Taxes, Incentives, and Being Poor

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Now Updated with proofreading!

Political debates about taxes and tax rates in the U.S. often focus on the rich and claims about the incentive effects of different tax rates. Rarely mentioned these days are the poor.  Indeed, the Republican demands in the last few years that tax rates should be cut  for the high-income rich are primarily about claims of incentive effects. And, no, high-income rich isn’t redundant; it’s precise.  There are at least two types of “rich”: High-income rich, which pay income taxes, and the high-asset, low income rich which pay much less. (I suppose there’s another type, the spiritually-rich, but that’s the domain of some other blog.) The claim is made that if tax rates are raised or raised too high, then that provides a disincentive to work and the rich will not work as much. It is often asserted that this is simple micro-economics–that people respond to incentives–and should be obvious.

There’s a problem with the claim, though.  Actually there are two problems. First, there’s very little empirical evidence of higher tax rates on the highest end, the rich, actually reducing their efforts to earn income.  Indeed, numerous studies (I don’t have time at the moment to look for citations) have found in “natural experiments” that the rich really don’t respond to higher tax rates by working less and earning less. Several studies have found that in situations where a large metropolis straddles two or more states, such as NYC, and different neighboring states changed their tax rates on the rich, the rich did not in fact do what they threatened or what would appear “rational”: move to the lower tax state in the same metro area.  There’s also substantial longitudinal evidence in the U.S. and other countries that shows when tax rates on the rich were a lot higher, such as in the 60′s and 70′s, effort and incomes were no less than in more recent times.

The other problem is the whole idea that the “rational” response to higher tax rates is to reduce one’s effort and income actually doesn’t hold microeconomic water.  It’s actually irrational to respond that way unless the marginal tax rate is truly so high that it approaches or exceeds 100%. The average tax rate, the percents you normally hear on TV, isn’t what affects incentives. Instead, it’s the marginal rate, or how much an extra dollar earned is taxed, that changes how we behave. Even then, a raising a marginal tax rate might reduce the incentive or attractiveness of additional effort and gross income, but won’t become a true dis-incentive until it becomes very, very high. An example:  Let’s suppose someone makes $1,000,000 a year and is taxed $400,000. Such a person is said to pay a 40% average tax rate or effective tax rate. But averages and effective rates tell us nothing about incentives.  Incentives deal with changes in behavior at the margins – the incremental changes.  If micro is clear about one thing and has been since the 1870′s, it’s that decisions and changes in behavior depend on changes in marginal costs and marginal benefits.  What matters is the taxes on the marginal, the incremental, change in income.  What matters is the marginal tax rate.  The only reliable way to figure the marginal tax rate is to compare two different amounts of income, preferably with only a small difference between them, the taxes paid and the after-tax-income that results.  What people work for is to get after-tax, spendable income.

So let’s continue the example.  Suppose the existing tax code, with all of its exemptions, deductions, rates, credits, etc, says that $1,000,000 income pays $400,000, but that $1,010,000 income pays $405,000 in taxes, then we have an increase in income of $10,000 of which $5,000 is used to pay the additional taxes. After-tax income rises from $600,000 to $605,000, leaving a net increase in after-tax income of $5,000. This means we have a marginal tax rate of 50%.  There be a disincentive effect only if opportunity cost (usually leisure) of the additional time/effort needed to generate the higher income is judged to be greater than the $5,000 increase in after-tax income.  Empirical evidence indicates that is not likely.  On the other hand, if the marginal tax rate were 100%, it would mean that $1,010,000 in income requires $410,000 in taxes. At a 100% marginal tax rate none of the additional effort results in more after-tax spendable income, so obviously it doesn’t make sense to exert the extra effort.

So what are the marginal tax rates for the highest brackets in the U.S.?  Even if all income comes from wages, the highest marginal rate is now around 38%.  Even if you include state or city income taxes, the marginal rates faced by the rich aren’t greater than 50% even in the most onerous tax-happy states. For the really rich, most income comes from capital gains and not wages.  Capital gains have a much lower marginal tax rate of close to 23-24% (including the 2013 Medicare tax on capital gains).  Evidence is pretty clear that such marginal rates do not provide a disincentive to additional work.

But, now I want to return to the poor.  We often assume that the poor don’t pay much in taxes.  That’s true in total  since they’re poor–there’s not much there to tax. But, marginal tax rates still exist. And they affect incentives.  In fact, it’s the working poor that face the most serious disincentives to work and earn income.  Our tax code is actually set up to make it rational for the poor to not try to earn more income!  As University of Southern Cal Professor Edward McCaffery notes on CNN.com,

…some of the working poor face marginal tax rates “approaching 90% as they lose benefits attempting to better themselves.”

Readers were incredulous, asking how it could be that in a nation with a top federal income tax rate of 39.6% on individuals making more than $400,000 a year, anyone could face a 90% rate.

It is true. Marginal tax rates, especially for those below the top rate brackets, are chaotic, confusing, and all over the map.

As a result, some of the working poor face extremely high rates on their next dollar earned. Tax scholars and economists have long known this. Dan Shaviro of NYU published a study in 1999 showing marginal tax rates above 100% on the working poor; specifically, he illustrated that a single parent earning $10,000 would lose over $2,500, after taxes, by earning another $15,000, pushing her income to $25,000.

Obviously, this is a policy failure.  We want to support the working poor, but we want them to be able to increase their incomes, join the middle class, and leave dependency behind.  Yet the way most welfare and aid to working poor programs are structured, a working poor person can find themselves in a situation where working additional hours or getting a modest raise in wage will actually result in less after-tax spendable money.

The problem is even worse, as Professor McCaffery points out.  The tax code exerts a genuine disincentive to getting married or to staying married if you are among the working poor.  Yet, we know that stable marriages and two-income households are often the key to escaping poverty for both the present and next generations .

It’s appropriate to talk about the incentive effects of tax rates.  Incentive effects should be part of the thinking when writing the tax code, just as reasons for government revenue should be a part.  But when we talk about incentive effects of tax rates, we must focus on the marginal rates and we really should be talking about the poor.  Not the rich.

Is “Right to Work” About Freedom?

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It’s Rick Snyder’s incredible flip-flop here in Michigan on so-called “Right to Work” legislation and his claims that it’s about “freedom” that brings me back to blogging.  Lately I’ve been getting increased questions about what “Right to Work” really means.  So, let me try to cut through the Orwellian rhetoric and explain.

So called “Right to Work” laws have absolutely nothing to do with “freedom” for workers. The “freedom” talk is purely a made-up rhetorical lie intended to get gullible workers to support something that most likely is not in their personal best interest.  Supporters of  so-called “Right to Work” laws (RTW)  claim it’s about establishing the “freedom to not be forced to join a union”, that it’s about “freedom of association”.  But that is an absolute falsehood.  Forcing someone to join a union as a condition of employment is called a “closed shop” rules.  Ever since the 1948 Taft Hartley (a US law covering all states) “the closed shop” has been illegal. Let me repeat for clarity. Forcing someone to join a union as a conditon of employment has been illegal everywhere, including Michigan, since 1948.  RTW laws change nothing in this respect.

But Taft Hartley law also says that if a union is certified as bargaining representative, then the union must bargain on behalf of ALL employees, whether union members or not.  Further all employees are covered by the union-negotiated contract, whether members or not. A union becomes the certified bargaining representative by a vote of ALL employees at some point in time, with a majority necessary to cerify.  A union may be de-certified later by another majority vote of all employees (whether members or not).  Until the union is decertified, the non-member employees benefit from the contract and are covered by the contract.  If a union is certified to represent, non-members are not free to strike different deals or contracts.

Employees who choose to be union members pay dues.  In return for dues, members receive the benefits of bargaining, the contract, and due process representation. Members also get to vote on union leadership and maybe participate in social events put on by the union, depending on which union it is. Non-members do not get the social benefits or voting rights, but they DO get the benefit of the contract, bargaining, and due process.  In return, non-members do not pay “dues”. Rick Ungar in Forbes clarifies:

But did you know that Taft-Hartley further requires that the union be additionally obligated to provide non-members’ with virtually all the benefits of union membership even if that worker elects not to become a card-carrying union member?

By way of example, if a non-member employee is fired for a reason that the employee believes to constitute a wrongful termination, the union is obligated to represent the rights of that employee in the identical fashion as it would represent a union member improperly terminated. So rock solid is this obligation that should the non-union member employee be displeased with the quality of the fight the union has put forth on his or her behalf, that non-union member has the right to sue the union for failing to prosecute as good a defense as would be expected by a wrongfully terminated union member.

Obviously, the Taft Hartley law puts a burden on unions. A certified bargaining agent union must bargain on behalf of all workers, whether they are members or not.  That costs the union money and time.  Yet,the union may only collect “dues” from members.  Herein lies the difference between RTW states and the rest. The rest should properly be called “union shop” states.  In a “union shop” state such as Michigan was until yesterday (Dec 11, 20123), the certified union may charge “agency fees”, not “dues”, to non-member employees on whose behalf they bargain. Agency fees are required by law of non-member employees in union shop states. In RTW states, non-member employees do not have to pay agency fees. In RTW states, non-member employees are allowed to benefit from the contract and protections and bargaining power of the union without paying a dime to support the bargaining activities.  The agency fees are established in union shop states to reimburse the union for it’s costs of negotiating, bargaining, etc.  RTW laws are all about how much money gets paid to certified unions and have nothing to do with “freedom”.

How Much Are Dues vs. Agency Fees?  Enter the Supreme Court

For a few decades after passage of Taft Hartley in 1948, many unions set the agency fee at the same dollar amount per month as the dues.  Obviously this encourages membership since an employee faces a choice of same cost for non-membership vs membership, yet membership brings some marginal benefits beyond the bargaining and contract benefits.  But, a few decades ago (I forget exactly when – I think it was in the 1980′s), some non-members of unions in union shop states sued to not have to pay the agency fee, claiming a First Amendment free speech violation. The logic of their argument was essentially that:

  • union shop labor laws required non-members to pay agency fees to an organization, the union, of which they were not a member and with whom they may disagree politically
  • unions use some of their money for political “speech” purposes: campaign contributions, advertising, lobbying, etc.
  • Ergo, the laws were forcing the non-members to supoort political speech with which they disagreed and therefore should be considered unconstitutional under the US Constitution 1st Amendment.

Countering the non-member’s argument was the union position that the non-members benefit from the union’s activity (bargaining) and should be required to contribute their share to the costs.  If non-members were not required to monetarily support the union’s bargaining and other activities, then it would constitute an unfair burden on members (they would be forced to pay to provide union benefits to non-members) which is itself probably unconstitutional (see Beverly Mann about Article 1, Section 10)

The Supreme Court “split the baby” and developed a solution that acknowledged both sides.  The Supreme Court established that required agency fees are indeed constitutional (ie. “union shop” laws are constitutional).  But, it also said that requiring non-members to support political speech and activities with which they disagreed was not constitutional.  The solution lay in establishing that unions report the amounts they spend on political speech and adjust the agency fee to be some fraction of the dues.  In other words, if the dues for members were $40 per month and the union reported that 20% of it’s total expenses were for political speech activities, then the agency fee would have to be set at $32. This decision was one of a few public policy and economy changes that helped to reduce union influence in the political arena starting in the 1980′s.  There were other more significant ones such as the PATCO strike, but the Supreme Court decision did help reduce marginally some of the money and support unions could provide to union-friendly politicians.  The effect was most pronounced in private sector unions.

Indeed, the battle over RTW laws vs. union shops has nothing to do at all with “freedom for workers”.  It has everything to do with money for political campaigns and political activities.  Historically, most union political activities have been in support of Democratic candidates, but not always.  Republicans perceive they can gain a significant advantage and perhaps a permanent power majority if they can weaken unions and cut-off the political support unions provide to Democrats while simultaneously increasing their financial support from corporations and billionaires, neither of which face any limitations any more.  It is no accident that police unions are exempt from the new RTW law in Michigan.  Police unions such as the FOP can continue in Michigan to demand either dues or agency fees from all police officers.  Why?  Police unions have historically been the unions most likely to support Republican candidates, particularly for court judgeships.

NOTE: Despite continuing really heavy work duties, I am going to try to make posts in the next few days about “Whether and How RTW Laws Weaken Unions and Affect Workers” and “What the Evidence Shows on RTW Laws and Economic Growth”. 

Talking At TEDx Lansing 2012

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I promise I’ll start regular posting again soon.  If nothing else, my special strategic planning project at the college should be wrapping up soon.

The latest delay in blogging is an opportunity that I’m pretty excited about.  I’ve been invited to speak at TEDx Lansing.  From the college’s announcement:

LCCTV is once again teaming up with organizers of TEDxLansing to live stream the upcoming event featuring more than a dozen presenters including one of Lansing Community College’s own Jim Luke.

When: April 13th 9am-2pm

Where: Washington Street Armory

Live Stream: www.lcc.edu/tv/watch

Buy Tickets/More Info: www.tedxlansing.com

Many of you are familiar with TED talks and their mission to promote Ideas Worth Spreading with a focus on technology, entertainment and design. At TEDx Lansing local thought leaders are handpicked from the community and are given 20 minutes to share their idea, inspiration or research.

TEDxLansing offers 11 speakers who explore creativity in its myriad forms, including filmmaking, engineering, advocacy and zombies. The event will include performers as well as TED Talk videos designed to spark deep conversation and connection.

Here’s the lineup for this year, it’s a diverse cast of characters including LCC economics professor, Jim Luke talking about education and technology, an idea further influenced by his role with LCC’s Learn Forward campaign.

His presentation is called “Will Plato Hack the iPAD?”

If you’re going to watch the live streaming on Friday, I’m scheduled to speak at 10:43 am to 11:00.

Contrary to Rumors…

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Contrary to rumors (and perhaps hopes of some), I’m not dead yet, and I’m not ready to go on the cart.  Indeed, I feel happy.  I’ve just been fighting (a) a cold, (b) bureaucratic & academic inertia, and (c) my own inability to say no to some interesting work.  Blogging to resume later this week, I hope.

Yes, Inflation/Deflation is Hard to Measure

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One of the hardest concepts for Principles students, politicians and pundits, oh heck, just about everyone to fully grasp is inflation.  A big part of the reason is because inflation is an abstract concept that is not directly measurable.  We can conceive of it, but we can’t measure it.  I’m no physicist (and open to correction) but it strikes me that it’s a bit on par with “momentum” or “latent energy” in physics.   We don’t have direct-measuring energy-o-meters.  We measure the effects and infer the energy.  Inflation is similar.  We can conceive of a generalized, across-the-economy, sustained trend pushing all/most prices upward such that the unit of money is losing real value in general terms.  Inflation is the sustained push behind all prices. We can’t measure that directly. But we can measure the effect it has: rising prices. The problem comes in that not all prices will be rising at the same time or by the same amount.  Further, during any time period, at least part of the change in price for any good is it’s change in real price relative to all other goods (supply and demand as taught in micro).

We try to deal with this measurement issue by creating a price index – an index that tracks the changes in shopping list of goods over time.  But any price index is a just a subset of all the prices.  Even the Billion Price Project index at MIT admittedly misses most services and lots of consumer goods that aren’t available online.  Price indices are very imperfect beasts.  They have many faults, not the least of them being that they often tend to be volatile in nature.  Since we’re looking for an estimate of inflation which means sustained increases, we need to massage the data further by creating some kind of “core inflation” measure or “trimmed means” type price index.  I’ll explain those some other time.

What prompted today’s post is an article in Bloomberg and a post by Krugman about it.  Together they illustrate one of the reasons so many people want to believe we have greater inflation than we really do.  Companies like to disguise price changes.  They don’t want to be known that prices could be cut in response to demand. Example: auto company offers $2000 rebate on $20,000 car but won’t cut price by 10%, or a firm offers a “value meal”, or they offer a freebie bundled product.  Similarly they often disguise price increases by reducing sizes or portions or by changing the financing.  From Krugman:

Good article in Bloomberg:

Procter & Gamble Co.’s failure to raise the price of Cascade dishwashing soap shows why investors are buying Treasuries at the lowest yields in history, giving the Federal Reserve more scope to boost the economy.

The world’s largest consumer-products company rolled back prices after an 8 percent increase lost the firm 7 percentage points of market share. Kimberly-Clark Corp. (KMB) started offering coupons on Huggies after resistance to the diapers’ cost. Darden Restaurants Inc. (DRI) raised prices at less than the inflation rate as patrons order more of Olive Garden’s discounted stuffed rigatoni than it anticipated.

This is basic economics; prices tend to fall, or at least slow their rise, when there is vast excess capacity and weak demand.

As both the article and Krugman’s excerpt show, we’re closer to deflation than most people realize.  They don’t see the failed attempts to raise prices.  They don’t see the shifts in portions or increase in coupons that reduce effective prices.  What they do see and remember is the $.50 increase in a loaf of bread or the $.70 increase in a gallon of gas.  But even with the gas, they selectively remember the $.70 price increase in summer, but forget the $.75 price drop in autumn.  Inflation and deflation are tricky things to measure.

 

David McWilliams Explains Why Austerity Is Doomed In Europe

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A very interesting video by an Irish economist explaining how the current reduce government spending (“austerity”) approach to the Eurozone debt and currency crisis is doomed to fail. It is doomed because cutting government spending in a recession only makes the recession worse, which in turn, reduces tax collections which then makes the government deficits worse not better.  But not only is the austerity approach all wrong to solving the debt crisis, it carries very significant risk of social upheaval.  (hat tip to Philip Pilkington and New Economic Perspectives).

Now I’ll offer one pre-emptive comment.  Critics of the arguments McWilliams makes often claim that either government spending isn’t really effective, that somehow only private investment spending will stimulate an economy.  Or, the critics claim that any resources the government puts into use through spending actually detract from the economy by denying those resources to some supposedly better, privately chosen use. Both of these criticism fail.  We are clearly discussing a situation in which there are excess, unused economic resources in the economy.  In plain language:  there’s high unemployment and people are out of work.  The criticisms are all based on an idea called “crowding out”.  For crowding out to occur, the economy must be at full employment – the opposite of being in a recession.

Remodeling

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I’m trying out a new look.  I’ve updated the theme as long-time viewers can tell.  The new theme has a few advantages over the old one.  First, it’s a “responsive” theme.  That means that it should automagically adjust to the width of whatever browser you’re using.  If you view it on a smart phone, it should push the side-bar stuff down to the bottom so the main text is more readable. And, as long as I can resist the urge to create a menu of tabs across the top, it should retain the fluid-width aspect of the old one.

Another reason for changing is that WordPress.com (the host for the blog) is really pushing it.  The old theme isn’t being updated.  We’ll just have to see if I get the spacing on the graphs right.

The new them also makes it easy for me to add short “Aside” posts.  I’m going to try to adding some of these usually as links to articles I find interesting but don’t have time to write a full commentary.

Anyway, I’m interested in any comments on either the theme or other ideas to make the blog more readable or useful (short of recommendations that I replace the author!).

jim