Three Economists Walk Into a Discussion, Part 1

On September 15, the Stanford Institute for Economic Policy had a virtual discussion about both Covid-19 and the views of the two major presidential candidates. The moderator was Gopi Shah Goda of SIEPR and the two interviewees were Kevin Hassett, who had been chairman of the Council of Economic Advisers under President Trump and Austan Goolsbee, who had had the same job under President Obama.

I watched it live.

I’ll hit some highlights and make some comments. This is Part 1.

At 4;24, Goda asks: “What are the right economic policies to provide relief to those whose livelihoods have been adversely affected by the pandemic and stimulate the economy? How much spending should we do in the short run on Covid relief issues like extended and extra unemployment and stimulus payments?”

She started with Kevin, and I got my first big disappointment. Notice that she asked two questions. Kevin, though, answered only the second. He gave a big number for spending and didn’t mention any other means of relief: deregulating, letting people work in occupations without having to get a license, allowing restaurants to sell food, allowing restaurants to open, getting the FDA to allow people to use home tests for the coronavirus.

And his number for additional federal spending was big: $1.5 to 2.5 trillion.

Goolsbee’s answer was what I would have predicted: lots more federal spending and a big bailout of state and local government.

14:50: Kevin defines classical liberals like me out of the discussion with “I don’t think there’s anyone who thinks there shouldn’t be state and local aid.”

15:10: Austan gets it right: There are a great number of people who are opposing state and local aid.

17:10: Austan has a funny line that riffs on the old can opener joke: “This is not just ‘assume we have a can opener; let’s assume we have the greatest of all can openers.’” Then he says that you wouldn’t want to use the price system to allocate the vaccine.

23:43: Goda asks about the differences between the two candidates’ tax policies.

24:20: Austan says that Biden wants to raise taxes on high-income people and on corporations. What’s important, he says, is what the money is used for. If the added revenue were used to provide universal child care, that would be very pro-growth, says Austan.

But wait. This is not a discussion between politicians. This is a discussion between economists. What’s the market failure that would justify government provision of child care? Austan doesn’t  even mention one. If my wife and I, when we were younger, had wanted to hire child care so she could work, we would have compared her after-tax income to our net-of-child-care-tax-credit cost of hiring child care. I showed in a piece in the Journal of Policy Analysis and Management in the late 1980s that the structure of the tax credit at the time could be seen as a way of offsetting the distorting high marginal tax rate of the second earner, typically the women. But Austan isn’t making that argument; in fact, for high earners, he wants an even higher marginal tax rate. Moreover, various changes in the tax law have been the tax credit much less pro-growth.

At about the 25:00 point, they get into a real substantive discussion about what happened to real wages and real family incomes after the tax cut. They literally disagreed about what the numbers were. Austan said that the effects of the tax cut on real median family incomes were disappointing. Kevin said that in a debate with Austan in Philadelphia a few years earlier, he had predicted that real median family income would rise by $4,000 and that the data that just came in (which were pre-pandemic), the number was actually a $4,900 gain. Kevin also pointed out that over 6 million people had moved out of poverty, the biggest drop since the War on Poverty had begun under LBJ. Kevin also pointed out that he had predicted that income inequality would fall as a result of the 2017 tax cut and that it had fallen.

Aside for non-economists: Why would reductions in income tax rates on corporations and on high-income individuals even be expected, at a theoretical level, to increase real wages? By increasing the incentive to invest in capital. The greater the capital to labor ratio, the higher are real wages.

29:10: Kevin catches Austan’s characterization of the proposed Biden tax hike as an increase in taxes on billionaires. Kevin points out that it would apply to people making over $400K annually. He then expresses optimism that Biden will hold off on raising marginal tax rates, due to the state of the economy.

31:00: Here is where Austan gives numbers on increases in real median family income that differ dramatically from Kevin’s data.

Aside:  As a viewer, I was able to type a question on line and I did. We learned near the end from Goda that a number of viewers had asked a similar question and it was this: “You two are disagreeing on actual facts; show us your sources.” I asked Mark Duggan, the SIEPR director, for the source and he sent me the link to the Census data that Kevin had cited. Kevin turned out to be right about the large growth in median family income of families, including black and Hispanic families. I’m still scratching my head about what data Austan had in mind.

32:00: Kevin says that growth in median real family income in the first 3 years of Trump vastly exceeded any 3-year period under Obama.

32:10: Goda lays out the deficit issue nicely and asks about the two candidates’ plans.

In Part 2, I’ll cover the rest of the discussion.




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Evidence that We’re Better Off Than in the 1960s, #2976

Those of you who read Don Boudreaux over at CafeHayek know that he often gives evidence that the average American is way better off than his/her counterpart in the 1960s, 1970s, and 1980s.

This is my story comparing now to the 1960s.

I was talking to a California friend recently and we were both belly-aching about state and local governments’ assaults on Californians’ freedom. The biggest ones right now are the lockdowns. (Parenthetical note: Governor Newsom’s new purple standard is absurd. It treats the whole of a county the same even though there’s incredible heterogeneity within a county. Monterey County’s average number of cases over the last 7 days is 15.6 per 100,000 residents, putting us in the purple zone. But Monterey Peninsula’s 7-day average is 3.6, which would allow us to jump up 2 zones to orange.) But even when the lockdowns end, California is one of the least economically free states in the union.

Back to our conversation. My friend was saying that he wants to move to a freer state and is considering New Hampshire. New Hampshire has no income tax and no sales tax and much less regulation. My immediate reaction, though, was to remind him how cold it is and how long the winter lasts. I grew up in rural Manitoba, where, I pointed out, it sometimes hit 40 below and at that temperature it didn’t matter whether you were talking Fahrenheit or Centigrade. I told him that in 20+ years of living in Manitoba I never got used to the cold. I was ready for winter weather to end by mid-February but it usually went to late March and occasionally early April.

Then I caught myself. I pointed out that people in Canada have it so much better than their counterparts of 50+ years ago: they can fly to Florida or Mexico for a week or even 2 weeks in late January or early February and that gives them a much-needed break from the winter. And many of them do. By contrast, when I was growing up, if someone suggested flying down south for even a week, it seemed no more plausible than flying to the moon. Maybe our family could have afforded it, but then we would have had to give up Christmas and about 2 years of my father’s saving for his 3 kids to go to college. (2 of us did.) My Uncle Fred and Aunt Jamie, however, typically went to Nassau for a week or two in the winter. He was a doctor and could easily afford it.

The world has changed.

A big part of the reason is that real incomes have gone up a lot. Another reason is that real air fares have plummeted, due both to improved technology and to massive deregulation. I pointed out to my friend how lower air fares have affected stag parties for guys getting married. I remember going to one for a friend in 1982 or 1983. Everyone there lived within 20 miles of the groom. There were drinks and food and a stripper. (That was actually the only stag party I ever went to and even though I found the stripper attractive, that’s not my idea of a good time. When she was getting dressed I asked her about the economics of her business and how she dealt with personal security.)

Today, guys will have a stag party in Vegas and people will fly in from other states.

Maybe stag parties for you, as for me, aren’t your thing. Then consider this. I taught at the University of Rochester Graduate School of Management from 1975 to 1975. I became friends with one of my students, who started dating, after she graduated, one of my colleagues. In the fall of 1980, Jeff, my colleague, called me to tell me that Laurie had died of cancer. I called an airline to price going back fro the funeral. I still remember the stunning air fare: $800 round trip. I could do it, but I was spending more each month than I was earning at Santa Clara University. So I would need to take $800 out of my low and diminishing savings. I decided not to. Do I regret the decision? No. But I regret that air fares weren’t lower. To put that $800 in perspective, it would be $2,450 today. Now I realize that the CPI overstates inflation by about one percentage point a year. But that would still make it about $1,400 today.

The world has changed and, economically, much for the better.

Back to the weather. If my wife would go for it, I could live in many states in the union and do fine by flying out for a few weeks here and there during the bad-weather parts. I would even consider South Dakota.



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The Fascinating Federalism of Capital Gains Taxes

Or, Why California Governor Gavin Newsom Should Hope that the Federal Capital Gains Tax Rate is Not Increased

One thing that economists are fairly sure of is that a cut in the tax rate on capital gains increases the amount of gains subject to the tax and that, conversely, an increase in the tax rate on capital gains decreases the amount of gains subject to the tax. This is especially true in the short run.

This is so because capital gains taxes are levied in the United States only when the capital gains are realized, i.e., when the asset is sold, and the decision about whether to sell the asset is up to the owner.

Here’s how George Washington University economist Joseph J. Cordes put it in, “Capital Gains Taxes,” in the first edition of my Concise Encyclopedia of Economics:

Because capital gains are not taxed unless an asset is sold, investors choose when to pay the tax by deciding when to sell assets. Payment of the tax can be delayed by holding on to an asset with a capital gain, which is financially worthwhile because the amount owed in taxes remains invested in the asset and continues to earn an investment return. Payment of capital gains can be avoided altogether if an asset is held until death. After weighing the advantages of not selling, a rational investor may conclude it is better to keep an asset rather than sell it. When this happens, the capital gain becomes “locked in.” No tax is collected because no capital gain is realized through sale. The gain from staying locked in is greater at higher tax rates, so that the volume of capital gains that are realized falls as the tax rate rises, and vice versa.

Cordes notes that this point is made by proponents of the view that decreasing capital gains tax rates increases capital gains tax revenue, but the point holds whether or not the net effect is to increase tax revenue.

Cordes points out that the net effect on capital gains tax revenues from cutting the capital gains tax rate will depend on how sensitive capital gains realizations are to the capital gains tax rate. If they rise by a higher percent than the percentage drop in the tax rate, that is, if realizations are highly elastic with respect to the tax rate, then capital gains tax revenues will rise. And if they aren’t very sensitive, capital gains taxes will fall. It’s an empirical issue and Cordes deals nicely with the state of knowledge at the time he wrote, namely in the early 1990s.

Stephen Moore makes the same point about capital gains realizations in “Capital Gains Taxes” in the second edition of the Concise Encyclopedia of Economics. He writes:

The capital gains tax is different from almost all other forms of federal taxation in that it is relatively easy to avoid. Because people pay the tax only when they sell an asset, they can legally avoid payment by holding on to their assets—a phenomenon known as the “lock-in effect.”

The effect is symmetric: If the federal government increases the tax rate on capital gains, as Democratic candidate Joe Biden proposes, the effect will be to make capital gains realizations lower than otherwise. Biden proposes to increase the top marginal income tax rate on long-term capital gains to 39.6 percent for taxpayers earning more than $1 million annually. The 39.6 percent is the same rate Biden would have on the ordinary income of the highest-income taxpayers. The top federal tax rate on ordinary income is now 37 percent and the top federal tax rate on long-term capital gains is now 20 percent. (Although, as Scott Eastman of the Tax Foundation points out, “Individuals with Modified Adjusted Gross Income surpassing $200,000 ($250,000 for married couples) pay an additional 3.8 percent tax on net investment income.)

In short, Biden’s proposed tax rate increase on capital gains is huge, especially for the highest-income taxpayers, who, by the way, have a large percent of overall capital gains.

Here’s what’s not ambiguous: the result of an increase in the federal tax rate on capital gains would be less capital gains tax revenue for California’s state government.

California’s government taxes capital gains at the same rate it taxes ordinary income. With lower capital realizations by California residents, the state government will get less tax revenue from capital gains taxes than otherwise.

And California’s government relies more on capital gains tax revenues than many other states do. In 2019, the latest year for which we have the data, capital gains tax revenues, at $13.8 billion, were 9.5 percent of general fund tax revenues.

Which is why Gavin Newsom, who is facing a large state government budget deficit (although he has substantially overstated it) should hope that whoever is elected in November will not raise the federal tax rate on capital gains.



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The Biden tax plan

With Joe Biden now favored in the election betting markets (albeit far from a sure thing), it’s time to take a look at his tax plan. Here are some of his proposals to change the personal income tax:

Imposes a 12.4 percent Old-Age, Survivors, and Disability Insurance (Social Security) payroll tax on income earned above $400,000, evenly split between employers and employees. This would create a “donut hole” in the current Social Security payroll tax, where wages between $137,700, the current wage cap, and $400,000 are not taxed.[1]

Reverts the top individual income tax rate for taxable incomes above $400,000 from 37 percent under current law to the pre-Tax Cuts and Jobs Act level of 39.6 percent.

Taxes long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6 percent on income above $1 million and eliminates step-up in basis for capital gains taxation.[2]

Caps the tax benefit of itemized deductions to 28 percent of value, which means that taxpayers in the brackets with tax rates higher than 28 percent will face limited itemized deductions.

The first item is something I’ve long favored—higher wage taxes on the rich.  In the long run, a progressive wage tax is identical to a progressive consumption tax, although due to tax avoidance they might not be identical in practice.   This tax will raise a great deal of revenue, and more revenue will certainly be needed due to the recklessly large budget deficits in recent years.

The second item is a mistake, in two ways.  First, it’s simply not true that the top rate on federal personal income taxes is currently 37%; it’s over 40%.  The US has two personal income tax systems (itself a really foolish idea) and we should count both systems when computing the top rate of federal income taxes.  It’s also a mistake in the sense that raising the top rate also raises taxes on capital income—a bad idea.

The third item is really stupid idea.  And I don’t mean “stupid” in the sense of “I strongly disagree”. I mean stupid in the sense that it implies a lack of understanding of basic public finance concepts.  Capital income has already been taxed once as wage income, and is thus being double taxed by capital income taxes.  In addition, we tax nominal capital income.  Even if I am wrong and there is some “second best” argument for taxing capital income, you certainly don’t want to tax it at exactly the same rate as labor income. Setting both rates at precisely 39.6% (actually even higher), would like saying that since apples and oranges are both fruit, there should be a law requiring stores to sell apples and oranges at exactly the same price.  Even in the unlikely event that there is an argument for price controls on fruit, it’s almost inconceivable that the optimal price ceiling is identical for all types of fruit.

We need to transition from an income tax to a consumption tax.  One way of doing so is by removing all limits on 401k plans.  Allow unlimited contributions and allow withdrawals at any time, which would effectively eliminate taxes on capital income.  This approach may not be the most efficient, but it at least makes it obvious to voters that this money has been taxed once, and doesn’t need to be double taxed. Once you do that, you can make the overall system more progressive than today, without killing off capital formation.

It’s a good idea to cap the deductions at 28%, but an even better idea would be to cap them at zero percent.  In other words, move toward a system with only a standard deduction.  The tax reform of 2017 moved us a good distance toward eliminating deductions, but many in Congress want to bring them back.  To his credit, Biden doesn’t propose doing so, but I fear he’ll be pressured by Congress to undo the tax simplification of 2017, which caused the vast majority of people to shift to the (simpler) standard deduction.

Increases the corporate income tax rate from 21 percent to 28 percent.

This is a bad idea, but it does tend to confirm a point I’ve been making for years.  Back in 2017, I claimed that Hillary Clinton would have reduced the corporate rate to 28%, and this seems to confirm that 28% is the preferred rate of the Democratic Party.

There are lots of other minor suggestions, of which this seems to be the best:

Expands the Earned Income Tax Credit (EITC) for childless workers aged 65+

There are also lots of missed opportunities, such as a carbon tax.  Overall, I’m not a fan of Biden’s plan, and hope the Senate can block the more counterproductive changes.  But I fear the opposite—the worst aspects of the plan might be adopted, without the better suggestions.  Pray for gridlock.


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What does it mean to say a debt is “unsustainable”?

I often warn against countries running up excessively large public debts. Some people interpret my worry as a prediction of a future financial crisis, perhaps including default and/or very high inflation. They point out that countries such as Japan have run large deficits for many decades, with interest rates on long-term bonds remaining near zero. So are these worries overblown?

For developed countries with their own currency my actual fear is not outright default, or even hyperinflation. Rather I fear that an excessively large public debt will eventually force painful changes in fiscal policy, such as benefit cuts or more likely large tax increases. The most efficient fiscal policy is one that smooths tax rates over time, as high taxes are a drag on the economy.  Furthermore, the effect of tax increases is not linear. A doubling of the tax rate will lead to a roughly fourfold increase in the deadweight loss, without even doubling tax revenue.

By the mid-1990s, Japan’s budget deficits were on an unsustainable path while the US budget deficits were still on a more sustainable path.  At this time, Japan had a 3% national sales tax whereas the US had no national sales tax.  Both countries had overall tax burdens that were below average for developed countries.

In 1997, Japan raised its national sales tax to 5%.  In 2014 they raised the tax to 8%.  In 2019 they raised the tax to 10%.  These increases were intended to address the debt problem.  Meanwhile the US continued to have no national sales tax.  Thus the very thing I was worried about did actually occur in Japan.  Furthermore, more tax increases are almost certainly on the way.  Unfortunately, the US budget deficit situation also became unsustainable during the late 2010s, due to a highly expansionary fiscal policy.  Thus the US is likely to be forced to raise taxes (or cut benefits) in future years.

To summarize, it is true that Japan is likely to be able to avoid default on their public debt.  But this does not mean that those who warned the deficits were unsustainable were wrong.  Indeed, Japan was forced to repeatedly raise taxes precisely because the path of the public debt was unsustainable without future tax increases.

PS. The FRED data site shows net debt for Japan (blue line) and gross debt for the US (both as shares of GDP.)  So the actual gap is even larger than it appears:



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