Strangely Liberating

Working on my taxes recently reminded me of a fun discussion I had with the late Stephen Williams, a judge on the United States Court of Appeals for the District of Columbia. (He’s pictured above.) I never met him and we mainly corresponded by email. After I told him that in December 2017 I had doubled my usual charitable contribution to the Institute for Justice so that I could get the tax deduction one last time (due to the 2017 tax cut law), we went back and forth.

Here’s the email thread with Steven in box quotes:

Last chance for taking deduction because of increase in the standard
deduction/exemption?

Steve

 

Yes on both. My state and local tax deduction is limited to $10K, our mortgage balance is so low that our annual mortgage interest is less than $3K, and my normal charitable deductions are around $2K. So I don’t come close to $24K.

Best,

D.

So here’s the big question on the tax-elasticity of donations:  Will you maintain your historic level?  (Of course one swallow doesn’t make a summer, or one donor a supply curve.)

Steve

Dear Steve,

Hey, I thought I was talking to a judge, not a literate economist. 🙂

That IS the question, isn’t it. I’m not sure of the answer. 2019 will tell. One little difference I’ve noted already: In 2018 I’ve given small amounts (I think $50 in each case) to 2 go fund me sites (one a woman who is a friend of a friend of a friend facing cancer with few financial resources and one a state employee in Montana who quit his job rather than cooperate with ICE in turning in workers). I probably would have given to neither of those causes but instead would have looked around for a tax-deductible charity that mimicked, as close as possible, the same ends. Not worrying about the tax consequences felt strangely liberating.

Best,

David

I especially like your last sentence!

Steve

As it turns out, I was back a little higher in 2019 than in my normal pre-2017 charitable contributions.

I said time would tell. Well, 2020 shouted. Going through our charitable that can be deducted, I found a little over $3,000. But my wife and I each gave between $3,000 and $4,000 to various people who suffered hardship because of the lockdowns. And yes, it was strangely liberating to do it with no thought of tax consequences.

 

 

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Alice Rivlin on Bracket Creep

In yesterday’s post on Alan Blinder and inflation-induced bracket creep, I promised to tell this story.

At the American Economic Association meetings in New York in December 1988, there was a session on economic policy and the economy. A number of major economists presented, but the two I remember clearly, because I asked them both questions, were Alice Rivlin and Joe Pechman. I’ve sometimes referred to Alice as “my favorite liberal economist” because she had a no-nonsense, clear-eyed view of things (although I think she never gave supply-side cuts in marginal tax rates their due.) But that was after I started following her work during the Clinton administration, when she was deputy director and then director of the Office of Management and Budget.

In her talk at the AEA meetings, Alice noted that there just hadn’t been nearly as much controversy about raising taxes to prevent major federal budget deficits in the late 1970s, when she was director of the Congressional Budget Office, as there had been from the mid-1980s to the year we were in, 1988. She stated it as if it were a puzzle. To me, it wasn’t a puzzle at all. So I stood up and asked the following (of course I’m going from memory here):

Dr. Rivlin,

You stated that there wasn’t nearly the controversy about raising taxes to reduce the deficit in the late 1970s as there is now, but isn’t there an obvious answer? Inflation in the last half of the 1970s averaged high single digits and the federal income tax brackets were not indexed for inflation. So inflation plus non-indexing assured that federal government revenues grew substantially every year, even without explicit legislated tax increases.

She answered, “Well, there’s that.”

When I had a chance to talk about this in my class when it was relevant to our discussion of bracket creep, I quoted her “Well, there’s that.”

Funny story: The next day after I quoted her in class, a sharp student caught me out on some important causal factor that I had left out of another discussion unrelated to bracket creep. I hesitated, thought through it, and then admitted his point. Another student piped up, “Well, there’s that.” We all got a good laugh.

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Alan Blinder’s Tin Ear on Inflation

I’m taking Jeff Hummel’s Masters’ course in Monetary Theory and Policy. Two lectures ago, he discussed the costs of inflation and highlighted Greg Mankiw’s discussion of it in Greg’s Intermediate Macro text. Greg covered many of the bases but the tone of his treatment suggests that he doesn’t think high inflation, even when it exists, is much of a problem. He compares the views of the public and the views of economists on the issue and finds the views of the public deficient.

Jeff disagreed and highlighted three areas that Greg left out. One is that inflation presents a “signal extraction” problem, making it difficult for people to know whether and by how much relative prices have changed. The second is that high inflation virtually always tends to be variable, and for a given mean inflation rate, variable inflation is more destructive than constant inflation. The third is that inflation is a tax. Greg dealt with that issue but focused on the deadweight loss from the tax rather than the DWL plus government revenue from the tax. When you look at how non-economists think about other taxes, you see that they care about the fact that the government is getting revenue from them. That seems like a reasonable concern, whether the revenue generator is a sales tax or an inflation tax.

Greg did note that inflation creates apparent capital gains (I call them “phantom gains”) that are not gains at all. You buy a stock for $100, inflation is 10%, you’re in a 20% capital gains tax bracket, the stock holds its real value at $110 a year from now, you sell the stock for $110, and you pay $2 in capital gains tax. You’re left with $108, which, inflation-adjusted, is worth $98.18, which is less than what you paid for it a year ago.

I assume that Greg focused on the capital gains tax rather than income taxes because Reagan and Congress, in the Economic Recovery Tax Act of 1981, implemented indexing of tax brackets for inflation, effective in 1985. But there are a few things to note. First, other things besides the capital gains tax are not adjusted for inflation. The thresholds after which you pay taxes on your Social Security income have not been adjusted for inflation in 3 decades. Second, the income cutoff beyond which you can’t contribute to a Roth IRA is not adjusted for inflation. Third, many state governments have not adjusted their tax brackets for inflation.

The discussion in class reminded me of two people. The first is Princeton University economist Alan Blinder.

Blinder, even more than Greg Mankiw, missed people’s upset about inflation in his 1987 book, Hard Heads, Soft Hearts. I reviewed it in Fortune, November 9, 1987. Here’s part of what I wrote on the issue.

In discussing employment and inflation, Blinder says we worry too much about inflation. He estimates that for every percentage-point reduction in the inflation rate, we must accept a two point or so increase in the unemployment rate for one year. Blinder says that is too high a price to pay, and launches into an argument about the true cost of inflation, which, he says, noneconomists tend to exaggerate. If inflation is running at an 8% rate while real wages are rising by 2%, people’s money wages will increase by 10%. The noneconomists among them will attribute the whole 10% gain to their own increased productivity [DRH note: I’m not sure he’s right; I never met this mythical non-economist] and will feel that inflation robbed them of the other 8%. They weren’t robbed at all, Blinder argues: 2% is all they were entitled to, and 2% is what they got.

That argument is incomplete, however. Before 1985 people were being robbed because individual income taxes were not indexed: Inflation kept bumping people into higher margin tax brackets, thus enabling the Treasury to steal some of the income they were entitled to. Blinder acknowledges this difficulty and says at one point that a failure to index the tax system can impose “sizable costs.” But then he turns around and says that unless you are an economist or accountant, this cost “will leave you yawning.”

Where was Blinder during the late 1970s? I knew people with only a high school education who noticed instantly that an 8% increase in their hourly rate translated into only a 6% or so increase in their take-home pay, not enough to stay abreast of inflation. They didn’t yawn when that happened–they got mad, which is one reason taxes ended up being indexed.

By the way, in writing this, I had in mind a discussion I had with a high school graduate named Chrissy Morganello, who was a secretary to three other faculty members and me from 1975 to 1979, when I was an assistant professor of economics at the University of Rochester’s Graduate School of Management.

Here, by the way, is Blinder’s first rate article on “Free Trade” in David R. Henderson, ed., The Concise Encyclopedia of Economics.

Next up: Alice Rivlin’s blasé attitude about high inflation in the 1970s.

 

 

 

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Dean Baker on wealth

In the past, I’ve poked fun at progressives who don’t seem to know what they want. The wealth tax on luxury yachts was repealed partly at the behest of progressive politicians that worried it might cost jobs in the yacht building industry. But unless you destroy jobs producing consumption goods for the rich, it is literally impossible to use their resources to help the poor.

Dean Baker is one progressive who does understand this point:

If we think of the prospects of reducing consumption with a wealth tax, they don’t look very promising. Consider our latest round of incredibly rich people, like Elon Musk, Jeff Bezos, and Mark Zuckerberg, all of whom have over $100 billion in wealth. While I am sure these people all live very well, I doubt they spend substantially more on their own consumption in a year than your typical single-digit billionaire. There are only so many homes you can live in, cars you can drive, trips you take, etc.

This means that if we taxed away 10 percent, 20 percent, or even 50 percent of their wealth, it will have very little impact on their consumption. This means that it will not get us very far in freeing up resources for an expanded social welfare state. We will not be able to pay for Medicare for All or free college by taxing away these people’s wealth, we will have to focus on policies that reduce the consumption of a far larger group of people.

Of course just because a wealth tax is bad doesn’t mean that taxing the consumption of the rich is necessarily any better.  I favor a progressive consumption tax, but there are also reasonable arguments against the idea.  My point is that the rich basically can do three things with their wealth: consumption, investment and charity.  Progressives tend to deny that government spending crowds out investment, and they presumably don’t want the funds to come out of charity.  So that leaves consumption.  Either accept that you are trying to destroy jobs in the production of luxury goods, or else give up all hope for economic redistribution.

The essay is full of lots of other great observations:

If we stacked everyone in the world by wealth, going from richest to poorest, those at the very bottom would be recent graduates of Harvard business and medical school. I’m not kidding. Many of these people have borrowed hundreds of thousands of dollars to pay for their education. Most of them have few if any assets. This means that on net, they are hundreds of thousands of dollars in the hole.

Do we really want a definition of economic wellbeing that says a recent HBS grad is much poorer than homeless person in Calcutta?

And this:

The money in a retirement account is included in standard calculations of wealth. Traditional pensions generally are not. (We can impute values for these pensions, but this is generally not done in most wealth calculations.) This leads to a story where we would say that a person with a 401(k) is much wealthier than a person with a traditional pension, even if they have no better prospects for retirement income.

PS.  I have a new piece in The Hill on asset price bubbles.

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What is Equity?

In a comment on one of my recent posts, co-blogger Scott Sumner quotes my statement:

But implicit in his discussion is the idea that equity is synonymous with income equality or, at least, reduced income inequality. That’s not my view. My view is that people are treated equitably when other people don’t take their stuff.

Scott then writes:

That’s fine as a definition, but in that case I’d just use a different term.  Even if I accepted your definition of “equity”, it would not change my views on Romney’s proposal at all.  I’d just replace “equity” with “income equality” in my post, and otherwise keep the argument the same.

If he had stopped there, we wouldn’t have had a disagreement, except that we have very different views on the desirability of Romney’s proposal.

But then Scott writes:

I think my use of equity is consistent with how it’s used in economics textbooks when they discuss the equity/efficiency trade-off.

That’s a bridge too far.

It is consistent with how it’s used in some, possibly many, economics textbooks. I found words to that effect, for example, in Jack Hirshleifer’s microeconomics text. But some, maybe many, economics textbooks give a few versions of “equity.”

Here are two examples, and I didn’t have to look hard in my remaining few economics textbooks to find them.

In the 9th edition of their textbook Economics: Principles and Policy (2003), William J. Baumol and Alan S. Blinder consider various versions of equity. The two most directly related to this discussion are the concept of “vertical equity” and the benefits principle.

The version of the vertical equity principle they discuss is the “ability-to-pay principle,” which says that “those most able to pay should pay the highest taxes.” But they then give examples of a progressive, a proportional, and a regressive income tax system, in all of which those most able to pay do pay the highest taxes. So that’s not guidance that leads you to income equality or even to reducing income inequality.

The other equity principle they discuss is the “benefits principle,” which says that “those who reap the benefits from government services should pay the taxes.” They note that this principle of fair taxation “often violates commonly accepted notions of vertical equity.”

You can see why. Bill Gates gains a lot from national defense, but does he gain much from U.S. foreign policy, which tends to be focused on national offense? Or even more obviously, does he gain from the existence of the SNAP (food stamp) program?

In the 5th edition of N. Gregory Mankiw’s Principles of Economics (2009), there’s a similar discussion. Indeed, Mankiw uses examples of progressive, proportional, and regressive tax systems, all of which cause those with higher incomes to pay more taxes.

Mankiw also discusses the benefits principle and even argues that it could be used to justify taxing higher-income people more for anti-poverty programs, on the grounds that reducing poverty is a public good. Whether or not you think this is a stretch, the point is that we still don’t get to the conclusion that high-income people should pay a larger percent of their income.

And notice that neither of the two textbooks equates equity with income equality.

 

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Mitt Romney’s Expensive and Unfair Child Allowance

Co-blogger Scott Sumner argues for, without quite endorsing, Senator Mitt Romney’s proposal for a large child allowance. I won’t lay out the specifics of Romney’s proposal in detail because Scott has already done it and the Tax Foundation has provided even more details.

I will point out that the budget cost of the plan, all else equal, is estimated to be about $229.5 billion annually. While that might not sound like a lot in this time of trillion-dollar spending programs, it is a lot.

Of course, not all else is equal. If Romney got his way, the child care tax credit would be eliminated, which would save $117 billion annually, leaving $112.5 billion as the net cost. He would also reform the Earned Income Tax Credit, saving $46.5 billion annually, driving the net expenditure for his plan down to $66 billion.

He would come up with the $66 billion by increasing taxes in three ways and cutting two other spending programs.

While the Tax Foundation did an excellent job of analyzing the provisions of the Romney plan, it did make one error. The analysts, Erica York and Garrett Watson, state:

Romney estimates eliminating the SALT deduction would result in $25.2 billion in annual savings through 2025.

But eliminating the SALT deduction doesn’t save money: it costs money. It costs taxpayers who will lose the deduction. Of course, York and Watson may be quoting Romney and so it may be Romney’s mistake. But it is a mistake.

Note also that the child allowance starts phasing out for single taxpayers with income about $200,000 and for married, filing jointly taxpayers with income above $400,000, at a rate of $50 per $1,000 in income. That implies that very high-income people, virtually all of whom are already in a fairly high federal tax bracket, will see their marginal tax rates increase by 5 percentage points. That’s if they have 1 child. And if they have 2 children, their marginal tax rates will be 5 percentage points higher over an even larger range of income than the Tax Foundation’s graph shows.

Most of these high-income people will be in a 35 percent tax bracket. This phase-out increases their marginal tax rate by 14.3 percent (5 is 14.3 percent of 35). The efficiency loss, also called deadweight loss (DWL), from taxes is proportional to the square of the tax rate. So the 14.3 percent increase in the marginal tax rate doesn’t increase DWL by 14.3 percent. It increases it by 30.6 percent. (Take 0.4 squared divided by 0.35 squared and you get 1.306.) That’s a large increase.

And why all this? Why does it make sense to subsidize people having children?

Two other points.

First, although Scott Sumner says that the proposal will increase equity, he doesn’t define equity. But implicit in his discussion is the idea that equity is synonymous with income equality or, at least, reduced income inequality. That’s not my view. My view is that people are treated equitably when other people don’t take their stuff. Romney would tax people more when they live in high-tax states and thus lose their deduction of state and local taxes. That’s not fair. (I think, along with Scott, that the SALT deduction should be zero, but in return, marginal tax rates for high-income people should be cut.)

Second, what happened to Romney’s fear, which he once had, of the deficit. The budget deficit is huge this year and, although it will likely be lower next year, it is set to be at least $1 trillion annually for a long, long time. We should be looking at paring down “entitlements” such as Social Security, Medicare, and Medicaid, not adding new ones.

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The equity and efficiency of SALT cap repeal

There’s currently some discussion in Washington DC about repealing the limitation on the deductibility of state and local taxes (from one’s federal taxes.) Back in 2018, the US government began limiting SALT deductions on federal income taxes to no more than $10,000/taxpayer. Repeal of this provision would have effects on both economic efficiency and economic equity:

Efficiency:

Repeal would cause many more people to itemize their taxes, which would increase the time and money costs of preparing taxes. It would also drive a wedge between the local cost of state and local spending and the total cost. Thus 70% of the cost of a $1 billion government project in New York or California might be paid for by local taxpayers, while the other 30% would be paid for by taxpayers in all 50 states. This would push states toward projects that don’t pass cost/benefit analysis, but that might seem desirable if one ignores the external costs imposed on out-of-state residents.  An example might be high-speed rail in California.

Equity:

Repeal of the SALT limitation would reduce taxes on upper income taxpayers. Because there is no free lunch, other taxpayers would have to pick up the slack.  If we run large budget deficits, then future taxpayers would absorb the bill.

PS.  Because I live in California, I would pay less in taxes if SALT limits were repealed.  However, my taxes would become much more complicated in terms of required record keeping, so I doubt I’d be any happier.  Don’t just think in terms of “who pays”; a successful country is one that avoids lots of needless deadweight losses.

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Charles Barkley Articulates the Benefit Principle

There are various versions of the benefit principle of taxation. One is the James Buchanan/Knut Wicksell version, which says that to get unanimous agreement for a government expenditure, you need to have people pay an amount in taxes that is less than the benefit they perceive.

That’s not what former NBA player Charles Barkley articulates but nevertheless he does state a reasonable version of the benefit principle.

Barkley said yesterday that NBA, NFL, and NHL players should get the vaccine right away because of the huge taxes they pay. He stated:

As much taxes as these players pay, they deserve some preferential treatment.

When Kenny Smith challenges him by saying “the amount of money you make” and then trails off but is clearly about to say that one’s income shouldn’t be a consideration in when one gets the vaccine. But Barkley stays on message saying, “I said taxes; I didn’t say the amount of money you make.” Kenny’s making the point that those are highly connected but Charles is right to keep it focused on his point. This is something that taxpayers paid for, players in those three leagues pay a lot of tax per person, and, therefore, they should bet preferential treatment.

There are two other reasons to give them preferential treatment.

First, as my Hoover colleague John Cochrane emphasizes, it’s important to get the vaccine early to those who would be superspreaders. The players are virtually all young and many of them have active social lives. So, simply from the externality viewpoint, they should get preferential treatment.

Second, and I think this is a weaker argument, various state governments have dictated the various things we can’t do together. One of the ways left is TV. We hear every day about this or that game that is postponed because of players having tested positive. My own Golden State Warriors won’t be playing tonight against the Phoenix Suns because of “ongoing contact tracing” of the Suns. More games; more entertainment; lower loss from the lockdowns.

Finally, note that if vaccines were allowed to be sold on the market, almost all players would have them by now and, of course, so would other people now in the queue. The slowness of the queue is due to government.

HT2 Tyler Cowen.

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Joe Stiglitz on Taxing Interest

This is another in my continuing series of excerpts from Joseph E. Stiglitz’s excellent 1988 textbook, Economics of the Public Sector. I’ve previously posted about this textbook here and here.

Thus an income tax that taxes interest can be viewed as a differential commodity tax in which future consumption is taxed more heavily than current consumption. The question of whether it is desirable to tax interest income is then equivalent to the question of whether it is desirable to tax future consumption at higher rates than current consumption.

Just as, with a well-designed income tax, there may be little to be gained by adding differential commodity taxation, so too there is little to be gained from taxing consumption at different dates at different rates. This means, in effect, that interest income should be exempt from taxation. An income tax that exempts interest income is, of course, equivalent to a wage tax, and we showed in Chapter 17 that a wage tax was equivalent to a consumption tax (in the absence of bequests. This suggests that it may be optimal to have a consumption tax.

That’s very tight reasoning on Stiglitz’s part.

Even though I hate taxes, I love analyzing the economics of taxation.

Co-blogger Scott Sumner is, I believe, an advocate of consumption taxes. If you’ve read me closely over the years, you’ll know that I’m not. I’ve been very critical of a VAT, for example, which comes close to a consumption tax.

So why am I not a fan? Because the analysis of a VAT that finds a VAT to be superior, on efficiency grounds, to other taxes, holds constant something that empirical evidence says should not be held constant: the amount of revenue raised. Because VATs tend to be less visible, they lead to less political resistance and result in a much larger amount of government tax revenue and government spending. Because so much of government spending is inefficient–how much do you value, relative to cost, the occupation of Iraq and Afghanistan or defending wealthy Germany or the middle-speed train in California’s central valley or agricultural subsidies?–the inefficiencies from higher government spending probably outweigh the inefficiency of a less-efficient form of collecting government revenue.

 

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Connect the dots

In recent months, a number of important firms have announced they are relocating from California to Texas. An article by Peter Yared discussing this trend had a graphic that caught my eye:

The movement of these industries is toward three states that have one thing in common—no state income tax. And these are the only three states with no income tax in the southeastern quadrant of the US—say Texas to Florida and south of the Ohio River.

Progressives often discount the supply side effects of tax changes, pointing to examples such as Kansas where tax cuts had little effect.  But Kansas lacks the sort of big cities that would typical draw these firms and its tax cuts were relatively modest.  If you are looking for a low tax state on the Great Plains, South Dakota has no state income tax at all.  The top rate in Kansas (5.7%) is higher than in Massachusetts (5.0%).  That won’t get the job done.

Miami clearly benefits from a mild climate, but Tennessee and Texas have climates that are only average for a southern state.

I’m certainly not a rabid supply sider who thinks that tax rates are all important.  But a person would have to be pretty blind to ignore the migration of firms from places like New York, New Jersey and California, to lower tax places.

Interestingly, Washington State has no income tax, which is unique for a northern state with a big city.  Washington is also home to the two of the three richest people on the planet (the other–Elon Musk–just announced he’s moving from California to Texas.)  Beyond these anecdotes, Washington is also experiencing rapid population growth, which is unique for a northern state with a big city.  Indeed it’s growing even faster than Oregon, which has a slightly nicer climate.

There’s no doubt that climate has been reshaping America in the decades since air conditioning was invented, with people moving to warmer locations.  But for the first time ever (AFAIK), California saw its population fall last year, and it has a delightful climate (even with the recent forest fires.)  High tax Hawaii also lost population.

So while people are gradually moving to warmer locations, state tax policies explain why certain states attract a disproportionate share of the migrants.  Indeed, last year more that half of the US population growth occurred in just two states—Texas and Florida.  I believe that’s the first time that has ever happened.  Add in Tennessee and Washington and you are at nearly two thirds of the nation’s population growth.  Recent limits on the deductibility of state and local taxes has exacerbated this trend.

PS.  Technically, Tennessee has no wage tax.  However, they do tax interest and dividends at 1%.  But even that small tax is being phased out at the end of this year.

PPS.  Yes, housing policies are another big factor in migration—especially for the middle class.

Happy Holidays everyone!

 

 

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