Taxes, Incentives, and Being Poor

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.

David McWilliams Explains Why Austerity Is Doomed In Europe

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.

Does Anybody Understand Debt?

Does anybody understand debt?  Some – but not many.  Today’s post is less of my normal extended prose and more of an outline.  I’ve been invited to speak at some writing classes here at the college and this is intended to serve as my speaking notes.


Background: What have you heard?

Krugman in New York Times

Harvey in Forbes

Background Info on U.S. National Debt

Brazelton:  The US CANNOT Go Broke


Numbers, Metaphors, and Stories


Get the terms right

Debt, Deficit, and tr/b/m-illions

$1,000,000,000,000

$1,000,000,000

$1,000,000

$1 trillion =  1 million times $1 million

Debt


Deficit

1984-present U.S. Federal Budget


Measuring the Debt

Counting Absolute Dollars of Debt Deceives. It's All Relative.


Three Bad Metaphors


Government is NOT a Household

Government is NOT like a Household!

Econproph: Once Again, Government is Not Like  a Household


 Govt Debt is NOT a Burden on future generations


Private Debt is NOT like Government Debt

Federal Reserve Breakdown of Household Debt

Foreigners Don’t Control


So…

A Sovereign Government Cannot “Go Broke”


Eurozone Countries Can “Go Broke”


Government Debt is Like Money that Pays Interest


But What About Inflation?  Printing money?

Inflation involves real demand vs. real supply, not just $


Test on Debt:  Interest Rates

Rates are historically low and staying low.


Are Gov. Deficits Necessary?

Yes, if you want to save money.

Forever?   Yes.

Econproph: But What About National Debt-to-GDP Ratio? Not a Problem, Really


Are There Limits to Deficits?

Yes, but related to full employment and capacity.


In Practice, Nobody Understands Money.

Well they understand yesterday’s money, not modern money.

That’s why they don’t understand debt.

Rhetoric Is A Powerful Tool To Advance Moneyed Interests

Money is essential to a successful economy.  But it’s money in circulation that’s useful.  Money that’s locked up in storage in vaults and savings doesn’t help.  The early economists understood this well and often used the analogy of money-is-to-economy as blood-is-to-human-body.  Circulating money, money that is used to buy things is as important to the economy as the blood in your arteries and veins.  The analogy works.  It leads us to realize that money, and more of it, can and usually is a good thing.

The analogy, however, doesn’t work for those economists and policy-makers who want are more interested in enabling the top 1% or so to profit at no risk by earning income on holding money.  Theoretically, the rich, the top 1%, could earn income from their large stores of wealth by investing it in production.  But the profit-by-investment-in-production method requires risk. It’s hard. It requires work to find and exploit good investment opportunities. From the perspective of the really wealthy, it can be more desirable to make money by simply owning money.  To do that, it’s necessary to that there be no inflation. They actually prefer deflation because then their cash wealth gets more valuable without being risked or used productively at all. The other approach to making money without risk by simply owning money is to lend it. Instead of starting, owning, and building a business, investing in equity, you make loans. Ideally you use your wealth and influence to get politicians to guarantee your loans – heads you win and tails somebody else loses. These approaches to making money by simply owning money require that money be scarce and hard to get.  It’s directly counter to the money in circulation paradigm.  A circulatory system deprived of money is good thing those who make money from money instead of labor.

But to persuade the mass of people, the 99%, the ones earning money from labor, it’s necessary to change the metaphor.  That’s been rather effectively in the second half of the 20th century.  It’s been done by extending a different metaphor.  Economists have long used the word liquidity for the idea of how easy it is to convert an asset into cash and therefore spent. For example, real estate (particularly in this market) is very illiquid.  I could own a $1 million house but be unable to buy a Coke from the 7-11 store because I lack any cash.  That’s an extreme example of illiquidity.  In contrast, a liquid asset is one that is either actually cash or easily turned into cash so it can be spent.  There’s a whole range of assets in between with varying degrees of liquidity.

This idea of liquidity and it’s association with cash has been used to push a metaphor that suggests the problem is too much money in the economy.  We’re peppered with phrases like “drowning in debt” or a house mortgage that is “underwater”.  It makes us feel that the liquid stuff is undesirable.  So we get  a central bank that’s reluctant to create and inject money into the economy because critics claim that will create too much liquidity and they falsely claim that it’s inflationary.  When the central bank does increase inject liquidity into the economy, it does it by getting the money to precisely the people who keep it from circulating.  We get a government that refuses to use it’s ability to directly inject money into the economy and get it into circulation.

Government ultimately is the source of all money.  Only government can define and create money.  It has two ways to do it. It can simply create (“print” or “mint” if you will, but it’s not that way anymore) money and spend it.  That puts money immediately into circulation in the circular flow of goods and services.  Or, the government could create money reserves for the banks, a riskier strategy.  The banks then can lend using a fractional reserve logic.  If the banks lend out the reserves, then money is created.  If the borrowers from the banks spend the borrowed money, then it’s in circulation.  If the borrowers use the money to simply buy other financial assets, then it’s not in circulation and is sterile.

In our modern system, the government (in the U.S. and many other nations) has delegated the responsibility for creating money and putting it into circulation to quasi-private central banks such as The Federal Reserve Bank.  In today’s workings of the financial system, these central banks have further delegated the responsibility and decision-making on money-creation to private commercial banks by providing reserves for whatever level of loans they choose.  When those banks choose not to create money or choose not to create and provide money in a way that puts it into circulation, the system suffers. We suffer from too little liquidity.

Daniel Becker at Angry Bear made this point very well in a long post there in June 2011.  He points out that we should really talk about “dehydrating in debt”, not “drowing in debt”.  The dehydration metaphor leads us directly to the solution – more money in circulation.  I from the conclusion to his post:

Got that? Let’s summarize: The share of income to the 99% of people declined from 1976 onward. At the same time the means of making money changed from labor production to money manipulation (producer economy to finanicialized economy) adding to the reduction in share of income. We also changed the ideology to one from relying on the vast population (as represented by the individual and We the People) to relying on a small portion of the population to distribute what money was created. We did this for 33 years. By 1996, people were borrowing as a means to sustain their standard of living (not increase it). If the people are not spending to increase their standard of living, then is the economy really growing? By 2006 people were no longer able to make the payments and consumption was declining.  Then gas hit $4/gal and winter heating was looking like another $4000 to $6000 would be needed.

To date, nothing has been done to address this. Nothing at all. And, by “this” I mean, the income inequality that has resulted in an an economy where a very small group of people (top 1%) are taking money out of the system (that is money that would fuel the engine) faster than the engine can make it which results in an ever faster declining share to the rest of the people. Instead, we have refined new fuel and dumped it right into the top 1%’s hands and wonder why the engine is still sputtering?

One other issue I have with framing and the words used today: Under water.

People are not under water. They are not drowning in debt. On the contrary, people are dehydrating. They are starving for water. Do you know what the symptoms are of dehydration? You get thirsty and then urinate less to conserve water. (debt spending) Then you stop making tears and stop sweating. (can’t borrow) Eventually your muscles cramp, the heart palpitates and you get dizzy. (close to bankruptcy, voting against your interest) Let it go long enough and you get confused, weak and your coping mechanisms fail. (Tea Party, etc) In the end, your systems fail and you die. (recession)

People are dehydrating and Washington is doing nothing about it because they believe it is drowning.  They are throwing out life boats to people in a desert.  That is the chart Ken linked to.

Oligopoly and the Costs of Higher Education – Journals Edition

There are many reasons why costs in higher education have been rising faster than inflation for many decades.  A fundamental reason is because education is so labor-intensive and (so far) has been resistant to improved productivity via capital investment or technology.  This is called Baumol’s Cost Disease.

But there are other reasons too.  One is that historically higher education has been a non-profit industry but it is like healthcare in that much, if not all, of the costs are paid for by a third-party such as government instead of the consuming customer themselves.  There’s another similarity to healthcare in that in both it’s the seller, the doctor or the professor/university, that tells the consumer, the patient or student, what specifically they need to consume.  The consuming customer, the student or patient, doesn’t have all the information to know what they need.  This 3-way or 4-way transaction arrangement isn’t the standard buyer-seller arrangement of micro-economic texts about markets.  When a 3-way arrangement exists where there’s a seller, a consumer and a separate payor, conditions are ripe for abuse.  Basically, the seller tells the consumer to buy more at higher prices.  The consumer doesn’t object because somebody else is paying.

Historically, the arrangements never got out of hand because doctors in healthcare and universities in higher education were non-profit “professionals”.  But when for-profit entities entered, the dynamics shifted.  Higher education still consists of a a strong majority of non-profit institutions.  But they are surrounded by a several supplier industries that are very definitely profit-maximizers such as book publishers.  Publishers have long pursued a process of competing on features and making textbooks more expensive because the person who selected the book, the professor, didn’t have to pay.  Students paid through their student loans and they didn’t have much choice.

Eliminating choice is the key to higher profits.  That’s why monopolies and oligopolies make economic profits while firms in pure price competition don’t.

Now courtesy of a lecture by Hal Abelson at the Educause 2011 conference, passed our way by George Siemens at elearnspace.org, we see why prices of academic journals have risen so much that many libraries can’t afford them.  It’s the trend towards concentration and oligopoly.  The government could do something about it via antitrust enforcement, but for several decades antitrust enforcement has been weak except for blatant conspiratorial price-fixing.  This image below (from this article – .pdf) demonstrates:

Too Big to Fail Should Be Too Big to Exist

Against Monopoly has a great graphic that shows a big part of the problem with our financial sector and our economy.

How the Too Big to Fail Banks Got  So Big

How the Too Big To Fail Banks Got So Big

The four banks shown above are the four largest banks in the U.S.: JP Morgan Chase, Citi, BofA, and Wells Fargo.  Together they dominate the financial industry. If you add in Goldman Sachs and Morgan Stanley, the domination is near complete.  They all received large bailouts in the 2008-09 crisis.  Today they are much larger than when we entered the crisis. As the graph shows, none of these banks grew so large by “natural” or “organic” means.  They didn’t grow because they offered better or more efficient services to customers.  They didn’t “win in the marketplace” by competing better.  They simply bought the competition.  It’s domination by merger.  The U.S. banking system which at one time was very competitive and decentralized with literally thousands of very competitive banks is now dominated by a few.  We call it oligopoly on the way to monopoly.

When very, very large banks get too big, they become “Too Big To Fail”.  That means, if the banks were allowed to fail because of bad decisions, bad management, or bad investments, it would set off a domino effect throughout the economy and financial system.  That would punish all of us and not just the bank’s owners.  This, of course, is what happened in 2008 when Lehman Brothers was allowed to fail.  It set off a financial panic where banks wouldn’t / couldn’t loan to each other (or anyone else).  Result:  big bailouts of big banks.

But it doesn’t have to be this way.  Yes, once we have a “too big to fail” bank and it fails, then there’s pretty much no choice but to bail them out.  There are choices about the structure of the bailout. We could have set up the bailouts in a way that the economy wins and the failed managers and bank owners suffered.  We didn’t.  The Federal Reserve, the Bush administration, and then the Obama administration made it a priority to keep the bank managers and bank owners whole.  The economy has suffered from a slow recovery partly as a result.

But bailouts shouldn’t be necessary because we shouldn’t allow the banks to become this big in the first place.  Again, we have a choice.  We could have prevented some or all of these mergers.  The laws are on the books to do it.  Washington, following the failed anti- antitrust philosophy of the Chicago school since the 1980’s simply doesn’t challenge many mergers these days.  It’s bad for campaign contributions.  Besides we’re supposed to believe that a market fairy will make it all right.  Instead of challenging and stopping some of these mergers, both the government and The Federal Reserve have actually facilitated and acted as match-maker for many of the mergers.  In March 2008, when Bear Stearns failed, The Federal Reserve offered a deal to JP Morgan Chase.  If Chase would buy Bear Stearns, The Fed would reimburse Chase for any losses over a set amount.  Heads Chase wins. Tails Chase wins.  Nice deal.

We have other choices as well.  In other industries historically when the private competition in the market led to monopoly or near-monopoly outcomes, the government chose to regulate the industry as a public utility.  We did it in the 1920’s and 1930’s with the electrical industry.  Your local electrical company wasn’t always a regulated utility.  At one time it was ravenous and rapacious private monopoly just like these banks are becoming.  When Standard Oil became a monopoly over a hundred years ago, we sued and broke it up into a bunch of other companies.

This complicity in allowing the big banks to become Too Big To Fail is among the types of policies that the protesters of #OccupyWallStreet want changed.  Me, too.

UPDATE on President Obama’s Jobs Proposal – Better, But Still Weak

First an update on a post I made a few days ago. When I commented last Monday on President Obama’s jobs proposal, I was less than excited. Having read more detail of the proposal, I should correct some statements I made.  I incorrectly left the impression that the payroll tax (Social Security/Medicare tax) cut that the President was proposing was only an extension of the present year cut that is scheduled to expire December 31, 2011.

In fact, the President is proposing not only a 1 year extension of this year’s temporary payroll tax cut, but an increase in the size of that tax cut.  Estimates are that for a median household income of near $50,000, it would result in a $1,500 reduction in payroll taxes compared to not having any payroll tax cut at all. However, the existing, this-year only, payroll tax cut had already cut payroll taxes by up to $500 per household.  So of the claimed $1,500 tax cut for next year for the median household, $500 is an extension of this year’s situation and  $1000 is new stimulus.  Today’s economy is weak even with the existing temporary $500 tax cut, so extending that cut won’t improve things. It will only prevent things from deteriorating further.  In my world, simply agreeing to not put on the brakes is not the same thing as actually hitting the accelerator.

But, the proposal does contain perhaps $1000 worth of tax cut stimulus to nearly all working households. That’s perhaps $150 billion of pure, new stimulus to economy.  It’s more than I estimated on Monday, so the plan will likely have some more stimulative effects than I thought.  But how much?  Let’s do a quick “back of the envelope” type calculation.  The proposal puts $150 billion in consumers’ hands that wouldn’t have been there without it.  But for this money to generate jobs, people have to spend the money.  Simply saving the money or paying down debt won’t cut it.  That improves individual household balance sheets but it doesn’t cause any firm out there to go “oh, more business! I need to hire people!”  In normal times like the 1960’s or 1970’s people would have spent 85-90% of the tax cut.  But these aren’t normal times. We live in high debt, high debt payments, and scared-of-the-future times.  More people save in these kind of times. (paying down debt is economically the same as savings – think of your debt as a negative balance in a savings account).  Let’s assume that people spend 2/3 of the money.  Both history and theory indicate that people save more of a tax cut when they know it’s temporary, but let’s be generous/optimistic and say 2/3 gets spent.  That’s $100 billion in new spending.

Now when it gets spent, it generates business demand and jobs.  Those people get paid and then they go spend the money again – the circular flow of money in the economy.  How much?  That’s a huge controversy in empirical macroeconomics.  This is the question of what the spending multiplier is.  Estimates vary widely, although often the studies are heavily biased by ideology to begin with.  Let’s be modestly optimistic and say the multiplier is 1.5 – 2.0.  This is a relatively high estimate given recent studies as far as I know, but let’s run with it.  That means that after some months, this initial $150 billion in tax cuts becomes $100 billion in new, initial spending which ultimately increases total spending by $150-$200 billion.  Total spending is another way of saying GDP.  This puts it in the range of 1.0% to 1.5% of GDP.

There’s a rule of thumb about the relationship between changes in GDP to changes in unemployment rate. It’s called Okun’s Law.  It’s not a law so much as a statistical regularity. There are many versions, but let’s use a real simple one: each 2 percentage point change in GDP equates to a 1 percentage point change in the unemployment rate.  So if we have GDP growth increasing by 1.5% points, we can count on unemployment rate going down by 0.75 to 1.0% points.

We’re currently over 9% unemployment rate and stuck there.  I’m not real excited about a proposal that aims to reduce the unemployment rate from over 9% to maybe 8%.  We know 4-5% unemployment is possible.  We did it in 2006 even with the slow-growth policies of the Bush administration.  We did better than that under Clinton. In the 1960’s we were even below 4%.   Why are we settling for tepid responses and setting goals of only getting to 8% unemployment and then calling this “bold”?  I don’t know.  But then maybe I’m just a grumpy old man.