Friday, October 27, 2017

Economists and taxes

My last post on taxes continued the question, who bears the burden of the corporate tax? Will a reduction in corporate taxes benefit stockholders or workers? It was a fun technical discussion.

But the whole time I want to scream: That is the wrong question! And the public economists job should be to scream from the rafters, that is the wrong question!  By just accepting the question, we are doomed to bad answers.

The public, and politicians, analyze taxes entirely through the lens of who gains and who loses. Income redistribution, yes, but also redistribution from renters to homeowners, married to unmarried, young to old, city dwellers to farmers, Texans to Californians, and so on. The political and popular discussion is about taxES, and who pays what.

Economists serve best when they offer thoughts outside the standard left-right partisan divide. Our first function should be always to remind people that marginal tax rates matter to the economy not taxes. 

Our second insight is always to analyze things comprehensively. The Federal income tax is not what counts, the entire wedge between work and consumption matters. Whether the corporate tax is progressive or not does not matter, whether the overall tax code is progressive (plus the overall spending code, and forced cross-subsidy code!) matters.   Don't tax wine over beer to redistribute; tax goods evenly and achieve progressivity through a progressive income (or better, consumption) tax, or spend money on programs to help people whose distress is correlated (imperfectly) with beer drinking.

Economists may feel their moral sentiments about redistribution are really important. But we have little professional reason to argue our feelings are better than anyone else's. What we can argue is, if you'r going to do more or less redistribution, do it efficiently and comprehensively.

In this context, the current tax reform proposal, and its instant dismissal from self-identified Democratic economists, echoing political rhetoric, is a deep disappointment.

The economists' tax reform starts with a detailed breakdown by income. (I'm caving to political reality that our nation is obsessed with income, not more meaningful measures of economic advantage and disadvantage.) Then, we create a tax reform in which each group pays the same amount (ideally, bears the same burden), but trades lower marginal rates for fewer deductions, exemptions, and for the reduction or elimination of taxes that either highly distort economic activity or lead to lots of inefficient avoidance  (corporate, rates of return, estate).

In short, we aim for a revenue-neutral, redistribution-neutral, reform. We recognize that eventually tax rates must be high enough to cover spending. There isn't a big need to argue over Laffer effects. Even if scored as statically revenue neutral, when the economy booms, revenue flows in, and we have paid off the debt we can start lowering rates. We recognize that if the structure if the tax reform is fixed, we can later continue to argue over the right amount of redistribution.

1986 came close. It wasn't perfect. But at least the rhetoric was this, and politicians explained this goal to the public. You will pay the same taxes, but at lower rates for fewer deductions, and the economy will grow. And lo, it did.

For thirty-one years, we have waited to finish the job. As the tax code grew more complex, with higher statutory rates and more deductions, we waited to redo the job. Reform proposal came and went, with at least a nod to this amount of economic sense.

But no more. Now tax policy is all redistribution all the time. Democratic politicians have decided that their mantra is "tax cuts for the rich." Well, a slogan is a slogan. More sadly, self-identified democratic economists echo this mantra, and little other. Anytime you're arguing one side's talking point or another, you're doing little to illuminate a discussion.

Each provision is examined in isolation for its redistributive impact. It's profoundly hypocritical of course.  Tax deductions are indeed a "tax cut for the rich" since people in the 40% marginal bracket who itemize get a lot more than Joe and Jane down in the lower brackets. But you hear either silence, or pretzel logic defense, such as the New York Times defense of the profoundly regressive deduction for state and local taxes.

I was disappointed at both the rhetoric and the small progress of the administration's proposal's to date. Yes, cutting the corporate rate is a good idea. But they don't even try to argue for marginal rate reductions or incentives. The buzzword is to give "tax cuts to help the middle class," which the left can then argue is a "lie" or not. Once you fall for redistributionist rhetoric, once you say that tax policy is all about giving the right people more and the wrong people less money, I think the hope for a tax reform that actually gets the economy going is dim.

The holy trinity was off the table from the start -- home mortgage interest deduction, charitable deduction, and employer-provided health deduction. The fourth horseman of the apocalypse, the deduction for state  and local taxes, is in danger. (Sorry for mixing metaphors!) This is like a wayward husband saying, "sure, I'll clean up my act. However, the drinking, gambling, and smoking are off the table." The corporate tax reduction does not seem to be coming with a serious cleanup of the thousands of deductions and extenders, each catnip to the lobbyists who keep them in place.

The political challenge for a reform is to say to each group, "you're going to give up your deduction, yes even interest on future home mortgages. But, your rates will go down so much that you will end up paying no more overall, and as the economy grows you will pay less. I want your help holding the fort against those who will demand their deductions and subsidies." That's a deal that pretty much held together in 1986. But if we go into the negotiation saying "oh, and by the way the big three are getting theirs unscathed," and "therefore really big rate reductions are off the table," then the hope of putting that coalition together is gone. It's  a free for all, call your congressperson and make sure you keep yours.

The bottom line: I support the current tax proposal, as incomplete and flawed as it is. It is a step in the right direction. We get the corporate tax rates down to those common in that low-tax free-market nirvana, Europe. It is not, however, 1986 on its own.

I do not support the rhetoric. "Tax cuts" do not work absent spending cuts. Cuts in distorting marginal tax rates matter. The people in charge must surely understand this, so the choice to market it as "tax cuts for the middle class" represents, I think, an unwise rhetorical choice.  The American people are smart enough to understand this, and playing redistribution, bidding for support with handouts, is not a winning game.

Moreover, the sense I have from talking to people, less enshrined in economic theory, is that massive tax complexity and uncertainty are larger drags on growth than a stable simple but high tax rate would be. I see "simplification" in the rhetoric, but no substantial simplification in the body of the proposal. It leaves most of the "finish 1986" job undone, and unless magic happens on entitlement reform, this tax bill will be undone soon as the deficit widens. If it is all we get, and if it is passed as Obamacare was passed, with no votes from the other party, it will not give the sense of permanence necessary to induce a lot of investment and growth.

It needs to be a first step, not this generation's tax reform for the next 31 years. I understand the politics. Republican leadership needs to do something. If Democrats will unite in "resistance" to a bill celebrating mom and apple pie, they need to do something on their own. If they do something, and look like winners, they can get support to do more. But it must be that first step. And even so, I would have hoped for some more courage in the first step. Enshrining the triplet of deductions without  a fight, not even mentioning marginal rates, makes it ever harder to remove them in a second step.

And I wish I were hearing a lot of this, and not just echoing the political line "tax cuts for the rich," from top economists more critical of the proposals.


  1. How was Obamacare passed "with 51 votes from one party"? Didn't the Senate pass the ACA with 60 votes and the House then approved the Senate's version? I'm genuinely curious why Professor Cochrane is referencing Obamacare when discussing tax reform. Is it to say both methods of passing the laws are less than ideal? If so, the argument should be that both proposals would be passed without bipartisan support. This matters because Professor Cochrane's whole point is that economists should advocate on issues where they can contribute constructively rather than take usual partisan stances. This swipe at Obamacare, especially since it's factually wrong, is therefore unfortunate and unnecessarily distracts from his message.

    1. "How was Obamacare passed "with 51 votes from one party"? Didn't the Senate pass the ACA with 60 votes and the House then approved the Senate's version?"

      "This swipe at Obamacare, especially since it's factually wrong"

      Have I missed something important or did you just lie?

    2. Obamacare was passed PURELY on the party line. No Republican votes. He mentions Obamacare to make the point that if one side passes legislation with no approval from the other side, that legislation will almost surely be doomed when the power flips.

    3. Wayne Chang:

      When the Affordable Care Act ("Obamacare") was passed (early 2010), the Democrats had lost the 60th seat in the Senate, due to a special election in Massachusetts, which the Republicans won (it was Ted Kennedy's seat, he died in August of 2009).
      Therefore, when Obamacare was voted on, Republicans had 41 seats and Democrats 59 seats in the Senate.
      This is the reason why Democrats invoked "Reconciliation" to pass it in the Senate. This meant, they needed only 51 votes in the Senate to pass the Affordable Care Act.
      I hope this clears it up for you.

    4. Sorry, this is false. The Senate passed PPACA with 60 votes, after the House had passed its bill. They were supposed to go to conference committee to resolve the differences when Kennedy died, leaving them 1 vote short of a filibuster-proof majority to approve the resolved bill. As a result, they came to a deal with the House in which the House would pass PPACA as is, allowing the president to sign it into law, but then they passed a secondary bill through reconciliation to offer some concessions to the House. Reconciliation was only used for the supplement—PPACA was passed by both houses, including 60 votes in the Senate (all Democratic votes in both chambers).

    5. Ok Anonymous - why did they need the second (supplementary) bill? What would have happened if the second bill had not passed? If what you are saying is correct, why did they just not keep it with the first bill and be done with it? Why did Obama wait until March 2010 to sign the bill into law?

    6. Actually Anonymous, you are totally wrong.
      My source is: James Capretta, October 18, 2011 in the National Review, "The Reconciliation Option". I can send you the PDF if you would like.
      In that article, Capretta specifically states:

      [Quote:] "For starters, it seems that some might need a refresher course on the history of Obamacare’s enactment. Reconciliation didn’t play a small role in Obamacare’s passage, as has been suggested. Without reconciliation, Obamacare would not have become law at all. It’s true that the main Obamacare structure was passed by the Senate in December 2009 under normal rules for legislative consideration. That’s because Democrats at that time had 60 votes (including two independent senators who caucus with them). They didn’t need to resort to reconciliation to pass the bill as long as all 60 of their senators stuck together and supported passage, which they did.

      But then Scott Brown won the Massachusetts Senate race in January 2010; the Democrats lost their 60-vote supermajority and could no longer close off debate on legislation without the help of at least one Republican senator.

      At that point, the president and his allies had two choices. They could compromise with Republicans and bring back a bill to the Senate that could garner a large bipartisan majority. Or they could ignore the election results in Massachusetts and pull an unprecedented legislative maneuver, essentially switching from regular order to reconciliation at the eleventh hour, thereby bypassing any need for Republican support. As they had done at every other step in the process, the Democrats chose the partisan route. They created a separate bill, with scores and scores of legislative changes that essentially became the vehicle for a House-Senate conference on the legislation. That bill was designated a reconciliation bill. Then they passed the original Senate bill through the House on the explicit promise that it would be immediately amended by this highly unusual reconciliation bill, which then passed both the House and Senate a few days later, on an entirely party-line vote." [End of quote.]

      You, Anonymous, are totally wrong in claiming that the House had passed a first bill. No, the SENATE had, but not the House. But because the Democrats lost the majority when Scott Brown won, they changed tactics and invoked reconciliation.

      Let's keep the fact straight.

  2. Keeping marginal tax incentives positive is a double sided coin. The implication is that we all can adjust our inventory of both private and government goods. If the government goods distribution is illiquid then inevitably some of us come up short of the one or the other. That causes cycles because what individuals lose in a transaction they make up in transactions going forward, they try to complete the loop.

  3. You write: "marginal tax rates matter to the economy not taxes". I can see this from micro-economics -- marginal rates influence decisions. But the total effective tax rate determines government income and debt.

    Maybe economists, those specializing in the dynamics and social consequences of inequality have something useful to add to the debate on progressive taxation. I (not being an expert but willing to read expert research) have the impression that economic inequality is bad for society -- slows growth, harms democracy, lowers total utility.

    Our complex tax code leads to inefficiency (people waste work doing taxes). The bottom line numbers have little to do with this. Maybe you should go to work simplifying amortization rules, etc.?

    -- Jonathan Goodman, NYU (don't now how to make this my handle)

  4. John,

    "But the whole time I want to scream: That is the wrong question! And the public economists job should be to scream from the rafters, that is the wrong question! By just accepting the question, we are doomed to bad answers."

    So let me SCREAM!!! Focusing on the the deficit is asking the wrong question. Focus on the debt instead.

    "It leaves most of the finish 1986 job undone, and unless magic happens on entitlement reform, this tax bill will be undone soon as the DEFICIT widens."

    And so you are doomed to bad answers.

  5. John,

    "If it is all we get, and if it is passed as Obamacare was passed, with no votes from the other party, it will not give the sense of permanence necessary to induce a lot of investment and growth."

    The only way you will get the kind of tax policy permanance needed is for the federal government to sell tax breaks instead of bonds. You do realize that none of us will live forever - yes? I don't want a tax break that is going to extend beyond my own lifetime.

    It would be beneficial to me (and to anyone doing investment planning) if the federal government sold tax breaks in a variety of maturities and allowed me to purchase the maturity spectrum of tax breaks that make sense for me.

  6. Well, fair enough post.

    I do think there are ideas that are not even on the table.

    1. A payroll tax cut. This would incentivize working and hiring. Not worth a sentence in this blog or anywhere in D.C.

    2. Do nothing, but cut marginal income tax rates from the bottom, leave the top rates where they are. This would be a "middle-income" tax cut, and might even save the establishment GIOP from oblivion. Otherwise, the Trumpsters will take over the party, as rank-and-file GOP voters will sense the establishment is rigged against them. Which may be inevitable anyway.

    3. A national property tax.

    4. Higher tariffs. Interesting question, which is more destructive: Taxes on wages or taxes on imports?

    5. Higher gasoline taxes.

    6. I guess a larger standard deduction is part of the tax proposal, and this might be a good idea.

    7. A national sales tax.

    Right now, the macroeconomic problem is weak aggregate demand. There are capital gluts, globally. So taxes should be cut in a way that results in increases in demand

  7. You write "1986 came close. It wasn't perfect. ..... . You will pay the same taxes, but at lower rates for fewer deductions, and the economy will grow. And lo, it did."

    But according to the FRED data base US real GDP grew by 3.44% pa from 1975-1985; 2.92% pa from 1985-1995; and 3.36% pa from 1995-2005. The per capita equivalents are 2.46%, 1.8% and 2.32%.

    If the 1986 tax changes had a big "lo" effect on growth why isn't it there in the data? Indeed why did growth fall in the decade after the tax changes?

    1. I don't understand your choice of dates here. You're using 1985 as the dividing line when the rate reduction in question was phased in from 1987-88. Keep in mind there was also a large reduction in marginal rates in 1982-83. Looking at full business cycles, I think one could easily argue the cuts did boost growth rates.

      From Q1 of 1975 through Q3 1981 real GDP growth averaged 2.60% or 1.55% per capita. From Q4 1981 through Q3 1990 it averaged 3.38% or 2.41% per capita.

    2. I agree the choice of dates is an issue but in a way that's the point: it shouldn't matter that much if the effects on growth were so visible.

      But your choice of dates seems bizarre: the original blog was about the effects of the 1986 tax changes which as you say were phased in in 1987-8. Yet you are assessing them using a period of 9 years in 6 of which those changes weren't operating.

      But anyway let's take your period and assume we are assesing more general tax changes. I can't get your figures. From the FRED data base Real GDP per cap was 24601 in 1975Q1; 28931 in 1981Q3; 28519 in 1981Q4 and 35850 in 1990Q3. This implies an average growth rate of 2.49% (not 1.55%) in the earlier period and 2.61% in the second. Is this the "lo" boost to growth?

    3. Sorry, small typo there. The first cycle should have started in Q1 1974, not '75. Again, the dates I chose are for full business cycles (peak to peak) taken directly from the NBER. I also think you're using the wrong baseline for those calculations (i.e. if Q4 1981 was the first quarter of the new cycle, then your baseline should be Q3 of that year).

      There were two large reductions is marginal tax rates in the 80's. I thought this was the most sensible way of comparing the numbers. I suppose you could also measure cyclical troughs in which case the per capita averages I'm coming up with are 1.62% from Q2 '75 through Q4 '82 vs. 2.85% from Q1 '83 through Q1 '91.

  8. "I (not being an expert but willing to read expert research) have the impression that economic inequality is bad for society -- slows growth, harms democracy, lowers total utility."

    How do you define "economic inequality?" If income inequality reflects inequality in the value of goods and services provided, that inequality promotes growth and democracy. I don't know how to measure "total utility," so I offer no comment on it.

  9. The tax reform discussion is important in all its manifestations. Another discussion would include the public goods, progressive taxes finance. Bureaucrats assume the market place can't provide public health, welfare, education, national and domestic security or a clean environment. Actually, markets solve public goods and externalities problems in myriad ways. Free riding is eliminated. Cable TV, private roads, Police protection and fire services are often sold in the private sector via individual property rights. Privatizing public goods offers a solution to the distorted marginal tax rate issue. Intellectual objectivity requires imperfect market solutions to public goods problems be weighed against imperfect government solutions.

  10. If the economist's job is to improve the economy it seems like this improvement could be measured in multiple ways. You could measure the GDP growth of the overall economy, or you could use measure improvement to the sum of total utility values for all participants in the economy. Because of the concavity of the utility function (an extra $10K/year matters a lot more to someone making $50K/year as opposed to someone making $500K/year) if you measure the sum of participant utility values I think it is likely you would come to the conclusion that the highest priority facing America right now is to focus on increasing the utility/consumption of the lower and middle income tax brackets while still encouraging work and growth (if we can help the rich as well that's fantastic, but increasing their utility is more expensive). Some economists (which I am not) have arguments for why consumption gains for the lower and middle class are still optimal when thinking about overall GDB growth (eg increased spending on food stamps being the most efficient program in the stimulus) which you can agree or disagree with. I just wanted to chime in with an alternative reason for why focusing on whether low / middle income Americans "win" in any proposed legislation could be a primary focus of economists and voters alike. Obviously if someone is using a non-standard measure for country-wide economic utility they should say so explicitly.

    Thank you for the thoughtful discussion.


  11. "the profoundly regressive deduction for state and local taxes"
    I profoundly disagree. It is neither progressive nor regressive. That "deduction" is simply an obtuse method for arranging that states first take a percentage of our income and then the federal government takes a percentage of what's left. Remove (and not substitute a more rational mechanism) that "deduction" and we get double taxation. i.e. a portion of income gets taken twice.
    It can be illustrated with an extreme example. If the state/local tax rate amounts to 50% and the fed tax rate is 50% then there is nothing left over for the individual. The fed would be taking a percentage, from the individual, of money that was already taken away by the state.
    Whereas if the state took the first cut then the fed a cut of what's left then the individual would be left with 25%. The "deduction" we have (had?) is a peculiar way of implementing this second case.

  12. "Enshrining the triplet of deductions without a fight, not even mentioning marginal rates, makes it ever harder to remove them in a second step."

    The bill that the Senate just passed would appear to make it easier to remove these in the future, at least the charitable and home mortgage interest deduction. By doubling the standard deduction, they greatly reduce the number of taxpayers who benefit from these. Zillow estimates that a single-digit percentage of homes cost enough for taxpayers to benefit from itemizing under the Senate plan.


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