Thursday, October 4, 2012

Dynamic Tax Scoring

The Tax Foundation study, "Simulating the Effects of Romney's Tax Plan" is worth reading and thinking about, especially in contrast to the standard static analysis that I complained about at the CBO.

Gov. Romney has proposed, at heart, a reduction in marginal rates, together with tightening of deductions. He hopes to make the latter large enough so that the program is revenue neutral, or at least deficit neutral when some spending cuts are included, and as close to neutral across the income distribution as possible.

Unlike a Keynesian plan, whose purpose is to transfer wealth to the hands of people (voters) likely to "consume" it, or a redistributionist plan, whose purpose is to transfer wealth from one category to another of people, the point of a revenue-neutral, income-neutral tax reform is to permanently and predictably lower marginal rates, giving rise to incentives to work, save, invest, and increase economic growth over the long run.

What possible sense does it make, then, to evaluate such a plan by assuming off the bat that it has no effect at all on output, employment, investment and so forth? Yet that is precisely what the standard "static" scoring does!  We build a rocket ship to go to the moon, and we evaluate its cost effectiveness by assuming that it never leaves the launch pad?


There are all sorts of things to appluad in this approach.
we have simulated the effects using a model built on a standard neo-classical growth model
Hooray! The "standard neoclassical growth model" is exactly the right building block for this sort of exercise, one that has pretty much taken over all academic tax analysis for the last 20 - 30 years, but has been virtually absent in Washington, still using Keynesian macro models from the 1960s. What does it mean? In general, we model households making decisions between work and leisure, consumption and savings; we model businesses making investment, hiring, and output decisions to maximize profits, and find the equilibrium.

The general consensus, even from (sensible) Keynesians, is that this is the right sort of model to use for long run -- several years -- analysis. It's the benchmark model in which margins matter, in which lowering tax rates, while getting rid of deductions so you pay the same taxes, can possibly have an effect. The Keynesian models, which I criticized here also pay no attention to margins, and so assume away the effects that a reform focused on lowering marginal rates is trying to achieve.
This model produces a simulation of what the policy change would do to the economy, incomes, and tax revenues after all economic adjustments are given time to work, which is roughly 5 to 10 years. It does not show the annual progression, year by year, from the starting point to the final outcome, but most of the effects occur within 5 years.
More hooray. Nobody knows the exact adjustment path. The point of tax policy is to get things right for the long run, not to try to manage the year to year. So don't even try to produce numbers that we all know are meaningless.

What are the effects?
The Romney plan would raise actual and potential GDP by about 7.4 percent over a five to ten year adjustment period.
Here I actually think the model is being conservative. It seems the model is removing labor and capital distortions, but assumes no effect of tax rates on growth;  the rate of technical change is given. I suspect that lowering marginal tax rates also makes people work harder at inventions. If that's right, then there is a "growth effect" not just a "level effect." Yes, we don't know much about how large it is. But I submit that we know the sign!
...relative to the static revenue loss, the biggest bang for the buck comes from the capital gains and dividend relief, followed by the corporate rate reduction and the elimination of the estate tax
Here we see the standard conclusion from the optimal-tax literature, that taxing investment is particularly distorting.

I don't think the model has an evasion margin (it should) -- that as you reduce rates people find it less worthwhile to get their lawyers and lobbyists to find ways around them. If it did, that would increase the argument against the estate tax. There is nothing like confiscating half your wealth every generation to get you to go visit the tax lawyer.

Of course, the question of how large the dynamic effect is goes right to the heart of whether the plan is, in fact "revenue neutral," and just how many "base broadeners" are required. This analysis does not say the tax cuts pay for themselves,
The Romney tax plan would recover nearly 60 percent of the static projected revenue cost due to economic growth, higher wages and employment, and higher tax collections on the higher incomes. To keep the reform revenue neutral, the government would only need base-broadeners equal to about 40 percent of the static cost
In my view, we should get rid of all deductions period, for simplicity and to allow even more rate reductions. But this has been important in the political debate.

Models are built on assumptions, and here too. How much do people work more, save more, invest more when they face a 20% reduction in tax rates? That's an important question, and if you want to quibble with the answer, where you should look. I got as far as the description here of the underlying model, starting on p. 19.

The model assumes a rather low labor supply elasticity of 0.3. That's important and conservative -- the model is not assuming that, being allowed to keep more after-tax wages, people go out and work incredible numbers of more hours, or lots of people join the labor force. I suspect the real number is higher, especially on the latter margin.

On capital, the model starts with a central and very powerful observation
The long run real after-tax rate of return to physical capital is virtually constant over time, implying that the supply (quantity) of capital is very responsive to changes in the rate of return.
This is what's great about neoclassical growth models. A few basic facts have powerful implications. In this case, that small changes in rates of return will bring in lots of capital, from abroad if not from savers. If you want to assume otherwise, you have some hard facts staring at you.

I was not able to determine whether the model included payroll, state, local, and sales taxes. The overall tax wedge counts to distortions, and including those in the baseline will substantially raise the effects of lowering Federal taxes.

I haven't looked at the calculations, and I'm not vouching for them. But this is certainly the right way to ask the question! And if you want to disagree, we have a disciplined way to disagree. Disagree with the labor supply elasticity, the substitutability between capital and labor, and so on, if you will, but we know what we're debating.

Reading these analyses I wish they would do a Romney vs. Obama plan comparison, using the same methodology. For example, I was struck that the original Tax Policy analysis of Romney's plan concluded that, since in their static analysis there weren't enough base broadeners, that Romney must have a secret plan to raise middle-income taxes. OK, but Obama's budget numbers don't even pretend to reduce deficits. So what sense does it make to say, Romney has a secret plan to raise taxes because we forecast a  deficit, but Obama's plan has... a deficit? If we're going to hold plans to a deficit path and make up taxes to do it, shouldn't we see how both plans stack up on the same deficit path?

But, dear reader, remember to take all of this with a grain of salt. Campaign plans have very little to do with what Presidents propose, and what Congress actually votes. President Obama's plan last time was to cut the deficit in half, and you saw how that turned out. And rightly so. Events change the best plans. These are best read as general indicators of broad-brush themes, not for whether the tax credit for windmill powered cars will really truly be $5,000 or $7,000.


68 comments:

  1. What I don't understand is why a 'Keynesian' model be static? wouldn't such a model of the economy imply some sort of fiscal multiplier from tax cuts?

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    1. First, I don't think the CBO or most "static" analysis allows even Keynesian effects, i.e. a tax cut "stimulates" and raises GDP and thus is partially offset. Static is static, GDP stays the same. Second and more importantly, a revenue-neutral cut that cleans out the forest of deductions and lowers rates has no keynesian stimulus effect, even if keynesian stimulus worked in the real world.

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  2. I don't understand how lowering marginal rates will have any effect on the economy, if deductions are taken away to ensure our effective tax rates remain largely unchanged. If I'm paying the same amount of taxes, I don't have more money in my pocket to spend. Can you explain it in layman's terms?

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    1. I'd like to know this answer as well. If you're revenue neutral, outside of a simpler 1040, what's the economic incentive? I can see the new tax policy disproportionately benefits some payers with lower deductions, who gain incentive, but revenue neutral means there are losers as well.

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    2. Thanks for asking! This is the most important point. In economics "how much money you have in your pocket" is really a secondary question to the overall economy (I know it matters to you!)
      What matters is, if you (say) work an extra day, how much more money do you get to keep? If you get paid $100 per day, but the government takes half, then you keep $50. If it takes a third, then you keep $66, and are more likely to work that extra day rather than go home and watch the ball game. A revenue-neutral tax reform lowers this marginal rate, but eliminates deductions so you end up paying the same amount overall.
      Why not "put more money in your pocket?" reduce the rate and let you keep the deduction? Yes, that would be even better. But the government is broke and needs the money.
      Why does putting money in your pocket not really affect the economy overall? Because mostly the government takes your money and gives it to someone else to spend. You spend more, he or she spends less. You like it, but it's not much difference overall.
      Margins matter to economics.

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    3. The incentive you are talking about, i.e. lower marginal tax rate encourages more mork, higher rate discourages work, has been quantified by the Romers. It is (1-t)^0.2. t is the marginal tax rate, (1-t) is the after-tax share. This allows computation of the optimal tax rate for the wealthy, which is ~73% (federal + state + local + sales). So lowering tax on the rich at this time will not help the economy. I don't think you answered the question above about lower marginal rates helping the economy even if effective tax rates stay the same. Say, I have a small business and my tax rate is 20%. With the loopholes/deductions it drops to 16%. Romney lowers my tax rate by 20% so now it is 16%. He takes away the loopholes, so it stays 16%. Now I am really happy! I start expanding my business and hiring new employees!
      Right?

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    4. I think you're confusing "optimal" as in "raises the most revenue for the government" vs. "optimal" as in "raises GDP (or welfare) the most". 73% -- about the current value, actually -- is at best a calculation of the revenue-maximizing rate. To put it mildly, I'm not persuaded that maximizing the size of government maximizes welfare.
      Your second example confuses the average tax rate with the marginal tax rate. Average = taxes / income. Marginal = earn an extra dollar, how much do you get to keep.

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    5. Yes -- but versus the poor, the wealthy have lower utility from a marginal dollar. Hence maximizing government revenues from the wealthy allows redistribution to the poor -- thus optimizing social welfare (admittedly, in utility if not GDP terms).

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    6. I will try to answer this in a slightly different way from Dr Cochrane. Economic decisions happen on the margin. If rates are marginally high on a business, Even if it is getting a substantial break on it's deductions, then the chance of entering into a new economic activity is curtailed.

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    7. I am a tax lawyer, and the Romers study should be viewed as nonsense. To compare a rate with out understanding the base is silly. The 70s and early 80s had high tax rates, but a tax shelter industry which made sure you did not have to pay that rate if you did not want to. So the impact of high rates on economic activity is much less when the person whose work might be discouraged knows he can avoid the high rates with "tax shelters".
      The trade of the 86 act was to eliminate shelters for lower rates. If you now raise rates, it will have a much more dramatic impact than in the 70s and early 80s where you could "shelter" you income and avoid the impact of the higher rate (because tax shelters were a cost, on can almost view a higher rate with tax shelters as X, the sum of the taxes paid plus the cost of the tax shelter).

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    8. On these points, you might be interested in (and give a fair if conservative reading of) the new revision of the optimal income tax paper that does (try to) look at long-run growth, tax-base issues (lower effective marginal rates, avoidance) and unproductive bargaining.

      With empirical results too, however imperfect.

      http://elsa.berkeley.edu/~saez/piketty-saez-stantcheva12thirdelasticity_nber_v2.pdf

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    9. Thanks for the pointers. I'll add to the reading pile. I grew a bit disenchanted with Piketty-Saez the last time I read one of their pieces (JEL) carefully. The fact is, in the 1960s rich people didn't pay much taxes despite high statutory rates. PS goosed up the tax rate for rich people in the 1960s by adding the burden of corporate taxation entirely to rich people. This violates the conclusion practically everywhere else that the rate of return to capital is basically fixed, so taxes are passed on through prices and wages not lower rates of return. And, while "burden" of taxation is the right economic concept, to use it just once to goose up taxes paid by rich people and nowhere else seemed borderline dishonest. I guess this experience should make me anxious to dive in to dig up more dirt in other papers, but it has the opposite effect.

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    10. I think the theoretical framework is a nice way to organize our thoughts. (Very much in vein of the Chicago price theory tradition.)

      I checked the JEL piece, but I do not find corporate taxes lumped on the rich. I must be searching the wrong way. If you care, would you mind pointing me to it?
      http://elsa.berkeley.edu/~saez/atkinson-piketty-saezJEL10.pdf

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    11. Professor Cochrane,

      You said, "Thanks for asking! This is the most important point. In economics "how much money you have in your pocket" is really a secondary question to the overall economy (I know it matters to you!)
      What matters is, if you (say) work an extra day, how much more money do you get to keep? If you get paid $100 per day, but the government takes half, then you keep $50. If it takes a third, then you keep $66, and are more likely to work that extra day rather than go home and watch the ball game. A revenue-neutral tax reform lowers this marginal rate, but eliminates deductions so you end up paying the same amount overall."

      I'm a different poster than the original Anonymous. Here's what I don't understand -- are we assuming the Romney plan is revenue neutral because A) eliminating deductions will completely make up for the revenue loss from lower marginal rates; or B) eliminating deductions will partly make up for the revenue loss AND the increased growth from the lower rates will make up the rest? If it is the former, which is what I interpreted the original question to be referring to, I don't see how a business or person has more incentive to work, save, or invest when their after-tax income will be the same. If I have $100 to invest, why am I more likely to invest with a marginal tax rate of 28% and no deductions than a marginal tax rate of 35% and current deductions, if my after-tax income will be the same in both situations?

      Thanks for taking time to answer these (simple) questions.

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    12. Different anonymous here (I posted the question at top of this thread).
      OK, I see how a lower marginal rate makes additional work pay off more that with higher rates. But is there any empirical evidence that people actually do work more hours? Did people work more hours when Reagan or Bush II cut rates? Did people work less hours when Clinton raised rates?

      Plus, given that unemployment and under employment are so high right now, the question remains: can people actually work more, even if they want to? I build furniture for a living, I could work more hours to make more tables, but if I don't sell the additional ones the extra work is worth $0 to me. I can see that in an economy with higher consumer demand this would not be true & the extra work would pay off with more sales.

      And a greater point- even if lower rates encourage more hours worked, is that how we want to grow our economy? I understand your job is to predict what will maximize GDP or tax revenues, but maybe there are long term, negative implications to this we are not taking into consideration. What about laborers wearing out their bodies earlier (higher health care costs later)? Or parents able to spend less time with their kids?

      fyi I have no formal economics training past Econ 101 but find it fascinating and have been reading as much as I can the past few years. I appreciate you taking the time to read & respond.

      Jon

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    13. Conservatives say that the rich are purely money driven and if they get to keep 85% of their pay they will work more hours than if they get to keep 60% of their pay. Studies show only a very marginal effect of this. (Similarly they also say that the poor will work longer if they are paid less and don't notice the contradiction but that may be a separate issue.)
      The Tax Foundation is not an unbiased source - their raison d'ĂȘtre is to reduce taxes and I don't trust their models. Their model says a lower marginal tax increases work effort even if the total tax is the same and they have similar unproven assumptions in other parts of their models - garbage in - garbage out.

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    14. Gary, I am a tax lawyer and studies are nonsense. Think about the base, not the rate. It is not a question of being purely money driven, just acting in ones self interest. When I was a child, my father was a lawyer. WHen I went to doctor, dentist, ect., we never paid, it was professional courtesy. But I am sure my dad got a call and gave a bit of free legal advice. But with 70% rates, it made sense for both parties. As a young tax lawyer, near the end of year got calls to look at tax shelters so for a fee anyone with income could avoid income tax. With high tax rates the rich use corporations to hold assets (which they do in Europe and Canada) which generally have lower tax rates, so income is shifted. Do studies take these type of things into account? In tax policy, a page of logic is worth a volume of studies.

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  3. Dr. Cochrane, I wonder if you have read the analysis of Romney's tax plan from the Tax Policy Center at http://www.taxpolicycenter.org/UploadedPDF/1001631-FAQ-Romney-plan.pdf . They analyse 5 components of his plan and find that if you do 4 of them then you can't have a revenue neutral plan. The five points are:
    (1) cut current marginal income tax rates by 20 percent,
    (2) preserve and enhance incentives for saving and investment,
    (3) eliminate the alternative minimum tax,
    (4) eliminate the estate tax, and
    (5) maintain revenue neutrality.
    Love to see your comments.
    John O'Rourke

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    1. The tax foundation study was an explicit response to the tax policy center's static analysis. There are lots of other responses that ripped it apart.

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    2. "There are lots of other responses that ripped it apart."

      Please identify them. The last one I saw was very friendly to Romney and concluded that taxes would have to rise on people earning $100,000 to $200,000 to pay for the tax cuts for people over $200,000.

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    3. Absalon: all the criticisms of the Romney plan implicitly assume that it will fail to increase economic growth. But that is unfair, because that's the whole point of the plan. The people putting the plan forward believe it will in fact do that, and pay for itself that way. But my question is: what evidence makes them think that under our present conditions the plan will succeed. I think the theory behind why it could succeed is sound, but we often see practice and theory diverge

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    4. Um didn't the TPC study use the Mankiw-Weinzierl "dynamic scoring" model? In addition the assumptions were incredibly friendly to Romney (i.e. does anyone believe it is actually politically feasible to eliminate every single deduction in the tax code let alone do it in a way such that all of the deductions get removed for people at the top of the income distribution first?).

      In addition the Tax Foundation's claim that GDP could increase by 7.4% over a 5 year period just doesn't seem credible to me. The implications of such a large change when viewed in the context of tax policy abroad and tax policy under Clinton and Bush II are crazy. Growth in Europe wouldn't exist and we shouldn't have had sigh high growth under Clinton and low growth under Bush II.

      Note I am not arguing that the Clinton tax increases caused the boom in the mid 90's, but rather at the margin changes in tax rates don't seem to be that correlated with the business cycle.

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    5. The criticism I have with the Romney Plan is that appears to be the same package that Bush 43 & Reagan had. They both increased our debt (also I would credit Paul Volker w/ improving the 80's economy). Romney's make the ASSUMPTION that economy will improve, but our economy is insulated from the rest of the world. China's economy is slowing, Europe is still very shaky, and what if a rogue nation puts a squeeze on oil production. Do any of the "models" take any of this into account?? If the econmoy does not improve based on rosy assumptions, than we only create more debt

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    6. hey anonymous, you can only conclude that those plans increased the deficit if you assume that economic growth would have been the same or nearly the same without them, a big assumption. The deficit increased for one reason only, because spending continues to rise as it has since after ww2. By the way, Volker almost crashed the entire economy, I never want to experience that sort of bad medicine again.

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    7. Hey KyleN; I can conclude that Reagan and Bush tax increased the debt, because they did. I don't oppose tax cuts as long as there are real spending cuts and not offset by "increase tax payments - due to the improved economy". The issue is that our economy is effected by variables that we don't have control of. And yes a dose of Volker was not tasty, but we don't have 14% mortgage rates

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    8. Anonymous is confusing a forecast and a policy analysis, which is basically a partial derivative. "Other influences" are irrelevant. The point is not to forecast GDP, it is to figure out how much GDP would be higher or lower than otherwise -- holding other influences constant -- if we change tax law.

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    9. John, the partial derivative language is hard to argue with, because it's correct, strictly speaking. The problem is, it contradicts what you and other conservatives have been saying. You have been claiming that if we broaden the base and lower the rate, economic growth will follow. Now you are saying that it may not follow at all, because other factors combined can overwhelm the effect of this plan. Ok, but shouldn't we then try to identify what these factors are that are so important, rather than fixate on lowering rates ?

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  4. John, I understand the logic behind what you are talking about here. But the problem is very simple: what if we do all that stuff and the miraculous positive effects do not materialize? Wouldn't that blow a huge hole through the budget? In other words, if you do not do dynamic scoring you assume apriori the plan will not work, which seems silly, but if you do dynamic scoring you assume apriori that it will work. But how do we know it will work. After all, we did cut marginal income tax rates in 2001 and people took that extra money, invested it in bigger houses, which subsequently blew up. So how can you be sure this won't happen again? Do we have a shred of statistical evidence either based on historical data, or cross section of other economies that this actually works ?

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  5. Dynamic scoring is the only sensible idea. But you should have acknowledged your implicit assumption that all deductions have been infra-marginal; you do not donate to charity from your marginal earnings, you do not work more for more health insurance, you do not work for a bigger mortgage.

    Otherwise the 'effective' MTR is actually lower (though insalient and messy for sure) now than the statutory rate, and the nominal rate cut without deductions won't help anyone. It is not honest to call the (half-public) Romney plan as a pure 20 percentage-point MTR-cut.

    You can also refer to fiscal externalities if you like, from here:
    http://elsa.berkeley.edu/~saez/piketty-saez11handbook_v10.pdf
    http://elsa.berkeley.edu/~saez/piketty-saez-stantchevaNBER11thirdelasticity.pdf

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  6. "The model assumes a rather low labor supply elasticity of 0.3."

    Can somebody help me here? What does this mean? Thanks

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    1. It measures the question, suppose your boss gives you a raise, so (say) you earn $60 an hour not $50 per hour. How much more do you work? (Technically, we also take away some money so we measure the pure "substitution" effect without an "income" effect. So, your salary goes up but (say) they simultaneously raise property taxes)

      We also want to include here people who are out of the labor force at the wages they face now, going to school, looking for better jobs, waiting for their house value to recover before moving, taking disability, staying home with the kids, etc., and would be attracted to working more if their after-tax wages were higher.

      Obviously, this is a key effect for a revenue-neutral rate reduction to help the economy. And assuming bigger numbers can make the dynamic scoring look as good as you like. My impression is that 0.3 is pretty low in this game, but we will soon hear from labor economics experts if I'm wrong on that.

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    2. John, yes, in graduate macro we learned all about the labor supply elasticity. But having been working out in the real world for a dozen years, it strikes me as a bit contrived. Most people work about 2,000 hours a year, give or take. If my boss raises my wage from $50 to $60 an hour, I'm still going to put in my 8 hours a day then promptly head to the pub. I'm on a salary, but most hourly employees who do actual labor (instead of surfing the web at work, cough) just get physically tired after awhile and can't really work longer on a consistent basis.

      Even for most part-timers, I would speculate that most of them choose their labor supply not based predominantly on the wage but on other factors. Students work 20 hours a week instead of 30 not because of the wage, but because of class schedules, having sufficient time for partying, etc. Mothers who work part-time do so while their kids are at school or just long enough to qualify for company-sponsored health insurance.

      I fully appreciate that incentives matter and whatnot, and I can certainly see how lower tax rates can encourage investment. But it seems to me that labor supply isn't terribly elastic so that relatively minor tweaks in tax rates can make much difference.

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    3. That's why the participation margin is particularly important. Labor force participation dropped dramatically and hasn't recovered. Empirically, mothers especially seem to respond a lot to wages.

      Also, note that this report found the labor margin not particularly important. Most of its dynamic effects come from raising the returns to investment. Now tell me hedge fund managers don't pay attention to after tax rates of return in deciding where to put their money!

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    4. On the consensus (?) labor supply elasticities, for both intensive and extensive margins, see these papers:
      http://obs.rc.fas.harvard.edu/chetty/bounds_opt.pdf
      http://obs.rc.fas.harvard.edu/chetty/ext_margin.pdf

      Also note that we like to talk about earnings elasticities as they are a composite of many important margins (second job, effort, promotion, human capital investment, bonus). These papers take that into account. That said, there are many rigidities in real life, which do matter at least in the short run (organization of the workplace, salience, switching costs). These estimates go a long way to be robust to that and still end up with 0.3.

      But everyone would admit that truly long-run responses like investing in your kids and career choices and what not are very hard to estimate, so are missing from the 0.3 number. That said, clinging to a hope of large responses contrary to all our best though imperfect evidence does not sound like a good Bayesian thing, unless one has unscientifically strong priors or in his heart lets anecdotal evidence outweigh economists best efforts at scientific estimates.

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    5. Absolutely on mothers responding to wages.

      My wife is a well paid consultant 100k+, but after taxes, in home child care, eating out, guilt at not being there, outsourcing of most houshold work she is really close to the margin on wether to work or not.

      The wives of most of my peers and neighbors do not work. Most of these women are college graduates in desirable fields (nursing, engineering, etc) but given that their husbands also do quite well it is not worth the effort to work given that 1/3 of the extra income will go to the fed/state govt.

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    6. I know no one who gives that as an excuse and it is actually a counter argument. So even with a tax rate of 33% someone with a high income will not put in more hours if they already have a high income. Under this theory those people who pay no income taxes because should be putting in the most hours and as your income goes up and your tax rate you work less and less.

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  7. "Now tell me hedge fund managers don't pay attention to after tax rates of return in deciding where to put their money!"

    I do not see the connection between what you just said and the investment rate in the economy. Why letting a hedge fund manager take more at the margin would raise the investment rate? Please elaborate.

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  8. I'd like to know if the CBO gives any multiplier effect to a dollar spent by government. Surely the highest this multiplier can be is zero, and in all probability the multiplier is negative because of the inefficiency of government bureaucracy handling the transfer from tax payer to government.

    Romney's plan eliminates the inefficiency of the transfer outright by leaving the money in the hands of the originator. Doesn't Romney's plan get a multiplier boost where the dollar remaining with the originator who earned the dollar is spent directly by that individual without the loss incurred by tax collection?

    Does the CBO account for this efficiency in any way?

    I hope my thought is clear.

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    1. "I'd like to know if the CBO gives any multiplier effect to a dollar spent by government. Surely the highest this multiplier can be is zero"

      Not sure why. There is no macroeconomic model that I am aware of that would generate a multiplier of zero and there is plenty of empirical evidence that this multiplier is about 1 or higher.

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    2. really, you need to do more research. There is evidence that the multiplier is less than one.

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    3. KyleN: I do not need to do research, other people smarter than me have done it already. If you bother learning try the review of the literature that recently came out at The Journal of Economic Literature.

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  9. CBO defers to JCT [Joint Committee on Taxation] for tax analysis and uses JCT revenue estimates. JCT allows for some tax avoidance behavior, such as postponing sales with capital gains, switching to muni bonds and other non-taxable income, etc. However, JCT assumes in its analyses that tax policy has a negligible effect on GDP growth.

    Consequently, CBO overestimates tax revenue from a tax rate increase or a new tax, and CBO underestimates tax revenue form a tax rate decrease.

    Built into the Congressional legislative system is a bias towards overestimating the tax and fee revenues, and economic growth, for new government spending programs. As long as Congress overestimates tax revenues from a tax increase and ignores GDP growth effects of tax changes, the US deficit will continue to grow and new programs will be introduced that worsen the deficit.

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  10. Professor Cochrane thank you for answering my question on the meaning of labor supply elasticity.

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  11. I am discouraged by the knee jerk reactions from certain economists like Paul Krugman to Romney's tax plan, that he is just lying.

    Lower marginal rates, eliminating deductions on high income earners, staying revenue neutral, while not increasing the deficit is certainly possible. These goals may come partially as trade-offs to one another, so you have to ask which of the goals is most important. My sense is that not increasing the deficit would be his primary goal - and then, through negotiation in the legislature, the various marginal rates could be tweaked in a fashion to achieve this goal.

    Why can't the normative differences between the camps be a discussion about just that - differences in value, rather than immediately delving into the name calling. That is usually the tactic of lesser minds or those who cannot understand the discussion. I do not understand why this is the tact taken by Dr. Krugman.

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    1. Actually, if Krugman thinks the "budget math" doesn't add up, he should be cheering. Hasn't Krugman been calling for about $5 trillion additional deficits for years now? Somewhere there seems to be a theory that Republican deficits lead to hyperinflation and Democratic ones to stimulus, but I haven't figured it out yet.

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    2. "Somewhere there seems to be a theory that Republican deficits lead to hyperinflation and Democratic ones to stimulus, but I haven't figured it out yet."

      I will help you figure it out:

      Republican deficits (as in Bush 2) were incurred in a fully employed economy. Democratic deficits (as in Obama) have been incurred in an economy with underemployment and underutilization of other resources.

      Such Republican deficits tend to be inflationary, whereas the Democratic ones are stimulative.

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    3. I would hardly use such a small sample size (2 presidencies decide the habits of all Republicans and Democrats?), but let's follow with what John said. If we'll still be underemployed, and Romney takes office and uses his plan, then, according to your logic, that would be "stimulating". I would argue that it's complete nonsense, but using YOUR logic and the circumstances that's the conclusion. Taking your logic to a further extreme, it's a matter of which candidate is claiming to add the largest amount to the debt that will be the most "stimulating". Hmmm.

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  12. "Actually, if Krugman thinks the "budget math" doesn't add up, he should be cheering. Hasn't Krugman been calling for about $5 trillion additional deficits for years now? Somewhere there seems to be a theory that Republican deficits lead to hyperinflation and Democratic ones to stimulus, but I haven't figured it out yet."


    The difference is that Republican deficits due to tax cuts not matched by expenditure cuts are permanent.


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    Replies
    1. But if they are permanent, wouldn't the Keynesian logic say that their stimulative effect is even higher?

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    2. Oh gee wiz! all deficits are permanent unless you cut spending!

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    3. To Gio:
      In most macroeconomic models, permanent deficits cause consumption to fall. That is because those deficits have to be financed by taxes. That is true in Keynesian models but also in neoclassical or monetarist models too.

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    4. Anonymous, Just trying to follow you: what about the Ricardian Equivalence Theorem, then?

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    5. Gio:
      That is irrelevant. Temporary fiscal stimulus in the form of government purchase of goods and services increases output even if RET holds and the world is completely neoclassical instead of Keynesian.

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  13. Does anybody really think Bill Gates or Steve Jobs would have worked harder were his tax rate lower.

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    Replies
    1. I think there is a good case that they would have worked less hard facing, say, the new French 75% taxes on capital gains. Gates might have finished college rather than risk it all on starting a business. More importantly,businesses like these don't spring from the minds of their founders, they need venture capital willing to take big risks funding them in early stages. That activity is much less likely to persist if we squeeze the golden goose for its eggs.

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    2. That is simplistic. Could they have got the financing for their businesses if after tax profits on investment were only 10%? Doubtful.

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    3. You are making exactly my point, Professor. Indeed, the French rate might be the tipping point. Our highest rate of 35% (soon to be 39%) is not that. In fact, a paper by Christina Romer indicates it may be 33%, while others say it could be as high as 70%. I'm not arguing about a particular number. Just pointing out that raising or lower the rate in and of itself does not do what you claim it does. A certain (perhaps unknown) threshold must be met for that to happen.

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    4. I know that my wife, a working mother, WOULD work substantially fewer hours or retire if her marginal income tax rate rose from 35% to 75%. Economists have found that the marginal rate cuts of Reagan did encourage married women to work.

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    5. If Gates and Jobs would not have worked harder or smarter, their financiers, investors, and employees most likely would have financed less and at higher costs and worked less or elsewhere (where the pressures would have been less).

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  14. I am all for lowering the rate and broadening the base on federal taxes.

    Of course, for FICA taxes, that would mean lowering the rate and broadening the base to include all income to whatever level (now capped at $100k of wage income), even non-wage income, such as income from rents or interest etc.

    Of course, Cochrane will have a nice explanation of why that is not what he endorses.

    ReplyDelete
    Replies
    1. It is not a bad idea if you also simultaneously lower the income tax rates at the high end, otherwise it is like a 12% marginal tax increase, and that would lower income available for investment considerably. Any way you want to slice it, you cannot get away with trying to soak the rich. They will simply move out (as they are doing in France) invest abroad, invest in municipals or something that does nothing for the economy, or simply not invest.

      You can have your politics of envy or you can have growth and high employment, but you can't have both.

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  15. The Tax Foundation says that 60% of the cost from a marginal rate reduction will be recouped because of higher economic growth and higher incomes, and therefore only 40% actually needs to be recovered with base broadeners to be revenue neutral. But by getting rid of deductions and taxing the income that was formerly deductible, wouldn't that work against the economic growth effect, so that the more the plan broadens the base, the less that economic growth can recoup the revenue? To be revenue neutral, wouldn't Romney's plan therefore need more base broadeners than the 40% of the cost figure?

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  16. Could we do a dynamic scoring analysis on this country's last round of tax cuts in the prior presidential administration? Don't we have that data?

    Also, I'm not sure I'm buying the idea that people as a rule will work longer hours/an extra day/ etc. with a lowered tax rate. We've had years of people working longer hours for less money. Aren't there also reams of data that show people really don't "Go Galt" until their tax rates are much, much higher than they are now, or than they are proposed to be under Obama?

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  17. I think the reason the Tax Policy Center is right to hold Romney to the standard of revenue neutrality is because they take his word for it, but Obama's plan is overtly revenue-positive because he's talking about raising marginal rates on high income earners. Saying a tax increase is revenue neutral is nonsense: his is increasing revenue vs. baseline (extend Bush tax cuts ad infinitum) and Romney says he's cutting taxes without increasing revenue. I get your earlier point abt dynamic scoring, but if the TPC doesn't do dynamic scoring, then neutrality would have to come from some revenue enhancements somewhere.

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  18. If you look back at the Tax Reform Act of 1986, the top rate was brought down from 51% to 34% and income tax collections never missed a beat. Reduction in rates, reduction in deductions, revenue neutrality.

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  19. Here is a recent post from one of the authors of the original TPC study:

    http://www.brookings.edu/research/opinions/2012/10/08-romney-tax-debate-gale

    and an article on Bloomberg reviewing the studies Romney is relying on (the Romney campaign gave him the list so we know this is what the Romney campaign is referring to):

    http://www.bloomberg.com/news/2012-10-12/the-final-word-on-mitt-romney-s-tax-plan.html

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  20. Sorry, I should have included this in my last post. Here is a letter from the Joint Committee on Taxation, talking about how hard base broadening is in practice:

    http://www.washingtonpost.com/blogs/ezra-klein/files/2012/10/BN_101212_192832.pdf

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  21. Dear Mr. Cochrane,

    Your statement:

    "Unlike a Keynesian plan, whose purpose is to transfer wealth to the hands of people (voters) likely to consume it, or a redistributionist plan, whose purpose is to transfer wealth from one category to another of people, the point of a revenue-neutral, income-neutral tax reform is to permanently and predictably lower marginal rates, giving rise to incentives to work, save, invest, and increase economic growth over the long run."

    First, there is no such thing as permanent and lower marginal tax rates. They didn't stay low after Reagan left office, and it would be highly unlikely that they would stay low when and if Mr. Romney were elected and then left office.

    The only thing even close to permanent that you get from a political organization like the federal government are the long term contracts that it sells (currently bonds). Milton Friedman (a one time Keynesian) realized this and derived his permanent income hypothesis.

    A federal government bond is a contract sold by the Federal Government that makes regular interest payments. Those interest payments are funded by tax revenue and are guaranteed by the 14th Amendment to the Constitution. It would seem to me that the federal government could at its choosing sell non-guaranteed equity like claims against the same future tax revenue. In essence, the federal government would be selling tax breaks.

    The primary reason to do this is as follows:

    Because the federal government does not exist to compete with the private sector in the production of price sensitive goods and because the buyer of a U. S. Treasury bond is guaranteed to receive his / her money back plus interest, neither the federal government nor the bond buyer has an economic incentive to produce anything.

    When the federal government sells a tax break with a rate of return and a duration, the owner of that tax break must have a taxable revenue stream to realize the gains against. Meaning, that person must be out working a job and producing something to sell to realize the return on investment.

    In this way you get a lower tax burden AND a reduction in the federal debt.

    ReplyDelete

Comments are welcome. Keep it short, polite, and on topic.

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