:01 PM

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February 05, 2009

There is no accounting for priorities

Just in case you are desperately seeking some refuge from the pervasive blogland commentary on the fiscal stimulus proposal winding through the Senate (which already made its way through the House of Representatives), be forewarned: You won't find it here, but you will find an update to the old adage, There's no accounting for taste (de gustibus non est disputandum), which is to say that when it comes to the fiscal stimulus package, there's no accounting for priorities.

The Senate bill is not yet a done deal, of course, but a couple of clear differences between it and the House bill have emerged. According to the Congressional Budget Office—or CBO, from whom all figures in this post spring—the Senate bill is slightly bigger ($884.5 billion versus $819.5 billion) and would implement the stimulus at a faster pace. The current Senate bill would introduce about 79 percent of the expenditures and tax cuts in 2009 and 2010. The corresponding figure in the plan that came out of the House is 64 percent.

Perhaps more interesting—and maybe more confusing—are the priorities reflected in the separate bills:

020509a


020509b

The share of the stimulus devoted to discretionary spending—the place where, for example, infrastructure and education spending reside—is pretty similar in both stimulus plans (about 28 percent in the House version, about 26 percent in the Senate version). What is clearly different is the much greater reliance on tax cuts in the Senate bill, compared with the House bill's emphasis on "direct spending."

In a sense, this distinction is as much an issue of labeling as anything. The majority of the items in this category of direct spending are "provisions that would increase direct spending for unemployment insurance, health care, fiscal relief for states through the Medicaid program, and other programs," according to the CBO. In the language of economists and national income accountants these are "transfer payments," or funds that are transferred to individuals. Formally, they are subsidies for certain types of economic behavior—job seeking and purchasing health care, for example—and hence are really just a negative tax.

There is a certain arbitrariness to the distinction between increases in transfer payments and reductions in tax payments. This arbitrariness is illustrated by a change the CBO made between its initial assessment of the draft House bill and its (largely unchanged) summary of the bill that passed:

"The Congressional Budget Office, in consultation with JCT [Joint Committee on Taxation], has concluded that the subsidy for health insurance assistance for the unemployed should be treated as an increase in outlays rather than a decrease in revenues. Although this treatment is different from that in the table provided in our estimate for H.R. 1 as introduced on January 26, the overall effect on the budget remains the same for each year. JCT has also adjusted its estimates of the mix of revenue losses and outlay increases associated with certain refundable tax credits; that change also has no effect on the budget totals for each year."

Still, if you are likely to be on the receiving end of one of these programs, the distinction is probably not so arbitrary. From this end-user perspective, there is an important economic distinction between approaches taken in the competing plans. So then, which approach to "tax cuts" is better? At this point, I will send you to the aforementioned pervasive blogland commentary. You will find no shortage of opinions.

By David Altig, senior vice president and research director at the Atlanta Fed

February 5, 2009 in Federal Debt and Deficits, Fiscal Policy, Taxes | Permalink

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the stimulus is disturbing to me in where it is spending the money as well. it will go into non-productive things from a GDP perspective.

the other disturbing thing that I saw was an interview with Christine Roemer on CNBC. She was asked point blank if the Obama administration was confident in Bernancke, and she refused to give him that vote of confidence.

mankiw in his blog cites the multiplier effect on tax cuts versus spending. He calculates that tax cuts offer a 3:1 bang to the buck growth in GDP, where govt spending offers a 1:1 bang to the buck.

Economic results over the last 3 decades would tend to prove him right.

Posted by: jeff | February 07, 2009 at 02:03 PM

David,
When are MBS yields affected by the Fed's purchases? At the time the purchase agreement is signed, or afterward, at settlement?

Posted by: Holden Lewis | February 09, 2009 at 02:44 PM

But as past attempts to reduce financial stress on homeowners have shown, the task is not easy.


I'm not sure I agree the purpose was ever to reduce financial stress on homeowners. That said, I agree the task is not easy.

Posted by: FutureRob | April 09, 2009 at 09:55 PM

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January 07, 2009

Will tax stimulus stimulate investment?

Update: Reader Doug Lee points out that the fixed investment series above is dominated by the extraordinary decline in residential investment over the past several years. For that sector, the questions posed above are in a bit sharper focus. Are firms in the residential investment sector pessimistic about future prospects? Absolutely. Are compromised credit markets behind the low investment levels? Quite possibly, though given the large inventory overhang in housing it is improbable that activity in the sector would be robust in any case. Is the low investment/net worth ratio symptomatic of a general deleveraging within the nonfinancial business sector? Not so clear, as it is pretty hard to see through the effect in residential category.

Here, then is a chart of the history of nonresidential fixed investment relative to corporate net worth:

010709_update

The recent decline in the ratio, while still there, is much less dramatic and, in fact, seems to be part of a more persistent trend that commenced prior to the 2001 recession (and which may have been temporarily disguised by the housing boom that followed).

Was the nonfinancial nonresidential business sector ahead in the deleveraging game—ahead of residential construction businesses, financial firms, and consumers? And could this bode well for this sector when the recovery begins? Unfortunately, I have more questions than answers.

By David Altig, senior vice president and research director at the Atlanta Fed


Original post:

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:

010709

Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low.

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds. (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending. (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.

By David Altig, senior vice president and research director at the Atlanta Fed

January 7, 2009 in Capital Markets, Saving, Capital, and Investment, Taxes | Permalink

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Very interesting to see some real data on this, which seems to support recent anecdotal evidence. I have written up two separate but related thoughts on stimulating business investment:

1. Should the stimulus aim at boosting investment instead of consumption, and how? http://www.knowingandmaking.com/2009/01/stimulus-spend-invest-or-incentivise.html

2. Should central banks consider equity investments if debt instruments are not effective in routing funding to the non-financial sector? http://www.knowingandmaking.com/2009/01/private-investment-by-central-banks.html

Posted by: Leigh Caldwell | January 07, 2009 at 11:10 AM

The loss carry back provisions seem to me like a particularly poor way to encourage investment and seem to smack of political pork to produce big transfer payments to financial sector companies. An investment tax credit would be much better, but I suspect investment demand is inelastic with respect to the cost of capital so most of the credit would go to projects that would have been undertaken anyway. Summers touted investment tax credits for machinery and equipment at one time. Has he been intimidated by the comment that crushed his research findings on the topic?

Posted by: don | January 07, 2009 at 02:00 PM

Since it seems to be a key question at the moment, can someone (Dave?) please explain to me why it matters whether a stimulus is saved or spent? Surely, in order to save it is necessary to find someone to lend to (even just holding a banknote is effectively an interest-free loan to the government). And they are not going to borrow unless they have a use for the money, so any money that is saved must be spent anyway.

Posted by: RebelEconomist | January 09, 2009 at 04:11 PM

Very interesting data indeed. Especially when you cross pollinate the data with Greg Mankiw's that shows that tax cuts have a greater effect on GDP than government spending.

We are in a deflationary time. Everything just gets cheaper. I don't view it as a spiral, because we were severely overleveraged. Once the leverage of the market reaches equilibrium, there should be some stable footing.

The government spending package will of course have a bunch of lard in it. Unfortunately, it will be too big, and because the government can't keep it up forever, people will save instead of spend. The jobs created for road building and bridge building are temporary. Once the road is built, the job goes away.
There will be some ancillary jobs that remain, but those will be small.

The way to really get business to invest is to make the cost of investing a lot cheaper. Businesses view taxes as a cost, so lower the corporate tax rate and the capital gains rate a bunch. This will spur business investment in long term capital projects that will encourage long term economic development.

But the bureaucrats in DC and Congress don't think that way.

Posted by: Jeff | January 12, 2009 at 08:46 AM

David,

Very clear analysis, and reasonable conclusion. It's nice to read something about the stimulus subject that isn't completely guided by preconceived notions and admits to ambiguity.

Posted by: Bob_in_MA | January 12, 2009 at 08:46 AM

How about redistributing purchasing power through the tax system?

Poor people generally spend more of an extra dollar than rich people do. So redistribution can be expected to boost aggregate demand without simultaneously boosting public deficits.

Even weak households can of course be expected to save some of the extra dollars. Given their indebtedness, that’s not a bad thing.

One may argue that poorer people spend their dollars differently from richer. But many products sold lately were anyway meant to satisfy needs for rather conspicuous consumption. More resources must be allocated to the satisfaction of (slightly) more basic demands.

Growing inequality is a major explanation for the crises. For many households credit growth has worked as a substitute for wage growth.

This process will have to be reversed one way or another. We must make sure that wage differentials decreases rather than the opposite. In addition to tax breaks for the weaker households, mortgage assistance is needed.

When you run out of helicopters, distribute fresh money through increased unemployment benefits. This will improve the bargaining power of the weakest employees. But make sure the informal economy doesn’t explode. ID-cards for all wage earners are needed!

Jan Tomas Owe
Norway

Posted by: Jan Tomas Owe | January 13, 2009 at 08:12 AM

"The way to really get business to invest is to make the cost of investing a lot cheaper. Businesses view taxes as a cost, so lower the corporate tax rate and the capital gains rate a bunch. This will spur business investment in long term capital projects that will encourage long term economic development.

But the bureaucrats in DC and Congress don't think that way."

I agree, but the politicians are intent on solving the wrong problem with the wrong tools. You mention "long term" economic development - everything the Democrats and Obama want to do is SHORT TERM.

If the 'problem' they have to fix is short-term recession fighting, then the only lever that works efficiently at that is federal reserve monetary policy, and they've already done the "flood the zone" approach with 0% interest rates and 'quantitative easing'. Even though unemployment is no higher than in 1992, they want to go far far beyond what has been done in previous recessions. Why? I can think of no reason other than a sense of panic among the political elites, or a desire to misuse a recession for political aggrandizement.

But the short-term is the WRONG PROBLEM TO SOLVE. The correct problem to solve is to set the country back on the path of stable long-term economic growth. When we look back in 2012 at what was done in 2009, we wont care if the Q4 2009 numbers were this or that, we WILL care if we are saddled with an extra trillion of foriegn debt that we can't easily pay back, suffering under subpar growth because our deficits and inflationary policies got out of hand and we had to 'fix' that with high-tax high-interest-rate stagflation-era policies.

It's a myth that govt deficits will reflate the economy. What ever happened to the 'rational expectations' refutation of this? Every attempt to grow the govt will be met by more private sector layoffs - as the private sector realizes they will bear the pain of paying for this mess the govt makes.

Keynes was wrong. In the long run we aren't dead, in the long run we look back, older and wiser, and say: "What the hell were we THINKING?!?"

Posted by: Travis Monitor | January 18, 2009 at 11:32 PM

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November 06, 2008

Saving and taxes

I hope you will excuse me for trading in a bit of old news, but I’ve been thinking about a post by Greg Mankiw from last week. Titled “My Personal Work Incentives,” the item takes published details of the McCain and Obama tax proposals. The essence of the post was to point out how these details impact the return to working for higher-income individuals, assuming that a marginal dollar earned is a marginal dollar saved (for the children, of course):

“Let t1 be the combined income and payroll tax rate, t2 be the corporate tax rate, t3 be the dividend and capital gains tax rate, and t4 be the estate tax rate. And let r be the before-tax rate of return on corporate capital. Then one dollar I earn today will yield my kids:

(1-t1){[1+r(1-t2)(1-t3)]^T}(1-t4).

“For my illustrative calculations, let me take r to be 10 percent and my remaining life expectancy T to be 35 years…

“Under the McCain plan, t1=.35, t2=.25, t3=.15, and t4=.15. In this case, a dollar earned today yields my kids $4.81. That is, even under the low-tax McCain plan, my incentive to work is cut by 83 percent compared to the situation without taxes.

“Under the Obama plan, t1=.43, t2=.35, t3=.2, and t4=.45. In this case, a dollar earned today yields my kids $1.85. That is, Obama's proposed tax hikes reduce my incentive to work by 62 percent compared to the McCain plan and by 93 percent compared to the no-tax scenario.”

Since the election is over, I trust that fact will keep the focus on the essential economic point, which is that tax policy does indeed affect incentives.

Which brings me to my point. Using Mankiw’s interest rate assumption, the present value of McCain’s $4.81 is $0.17 (which is implied directly by the 83 percent marginal tax rate). The comparable figure for Obama’s $1.85 is $0.07.

Mankiw’s point is that these sorts of numbers would substantially change his incentives to work. If the whole point is to leave a little nest egg for the kids, that is surely true, but there is another choice.

Here is another possibility: Suppose I forgo provisioning for the children altogether and simply consume that extra dollar of income. That way I avoid the corporate tax, dividend and capital gain tax, and the estate tax altogether. Under the McCain plan I get to enjoy $0.65 worth of extra consumption, or $0.57 worth under the Obama plan. I would have to value my children’s consumption an awful lot to trade $0.65 (or $0.57) of my own for $0.17 (or $0.07) of theirs.

As I think about this example, I am naturally drawn to the fact that savings rates in the United  States are, in an historical context, pretty darn low.

Personal Saving as a Percent of Disposable Income

There are almost certainly multiple reasons for the pattern shown in this chart. It would be tough to make the case that tax policy is the only culprit, but it would be equally tough to argue that it is irrelevant.

The distortion on saving from capital-income taxation could be eliminated, of course, by simply eliminating taxes on saving, but doing so would have exactly the sort of distributional consequences that account for a good deal of difference in the Obama and McCain tax plans in the first place. My training as an economist gives me no special expertise in determining how to value the trade-off between “fairness” and efficiency—and beware of any economist who pretends otherwise. But as you contemplate the distortions presented by your favorite tax proposal—a required step in any complete analysis—you might consider putting disincentives to save fairly high up on the list.

 

November 6, 2008 in Saving, Capital, and Investment, Taxes | Permalink

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I know this was not your point, but can you literally post Mankiw's analysis without discussing how few estates are actually subject to the inheritance tax? Is there any data that suggests that even if this extremely small sliver of the population subject to the estate tax actually does work less because of "disincentives," that overall output is lower (i.e., that those not subject to the estate tax do not "pick up the slack")? Is there any data that suggests that the money sent to the government via taxation does *nothing* to benefit this hypothetical worker's children? Do the taxes paid over to the government simply go into a hole? Is it impossible that any portion of those taxes actually benefited the children? Is it impossible that some high earners take pride in paying taxes while knowing that at least some small portion of the taxes are being used to build the communities in which their children will live? Do people have absolutely no incentive to help their communities unless they get a hospital wing named in their honor? With all due respect, let's admit that the incentives argument is usually far, far more complex than any blog post will ever be able to relate.

Posted by: Anonymous | November 06, 2008 at 04:50 PM

Except that the top tax rate from 1936-1981 was 70% or higher.

Corporate tax rates were 46% or higher from 1951-1986.

I can't find convenient numbers on estate and capital gains rates, but even Obama's proposals are at historically low levels.

But just with those two rates, his return would only be $1.89 in the 1970's. Factoring in 15% cap gains, and 15% estate taxes, and you get $1.22 for a 1970's investor vs. $1.85 for Obama's plan.

I'd speculate that 5-year CDs rates under 3% had something to do with the savings rate in the 2000's. Somewhat risky investments, like stocks, weren't doing significantly better.

And you could borrow money at single digits (in some cases low single digits).

And assets were increasing generating apparent wealth for everyone.

But I don't think it has to do with our (historically) relatively low tax rates.

Posted by: SKG | November 06, 2008 at 06:43 PM

Also, for example, a plumbing company entrepreneur with after tax NI of 250K plus would save more in taxes by hiring another worker at his newly purchased firm under the Obama than the McCain plan Since the deduction amount is higher against a higher marginal rate.

Furthermore the new worker pays payroll and income taxes which do not get dynamically scored, which means raising taxes raises employment rates AND total tax revenues. I'm sure the WSJ opinion page will cover this anomaly extensively.

Posted by: VennData | November 06, 2008 at 08:52 PM

Very interesting, as was the original.

However, wouldn't the analysis need to consider the implications of the two candidates' tax and spending plans on future deficits (and therefore, taxes for the children)?

In other words, I could propose a plan where we cut taxes to zero and borrow the entire federal budget. According to this analysis, that would yield a bigger inheritance and provide a greater incentive to work. But the kids doing the inheriting are going to have to pay that back through higher taxes. I worked hard, but it was a shell game. The kids just got taxed more later.

I think this analysis misses something that is missing from our political system as a whole - a clear distinction between a tax cut and a tax deferral.

Posted by: Chris | November 06, 2008 at 10:16 PM

Mankiw's math is suspect.

Why would he pay capital gains/dividend tax on 100% of his gross investment return every year? This implies 100% turnover of his investments every year. Why does he assume the entire investment will be taxed at the estate tax rate? Why does he assume that tax rates 35 years from now will be set by either 2008 Presidential candidate?

His boldest assumption is that the long-term value of r is invariant with respect to t1..t3. In a low-tax environment in which the National Debt increases geometrically over time, it is not obvious to me that r will stay constant or increase over time. It is plausible that the long-range value of r would be higher in a moderately higher tax rate environment.

Following Mankiw's logic, Warren Buffett would have never started investing.

Posted by: OreGuy | November 06, 2008 at 11:43 PM

For the life of me I can't understand any discussion dealing with tax reductions when I see the real issue as being over spending by the federal government. It seems as if this particular issue is never addressed by the media or elsewhere.

When was the last time the white house or members of Congress actually owned a company that hired people and put them to work verus talking about job creation that they have nothing to do with!!! any thoughts would be appreciated.

Norm

Posted by: norman | November 10, 2008 at 08:30 AM

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August 21, 2008

The “What’s Fair” contest

At Café Hayek, George Mason’s Russell Roberts opens up a brand new “Inequality Chart Contest.” The chart in question is based on work by Thomas Piketty (professor, Paris School of Economics) and Emmanuel Saez (professor, University of California Berkeley), the essence of which is that the rich have gotten richer and everyone else not so much. (You can find a link to the Piketty-Saez paper, as well as updated data and executive summaries, on Emmanuel Saez’ homepage. Russell links to more information from the Center on Budget and Policy Priorities.)

Here’s the picture…

Figure 2

… and the contest is to construct “ONE sentence explaining ONE thing that is wrong with concluding that these numbers are evidence that the U.S. economy has become more tilted toward the rich at the expense of the poor.”

In the spirit of prompting reflection on issues of inequality and fairness, I invite you to think about the following three pictures, generated from Internal Revenue Service (IRS) tax data through 2006:

Avg Tax Rates by Income Percentile

Avg Tax Rates by Income Percentile

Avg Tax Rates by Income Percentile

Let’s focus on the 1 percent of income-earners (by IRS defined Adjusted Gross Income, or AGI). If you look at the average federal tax rate paid by this group—that is, taxes paid divided by AGI—it did fall substantially over the period from 2000–2006. The average tax rates for other income groups fell as well, but not as dramatically.

If you instead prefer to look at taxes paid, the share the top 1 percent forked over to the federal government rose from 37.4 percent in 2000 to 39.9 percent in 2006. The share paid by the next highest 4 percent rose only slightly over this period, and the share paid by all other groups actually fell or stayed roughly the same.

On the other hand, concentrating on the share of taxes paid relative to the share of income earned by each group would lead you to the conclusion that not much had changed between the year 2000 and 2006.

So here’s the contest: Explain in one sentence which one of those pictures tells us whether the federal income-tax system has become more or less “fair.”

August 21, 2008 in Inequality, Taxes | Permalink

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The top 1% earns 350,000+

The top 0.1% earns 1.6 million+

The top 0.01% earns 5.5 million+

The disparity _among_ the top 1% dwarfs that between them and the remaining 99%.

Any study that does not go further into the top 1% is essentially dishonest

It’s like Bill Gates walks into a bar and average income of the patrons is into millions..

This has been well-documented, but still everyone screams about the top 1% is paying a lot.

But among that 1%, who pays?

Those earning more than $10 million a year now pay a lesser share of their income in these taxes than those making $100,000 to $200,000.

Tax rates increase with income, *except* for the top 0.1% - yes that’s 0.1 - thats only 145,000 households.

And that is just reported income on tax returns, leaving aside all the legal and illegal shelters that this 0.1% use.

This grand con - shifting the taxes onto the working “rich”, by the hyper-rich is the hallmark of the plutocratic conservatives

Posted by: bumble | August 21, 2008 at 06:03 PM

The 'fairness' just depends on the average tax rate. The ranking for each group should be the same in graphs one and three - I'm not sure what is added by dividing the average tax rate for each group by the average tax rate for the economy, as is done in the third graph.
Fair for who? The top 2% to 5% have not gotten the breaks that the rest seem to have enjoyed.

Posted by: don | August 21, 2008 at 07:05 PM

Changes in average tax rates have been limited but the income and therefore the tax share of the top 1% has grown greatly over the last 20 years, largely at the expense of the top 6-25%, though the tax share relative to income share has changed little. One does wonder whether their entire growth in income since 2000 was simply compounding of their tax cuts. With their rates at a low, it wouldn't be a surprise to see them rise.

Posted by: Lord | August 21, 2008 at 09:10 PM

I am not sure the question should be 'what is fair' so much as 'what is desirable'. I am not sure the disappearance of the middle class is.

Posted by: Lord | August 21, 2008 at 09:18 PM

"Fair" is not a capitalist concept.

Posted by: Ken | August 21, 2008 at 10:31 PM

Figure 2 clearly demonstrates our tax regimen is less fair than it used to be.

Posted by: Gegner | August 22, 2008 at 03:30 AM

If a rapidly increasing income is multiplied by a decreasing tax rate, does the resulting increase in the product mean that the wealthy are contributing more in taxes, or that the wealthy are sharing a smaller piece of a larger pie?

Posted by: pmorrisonfl | August 22, 2008 at 01:22 PM

Error: These charts and the words around them imply that the wealthy and the high income earners are the same people.

It is possible to be extremely wealthy with little income.

Bill Gates did not get rich by drawing huge paychecks. He got rich through appreciation of assets he owned (MSFT stock).

High income tax inhibits high income and keeps the richest on top.

If I'm winning a race I'm all in favor of adopting strict speed limits as soon as possible.

Posted by: Name | August 22, 2008 at 02:49 PM

Figure 1, by itself, demonstrates nothing about equity, unless you believe in equality of result rather than equality of opportunity. It would need to be accompanied by some explanation for the divergence in growth. For example, if the result shown comes largely from international trade or illegal immigration, is that 'fair'?

Posted by: don | August 22, 2008 at 04:57 PM

Didn't the best "improvement" in income disparity occur during the Great Depression?

Posted by: Empircal Conservative | August 22, 2008 at 05:43 PM

How did you control for the changes in the way AGI is calculated over these years?

Posted by: Patrick R. Sullivan | August 22, 2008 at 06:57 PM

Since about 25% have bachelor's degrees and most are likely in the top 25%, it does rather severely undercut the argument the disparity is due to education, other than graduate and professional education. It now looks like a substantial group of college educated will not profit from it, at least anytime soon.

Posted by: Lord | August 22, 2008 at 07:01 PM

All 3 charts show that the American tax system is unfair: although we are supposedly all equal, some of us are paying more than others, in both absolute and relative terms, for public goods and services -- a situation that would not be tolerated for non-public goods and services.

Posted by: TSowell Fan | August 22, 2008 at 07:16 PM

Unless I missed something, none of these pictures (graphs?) show how valuable paying customers/bosses found each individual person being measured.

Posted by: SteveO | August 23, 2008 at 12:46 AM

None of these graphs tells us about the fairness of the current tax structure.

The fairness is measured in the debt burden we are passing on for future generations to pay off.


That graph is here; http://zfacts.com/p/318.html

As far as inequality two major factors spurring that have been the Bush tax cuts and the Feds cheap credit policy combined with unregulated financial wizardry of Wall Street paper pushers using ponzi schemes and the backing of the US Treasury to steal wealth from the people who actually do things and make things for a living.

Posted by: muirgeo | August 23, 2008 at 01:28 AM

Ken's comment, "'Fair' is not a capitalist concept" is absolutely correct under the form of capitalism that we practice to varying degrees throughout the capitalist world.

Those who have acquired wealth by birthright or by government favor frequently oppose pure capitalism as it lets in the riff-raff or fosters competition that might shift wealth from the old guard to the innovator.

On the other hand, the bourgeois often view capitalism with suspicion as it appears to them that the hurdles to be crossed to achieve business success are insurmountable. Unfortunately those hurdles are not limited to competition provided by more capable competitors but, rather, a regulatory structure crafted and lobbied for by such competitors. Such chicanery exists as a component of the government's management of capitalism.

Posted by: sot | August 23, 2008 at 09:59 AM

Fairness is an issue only when special treatment by the government depends on defining a group. (If the definition is by race, creed, sex, etc. the issue transcends fairness and becomes unconstitutional.)

"Rich" as a group definition appeals to the human foible of envy, and seduces us into thinking it's only fair. Most other group definitions do not enjoy that political advantage.

Unfair group definitions are always arbitrary. In the case of progressive taxation, it's worse. The IRS changes the group definitions every year, when it updates the tax code's income brackets.

That is a dead giveaway. But we don't notice, because envy makes us believe it's only fair.

Posted by: John Mason | August 23, 2008 at 12:11 PM

Inequality is not the result of tax policy. It is the result of monetary policy. We have designed a system that goes to any measure to keep wages (i.e., inflation) low and asset values high. As a result only those who own assets get wealthy. Even now, with inequality known to be a problem, we have the Fed doing everything possible to keep rates low and add liquidity. These measures will flow directly into asset values and not into wages. Things got so bad that the average person felt there was no way to get ahead over the past decade other than by participating in a housing bubble.

Posted by: mlb | August 23, 2008 at 07:33 PM

Based on the figure plotting tax shares by income percentile - "The tax policies have been fair over the past two decades as the contribution to the tax pie by the top 1% has kept pace with the (albeit unfair) increase in their income."

Posted by: Venkatesh | August 24, 2008 at 11:55 PM

Fair is where grown men go to play games. A taxation system should not be judged based on fairness – a term so loaded it lacks a definition - but upon its efficacy to raise revenue.

Posted by: septagon49 | August 25, 2008 at 08:33 PM

The standard exemption is $5-10k. Does anyone think this represents a realistic estimate of the expenses of generating those incomes? I don't know of anyone that could even pay the rent with that. The income tax only appears progressive.

Posted by: Lord | August 26, 2008 at 04:13 PM

A taxation system should not be judged based upon its efficacy to raise revenue but upon its tendency to encourage growth in productivity. The less revenue the better, I'd say.

Wealthy people are statesmen entitled to organize resources through the market rather than our biannual plebiscites, and the market is a far more democratic process. Growing income of the wealthy is not the problem as much as a growing entitlement to consume the income, as opposed to reinvesting it.

We need a progressive consumption tax that would reverse a growing entitlement to organize many resources for the exclusive benefit of a few, both by limiting the personal consumption (as opposed to investment) of the very wealthy and by limiting the incredibly excessive consumption of the state sector.

Posted by: Martin Brock | August 28, 2008 at 05:37 AM

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August 19, 2008

Did the stimulus package actually stimulate?

One of the big questions of the policy season is surely “Did the $100 billion of tax rebates distributed to households in May, June, and July actually work?” “Work” in this case means “stimulate consumer spending.” You may want to sit down before I tell you this, but so far economists disagree. In one corner you have Christian Broda at the University of Chicago and Jonathan Parker at Northwestern University:

The Economic Stimulus Act of 2008 was aimed at increasing disposable income temporarily through tax rebates in the hope this would stimulate spending and end or at least mitigate the severity of a U.S. economic slowdown. We find that to a significant extent they succeeded. The stimulus payments are initially being spent at significant rates. These rates are slightly higher than those observed in 2001 when fiscal policy has been credited with helping end the 2001 recession.

In the other you have Martin Feldstein:

Although press stories emphasizing that the rebates induced additional consumer spending were technically correct, they missed the important point that the spending rise was very small in comparison to the size of the tax rebates.

A recent, widely reported academic study by Christian Broda and Jonathan Parker showing that the rebates led to increased spending on nondurable items (like food and drugs) does not contradict the implication of the more comprehensive data—on national retail sales and total consumer spending—that the induced rise in consumer outlays was small relative to the size of the rebate.

Oh boy. Let’s back up a step. Before the fact, here is what people said they were planning to do with their rebates (by at least one report):

081908a_3

So what did the people receiving the rebates do with them? Well, if we could answer that one, it would be easy to resolve the Feldstein vs. Broda-Parker dispute. It does seem undeniable that a pretty good piece of those rebates was saved, at least in the first two months.

081908a_3

Can those elevated saving rates recorded in May and June reflect an outbreak of thriftiness? The real answer is “who knows?” but we can do a little back-of-the-envelope arithmetic to put things in perspective. Ignoring the Katrina-related dip in August 2005, the average saving rate from the beginning of 2005 through this past April was about 0.61 percent.

So, here’s the question: Assuming that consumers saved out of nonrebate income at the rate of 0.61 percent, how much would they have had to save out of the sums distributed in May and June to raise the overall saving rates to the observed values of 4.9 and 2.5 percent?

If you do the annualized calculation for the $43 billion of rebates in May and $28 billion in June you get some pretty striking numbers: An implied saving rate out of the rebates of somewhere in the neighborhood of 83 percent in May and 63 percent in June.

You can argue that there is a sense in which even these figures are understated. Durable goods purchases, for example, are theoretically a form of household saving, and the Broda-Parker survey respondents did indicate that about 20 percent of their rebates went toward the purchase of durables. However, if that is so durable expenditures without the tax rebates would have been really low. Though expenditures on durables grew at an annualized rate of 5.8 percent in May—not bad—they shrank by 17.4 percent in June.

These back-of-the-envelope calculations are pretty rough, of course, but they are broadly consistent with evidence from the 2001 tax rebates. That evidence also suggests that about one-third of the rebates were spent in the quarter following their disbursement, so the spending effects of this year’s model may yet have legs.

On the other hand, even if the rebates do prop up consumer spending in the short run, that would hardly settle the debate about whether they were the best way to spend $100 billion. But that’s a different debate for a different time.

August 19, 2008 in Saving, Capital, and Investment, Taxes | Permalink

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Comments

Looking forward to our class starting next month.

A possibly dumb question from someone who has not had macro in 15+ years, but are the savings rates shown in these charts permanent?

Say I get a check for $1000 and I deposit it in my savings account with the best of intentions, but 2 weeks later I see a great new gizmo I cannot live without and spend the entire amount I had 'saved'.

Initially, I saved the money and later I consumed with it. How does the data handle such a situation? To me, it looks like my actions might be double counted as both saving and spending.

Posted by: Diorex | August 19, 2008 at 06:30 PM

I will bet that not a penny of the rebates will be left in personal or family "savings" by December 24, 2008.

Yes, I read both of your references. Interesting assessments. Not sure what to think. But I will stick with my prediction.

Posted by: Movie Guy | August 20, 2008 at 12:38 AM

I hypothesize that the remainder of the stimulus will be spent in direct relation to a turnaround in consumer sentiment.

Posted by: Marco Loureiro | August 20, 2008 at 08:49 AM

Looking at the 2001 episode, I can see no basis for tha argument that any of the rebate was saved - unless there is another explanation for the downward spike in the saving rate that occurred after the upward spike.

Posted by: don | August 20, 2008 at 04:22 PM

Dave,
1. You state, "the spending effects of this year's model may yet have legs". Does this not miss the point of the stimulus? I thought the point of a fiscal stimulus was to get money in the hands of consumers faster (so they can spend it) than could otherwise be done through monetary policy initiatives.
2. Doesn't this simply prove what you taught us about the marginal propensity to consume? Since the increase in disposable income (tax rebate) is temporary and not permanent, the incentive to increase consumption will be (has been) limited. Perhaps you should teach your Macro course up on Capitol Hill so that we don't have to have this debate in the future!

Posted by: Ken | August 20, 2008 at 08:47 PM

I am not American but I suspect that people spent their money on the petrol and food instead of saving.

Posted by: Man | August 21, 2008 at 01:01 AM

Why is there no discussion of the import share of spending from the stimulus checks? One survey (the Fed's beige book?) said that a lot of the PCE was for electronics, almost all of which are produced abroad. To the extent that the stimulus was spent on imports: the US borrowed money from abroad, sent checks to almost all households, who used a portion of the money to buy imported goods. Brilliant policy! Great for China; not for the US.

Posted by: Charlie Poole | August 21, 2008 at 12:36 PM

A couple of responses: To the question of whether the change in saving is permanent, the simplest response is probably "no.” The evidence of the 2001 tax cut clearly suggests that the "marginal propensity to consume"—that is, the fraction of the extra income spent—is smaller in the quarter the rebates are disbursed than it tends to be over several quarters. Does that run counter to the intent of the policy? I'd be inclined to say "no" here as well: If there is a fairly strong impact on spending for the year as a whole, I would count that as stimulating consumption spending even if the bulk of the impact occurs with a delay of a quarter or two.

The issue of whether or not rebate checks were spent on food and gas is an interesting one. One of the observations in the Parker and Broda study is that sales shifted from traditional grocery stores to supercenter outlets. The latter of course are more likely to sell fuel. As an example, in Wal-Mart's second quarter revenue report, fuel sales accounted for about half of the growth in sales at their Sam's Club stores.

I'll note that it is not too hard to construct a story that an outsized (by which I mean bigger than theoretically predicted) response to spending would be a perfectly rational response if consumers were actually expecting the pullback in oil and gasoline prices that has actually occurred. If the tax rebates are expected to more-or-less match higher energy prices, which themselves are also believed temporary, it would be perfectly reasonable for consumers to react by smoothing the impact on other types of spending by allocating the rebates to their bills at the pump.

As to whether the rebates went to imports, I don't know. The foregoing discussion of gasoline spending would be consistent with that—though China would not be the destination in this case. But more to the point, import growth did fall off substantially in the 2nd quarter, which is actually one of the bigger stories of the year's first half: http://www.marketwatch.com/news/story/economic-preview-big-upward-gdp/story.aspx?guid=%7BA62AF198-2B21-42D7-A11C-601643E74137%7D&dist=hpts.

Posted by: David Altig | August 25, 2008 at 06:02 AM

There is nothing in this post that suggests income tax refunds also start arriving in May,June,and July. Some that may have spent more heavily around that time may have been inclined to put something back from the rebate. This would help explain the pre - May downward spike bfore the upward boost.
Does this data include the entire spectrum of incomes? If so tax refunds were falling on those in the upper brackets, who did not set up their withholdings to minimize government use of their incomes, as well.
That could also affect the savings rate as those in the upper incomes may have been hedging, and their savings rate has the potential of being much higher, enogh to affect the aggragate picture.

Posted by: Dennis | September 18, 2008 at 10:28 PM

How about redistributing purchasing power through the tax system?

Poor people generally spend more of an extra dollar than rich people do. So redistribution can be expected to boost aggregate demand without simultaneously boosting public deficits.

Even weak households can of course be expected to save some of the extra dollars. Given their indebtedness, that’s not a bad thing.

One may argue that poorer people spend their dollars differently from richer. But many products sold lately were anyway meant to satisfy needs for rather conspicuous consumption. More resources must be allocated to the satisfaction of (slightly) more basic demands.

Growing inequality is a major explanation for the crises. For many households credit growth has worked as a substitute for wage growth.

This process will have to be reversed one way or another. We must make sure that wage differentials decreases rather than the opposite. In addition to tax breaks for the weaker households, mortgage assistance is needed.

When you run out of helicopters, distribute fresh money through increased unemployment benefits. This will improve the bargaining power of the weakest employees. But make sure the informal economy doesn’t explode. ID-cards for all wage earners are needed!

Jan Tomas Owe
Norway

Posted by: Jan Tomas Owe | January 13, 2009 at 08:12 AM

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