Friday, April 6, 2018


Economists delight in unravelings -- behavioral responses that undo bright ideas. A subsidy for skunks produces cats with white stripes. Two good ones came up this week.

As hare-brained as they are, I have to opine that the actual economic consequences of US steel import tariffs and Chinese soybean tariffs are essentially zero.

(Political comment: tariffs are taxes on imports. It would do fans of the Administration's trade policies good to utter the correct "tax" word to describe tariffs. Or "self-inflicted sanctions." )

Why do I say that? Each country is assessing a tariff on goods produced only by the other country. Well then, why not park the ships overnight in Vancouver, or Tokyo, fill out some paperwork, and say steel is imported first from China to Canada, and then Canada to the U.S., and vice versa?

Trade bureaucrats are smart enough to catch that. But they cannot hope to stop essentially the same thing: China sells steel to Canadian steel users, who currently buy from Canadian firms. Canadian steel producers reorient their production to the US, and sell to US companies who formerly bought from China. The steel is genuinely Canadian.

US soybean producers, rather than sell to China, sell to Canada, Brazil, and Europe. Producers there sell to China. The total amount made is the same in each country. The total amount used is the same in each country. It is just as if we parked the ships.

It's not exactly the same cost, because ships have to go further. People have to find new suppliers. But these rearrangements ought to be a very small proportion of the cost.

More. US farmers can take land that used to make soybeans and make wheat. Chinese farmers can take land that used to make rice and make soybeans. OK, not all land is great for all crops, but it is the kind of adjustment that quickly occurs.

Multiplying current trade patterns by a tariff to calculate the price impact is hopelessly wrong.

The second sad story comes from the Ruth Simon and Richard Rubin at the Wall Street Journal, on how passthrough businesses are adapting to the new corporate tax code -- largely as many people warned on its passage.

The issue: Corporations, pass-through businesses, and the highest income individuals, all used to pay about the same rate. The tax reform lowered the corporate rate to 21%. If it left the pass through rate intact, many of those businesses would incorporate. Also, the same economic arguments for a lower corporate tax apply equally to pass throughs. So, they lowered the pass through rate as well. But now high income people, facing a 40% federal rate (plus a 13.2% state rate in California, plus other taxes) have an incentive to become a pass through business rather than take wages. So Congress came up with a bunch of rules to try to limit that. Certain kinds of businesses -- doctors, lawyers -- couldn't become pass throughs. There are income limits and...
Dallas attorney Garry Davis plans to break up his immigration-law practice. One firm will have all the lawyers. The other will record the profits.
...Mr. Davis... figures he can still benefit from the break by splitting his law firm, Davis & Associates, into one entity holding four lawyers and another holding the 26-person administrative staff, who take information from new clients, put together immigration applications and handle other tasks. Profits in this part could be subject to lower taxes. 
... Mr. Davis’s approach, which some have dubbed “crack and pack,” seeks to get around a provision denying high-earning lawyers, doctors and other professionals a tax break available to plumbing contractors, restaurateurs and architects...By separating the lawyers from other parts of the business, he hopes to lower the business’s overall tax bill while changing little in his day-to-day operations.
Karen Brosi, an accountant in Palo Alto, Calif., is telling high earners who consult on engineering projects to indicate on tax returns that they are “engineers”—a group not subject to the income limits for service businesses—rather than “consultants,” who are. 
The article goes on with scheme after scheme. It didn't touch real estate, where the real pass through bonanza is.

The margin of incorporating to take advantage of the full 21% rate is still there, only incorporating just the cash flows that fully benefit from that treatment>
Marvin Blum, a wealth planner in Fort Worth, Texas, is pitching a related strategy to his clients: Profit meant to be reinvested into a business is channeled into an entity that pays the new, lower 21% corporate tax rate, while profit that is meant to be distributed to owners in the near term goes into a pass-through entity that pays just the individual taxes. He calls it the “half and half.”

The economic lesson is the same -- trying to tax one kind of income, like commodity imports from one country -- is likely to fail. As I've argued before, here for example, once we try to tax income, we're pretty much stuck with the current mess of individual, corporate, and estate and gift taxes.   The only real solution is to tax consumption rather than income.

The political lesson is more somber. As the article wryly notes:
It isn’t clear how the IRS will look at such arrangements or how it will determine where profits are made. The agency hasn’t yet issued regulations in this area.
The private sector’s old game of cat-and-mouse with the Internal Revenue Service and Congress, in other words, is intensifying, and is likely to play out over years in regulations, audits, appeals and litigation.
Forget the rates. My great sadness at this tax "reform" is that the once in a generation chance to radically simplify the tax code went up in smoke. Instead, you can see that we will have 20 years of wealthy business owners -- just the type to make sure they know their local congressperson well -- in and out of Washington pleading for an IRS ruling or a line in a bill treating this or that kind of pass through income differently. The lawyers, accountants, and lobbyist full employment act is in good shape. 
Back when the Federal Government was funded by tariffs, by the way, the same great game went on with dizzying differential tariff treatment for different kinds of goods.

One has to admire the capacity of Americans for innovation. My, our people are good at restructuring corporate forms towards better efficiency. Too bad we are devoting so much immense talent to gaming regulations and the tax code rather than productive innovation.

Important Update: 

A fellow economist, and tax expert, writes:
Corporate profit is taxed again when it reaches the investor, as dividends and capital gains. The advantage of passthrough taxation was already substantial before the lowering of the tax on the capital portion. It was deluded to think that the corporate rate should be the same as the capital rate for passthroughs. Rather, neutrality would call for a zero corporate rate, given that capital gains and dividends are taxed at the same rate as passthrough income.
The point: corporate profit is taxed at 21%. When they pay out dividends or capital gains, you pay another 20%, for a total of 1-0.79 x 0.80 = 37% rate. And that's after the corporate tax cut! (And just Federal.) Before, that rate was higher so pass throughs that only paid personal tax rates had a big advantage. I agree entirely that the correct corporate tax rate is zero.

I replied:
But… I thought the standard view was that people avoid the second round of corporate taxation...people defer capital gains. Or at least they should!
Well, they can't avoid the tax on dividends. Remember that dividends are taxed both at the notional rate and again by the investment income provision of the ACA. And entrepreneurial capital gains are always taxed when the entrepreneur diversifies. You are right that the conventional view is to ignore personal taxation of corporate income, but it's a big mistake.
This rings true. The strategy to avoid capital gains is to never sell anything, borrow against it if you must, and let the basis step up in your estate. I know enough people running high frequency hedge funds catering to rich people to know not everyone is doing that.

More importantly, according to my correspondent everyone in the article may be wasting their time, and going to jail:
Your discussion of fake passthroughs ignores the key point that the second branch of the coverage rule that defines the capital portion of a passthrough's income refers to the capital owned by the passthrough. None of the gimmicks you cite would actually be legal. The people you quote have not read the law.
The lower rate in the passthrough law applies only to what is deemed capital income. The key provision is that capital income cannot exceed a statutory return rate multiplied by book capital. That engineer who is trying to say he is not providing professional services (a position that would never fly in the first place) will certainly fail to have any significant income at the passthrough rate. It will remain ordinary income.
Another provision of the new law is that capital income cannot exceed wage income of the entrepreneur and employees. That would cut your engineer's capital income at least in half, even without the capital limitation. 
Nobody has given the Republicans credit for the intelligent design of the new passthrough provisions.  
My correspondent is a Democrat, by the way.

I stand by my comment that this is insanely complicated. Are we really achieving a result a whole lot better than a uniform VAT?


  1. Canada adopted a principle known as "integration". When a company pays a dividend to an individual, there is a gross up and a credit to recognize the taxes the company has already paid. The goal is to make the net tax payable the same as if the individual had earned the money.

    There is a benefit in delaying the payment of dividends in that corporate rates are lower than top marginal personal rates. The corporate taxes become, in a sense, for a privately owned firm, a draw against the ultimate personal taxes and a way to mitigate the effects on the public treasury of long term deferral of payment of dividends or the payment of dividends to tax exempt pension plans and retirement accounts.

  2. "Multiplying current trade patterns by a tariff to calculate the price impact is hopelessly wrong."

    I teach the core economics class to MBAs and I try to drill this concept (or a materially similar one) into their heads all the time. I just wish more people got it! Q (demanded/supplied) is a function of P. If you change P, you change Q also.

    My favorite example to use is from the DC city government in the 1980s. They proposed passing a new tax on gasoline and estimated the revenue they'd get by taking the current quantity of gas sold and multiplying it by the tax. What happened? It failed miserably. When the tax passed, drivers just substituted away to MD or VA and the quantity of gas sold in DC dropped dramatically.

  3. Agree with everything except the proposed solution to behavioral responses to the tax code. The same unraveling could occur with a consumption tax. Consumption would be relabeled as investment capital (e.g. iPhone cameras) or intermediate goods (e.g. seminar dinners at five star restaurants). My point: the idea that a consumption tax would radically simplify comes from the fact that it has not been tried, so we have not observed all the creative and devious behavioral responses. It appears radically simpler because it is only an idea on paper. If people can re-label w as rK or p-dot, then they can re-label C as K or M. There are good economic arguments for the consumption tax, but I think its a mistake to sell as simpler.

    1. Jonathan:
      Thanks for the good comment, which is why I am also dubious of a consumption tax implemented via the current code and deductions for "investments." Yeah, that Ferrari will soon be an investment. I favor a flat VAT that applies to all goods, consumption and investment goods, with no income, corporate or estate tax. I think that addresses the simplicity, even though yes it taxes investment goods when they are bought so it is not a consumption tax.

    2. I don't know how the European VATs work but in Canada the GST/HST allows a business which buys a capital asset to deduct the tax it paid on the purchase from the VAT it collects and just remit the net of tax collected minus tax paid. In fact there are special rules for large capital purchases where the business buyer does not pay - he just reports on his next filing in effect: "I owe X on the purchase of [a capital asset] and I claim a credit for that amount so I owe nothing on net."

      There is not a lot of gaming of the Canadian VAT. What there is, is a deep, almost pathological, hatred of the tax by right wing populists which lingers 19 years after the tax was brought in.

    3. Isn't a sales tax a consumption tax? The majority of states do have sales taxes...

    4. Kirk Parker,

      "Isn't a sales tax a consumption tax? The majority of states do have sales taxes..."

      And they are just as complicated and full of exceptions and loopholes as the federal income tax.

      I tend to agree with Johnathan Parker (relation to you?):

      "I think its a mistake to sell (a consumption tax) as simpler."

  4. Your point is well made. Selective tariffs on commodity products will only cause those markets to shift their ultimate destination. I would love to see how much Canada's steel exports to the USA will surge due to the tariff wavier and how much Canada's steel imports will surge to support their own domestic consumers. The same thing would likely happen with Soybeans in which Brazil might actually need to import Soybeans because so much of their own domestic production is being exported.

    Outright bans or quotas are the way to go. /sarc Try importing some sugar without the necessary permissions and bad things will happen.

    It should go without saying that commodity based tariffs are exceptionally bad.

    1. Exactly. In 2017 we actually did not import that much steel from China but we did import a lot of steel from Canada. One has to wonder whether Trump's team even check the facts.

  5. "The only real solution is to tax consumption rather than income." I think this is largely true, but this approach is not without its definitional problems too.

    For example, when you buy a house is that a consumption expense or an investment? Assuming the former, is the consumption value taxed annually on the changing value of the house? If so, how is that determined in the absence of an actual market rental?

    Not to say these questions don't have answers, but consumption taxes can fall prey to the same sorts of classification games that income taxes do. They just have the advantage of actually taxing the correct thing.

  6. The question of pass through vs corporation for Federal tax purposes is really difficult.

    The pass through deduction is subject to intricate carve-outs and caps. I sat through a lecture on the subject last week. The speaker passed out a flow chart that was truly frightening. The strategy for which is best for you is almost impossible to encapsulate. Every business owner will have to sit down with his accountant and go through alternative scenarios.

    Even if you do determine that the corporate route is better for you and your business, it is not the end of the world. Corporate dividends will still be taxed at the favorable rate they were in 2017. E.g. if your corporation earns $100 of income, it must pay $21 in tax. If you decide to distribute the $79 remaining as a dividend the tax on that will be a maximum of 23.8% or $19. That is a total of $40.

    Remember the top rate on income is 37% + the 3.8% on investment income. So, it may be a push between pass through and corporate + dividends. Other complications include state and local taxes and employee benefit plan rules. If you are a small business owner, expect to spend quality time with your accountant.

  7. It does seem like Trump's steel tariffs are going to be like the Reagan import quotas on Japanese cars, which led Americans to buy more European cars. I wonder if the Chinese will be smarter and impose tariffs on all soybean imports. China is already saying that they will win any trade war.

    1. Reagan's quotas were on numbers of cars so the Japanese responded in part by going up the value chain and sending over more expensive, better, cars, accelerating the downfall of Detroit.

    2. True! In this way Japan collected the quota rents and not the U.S.

  8. Teaching the agents to find the second fastest path. Makes all our single equilibrium theories go bzonker.

  9. Great post.

    I concur that consumption taxes, such as a national sales tax, are a much better idea than income taxes.

    Another good idea is a national property tax, since property cannot be hidden.

    I do not think taxes on imports are the end of the world and again imports are fairly easily identified and thus the tax is easily collected.

    Income, in sharp contrast, has become so squishy and global that it is nearly impossible to tax anymore.

    But Mr. Cochrane is right. The future is more manipulation of income tax law by influential people. The reason we will not have tax reform in the US is that the people who influence tax policy benefit from the current opaque and incomprehensible nature of income tax law.

  10. There are inherent limits to Faustian trade agreements.

    In all Faustian agreements, it's critically important for both parties to fully understand and fulfill their end of the agreed terms. This is clearly not happening today with the US and China on trade.

    The concepts of free trade were conceived during the time of a gold standard, which provided a self-correcting mechanism to keep trade imbalances in check. Deficit countries parted with their gold in exchange for goods. Their currencies depreciated and became more competitive, leading eventually to an improved trade balance. As trade deficits grew in the 1960s-70s, the US chose to abandon its commitments to the gold standard, finally under the Bretton Woods agreement, rather than part with all of its gold reserves. The mechanism for determining the value of the dollar was handed over to the US Treasury and Fed. Free trade was upheld in theory, but a new the era of managed trade was born.

    The US is turning to managed trade once again to guide US trade imbalances with China onto a more sustainable trajectory and move away from large, long-term, structural trade deficits, with tariffs being used as blunt force objects. Some question whether there is even a need to reduce large trade imbalances in today’s global economy. The US needs that liquidity to fund its persistent budget deficits, supported by an ever-rising debt ceiling. As we saw in the 2008 global financial crisis however, things tend to work and keep working until they just hit a wall and no longer work. In other words, how realistic is it for the US to rely on dollar hegemony and the ability to borrow an amount x at the rate of y, in perpetuity?

    The US trade imbalance with China began to accelerate under the Presidency of George Bush with China’s ascension to the WTO in late 2001. In the early 1980’s, large trade imbalances with Japan were tolerable under a tacit agreement that surpluses would be re-invested in US treasuries and other assets, enabling US rates to stay lower and help finance structurally high budget deficits. A critical third part of this Faustian arrangement, in the form of the Plaza Accord of 1985, led the US Dollar meaningfully lower against the Yen and Deutschemark, effectively monetizing the new US debt. What would be the effects on China’s economy of a similar quantum appreciation in the RMB? Just half the level of appreciation the yen experienced would equate to the RMB moving from the current 6.7-level to 5.2 against the dollar – a move undoubtedly viewed by Chinese negotiators as patently absurd and potentially destabilizing.

    Global trade imbalances, particularly between the two largest economies, have grown to unsustainable levels. A US-led trade model has allowed trade deficits to persist and trade surplus countries to grow faster than they otherwise would have, while also facilitating budget deficits and necessitating continued increases in the debt ceiling. The Faustian arrangement, whereby investment flows are recycled back to the US to keep interest rates low and help fund structural budget deficits, while surplus country currencies are depreciated against the dollar to effectively monetize new debt, is not mutually agreed upon by the U.S. and China at present. What does the sustainable path of global economic growth and cooperation look like? Finding a mutually acceptable framework requires a thorough understanding of how the relationship has evolved to date and an appreciation of mutual objectives of growth, peace and mutual prosperity.

  11. Sure, the point about how there will simply be substitution from one country to another is well made. That's not, however, the only issue arising from these tariffs, at least one other important point is the disregard for the rules (arguably) and the norms (certainly) that govern world trade.

    Of course, this isn't the first time the US has done this, it's unlikely to be the last, but by acting outside of the usual set procedures of the WTO in a particularly brazen manner, there is real risk of long lasting damage. It emboldens other countries, especially 'strong countries', to do the same (hello China!) for one thing. It also makes the US seem like a less trusted partner for the future, after all, and makes it in a hypocrite when criticizing future violations of norms and rules governing world trade and, to some extent, other aspects of diplomacy.

    It's not easy to quantify such costs, but I doubt they are small.

  12. "My correspondent is a Democrat, by the way."

    What about you, then?

  13. "why not park the ships overnight in Vancouver, or Tokyo, fill out some paperwork, and say steel is imported first from China to Canada, and then Canada to the U.S., and vice versa?"

    Did Larry Kudlow read this and then decide to seek his "trade coalition of the willing"? The parallels to the 2003 invasion of Iraq makes me wonder if The Onion is making White House policy?

  14. Menzie Chinn reads the portion of this post on country specific tariffs on soybeans, finds the relevant literature as well as market data to properly analyze this issue:


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