Actual Politician for State-Contingent Fiscal Policy!

Matthew Yglesias points to Maine Senate candidate Angus King's views on the expiration of the Bush tax cuts:

I was in favor of ending the Bush-era tax cuts immediately, but after continued poor employment numbers, we need a more nuanced approach. We should consider pegging the sunset of these tax cuts to something non-arbitrary, like a certain amount of GDP growth, or a lower level of unemployment. This would avoid the unproductive brinkmanship that Congress engages in over this issue – and could prevent our fragile recovery from being further slowed down.

This is essentially what I suggested in June (HC op-ed, blog post).  Nice to see someone who might actually be in a position to do something having similar thoughts.

Maybe America has a Greek Problem After All

I was asked recently if I was worried that the US was turning into Greece.  "I'm not worried about that at all," I said.  I gave the standard economist's explanation: the crucial difference is that the US government is borrowing in its own currency, and the primary evidence that markets aren't worried is the low yield on long-term Treasuries. 

However, reading Paul Krugman's column today about Mitt Romney's taxes, I realized that the US-Greece parallel may be valid in one unfortunate respect: both countries appear to have a serious tax-avoidance problem on the part of their elites. 

Wonkblog's Brad Plumer wrote about a study of tax evasion in Greece:

A bigger question is why Greece hasn’t been able to crack down on tax evasion. The authors note that Greek officials seem to have a very good idea of who’s avoiding taxes: In 2010, the parliament took up a bill that specifically targeted doctors, dentists, lawyers, architects, engineers and so forth. As the authors note, these are precisely the groups evading the most taxes (largely because they receive much of their income in bribes). But the crackdown bill failed — possibly because, as the authors discover, these are the professions best represented within the Greek parliament.

In the US, we have a problem of illegal tax evasion - the "tax gap" - which, while significant, may not be on the same scale as Greece's.  The bigger problem in the US is the ability - and willingness - by corporations and very high-earners to legally avoid taxes. 

Though its hard to know for sure what's going on without more information, Mitt Romney's IRA might be an example. According to Krugman:

I.R.A.’s are supposed to be a tax-advantaged vehicle for middle-class savers, with annual contributions limited to a few thousand dollars a year. Yet somehow Mr. Romney ended up with an account worth between $20 million and $101 million. 

I doubt Romney did anything illegal by the letter of the law, but the complexity of our tax system provides lots of ways for people and corporations that can muster legal and accounting firepower to minimize their taxes.  Moreover, the same people and corporations who benefit from the messiness of the tax code have disproportionate influence in Washington which may help them keep their loopholes open, and perhaps get them widened a little here and there.

The obvious policy answer is a simpler, and better-enforced tax code.  But, given the political economy, that's probably not realistic.  And focusing on the tax rules may miss the real issue, both here, and perhaps in Greece, that there is not a strong enough sense that taxes are a duty (one might even say noblesse oblige) and some attempts to avoid them - even if legal - might be wrong. 

Krugman noted that, in contrast to his son, George Romney was notably transparent about his finances:

Those returns also reveal that he paid a lot of taxes — 36 percent of his income in 1960, 37 percent over the whole period. This was in part because, as one report at the time put it, he “seldom took advantage of loopholes to escape his tax obligations.” 

There probably always have been and will be "loopholes", but what matters is the willingness to take advantage of them.  That depends, in part, on how socially acceptable it is to do so.  While the details are different (and the macroeconomics is very different), the US and Greece seem to share a significant failing in the "social norms" department.

A Trigger for the "Fiscal Cliff"

Under current law, taxes will rise significantly and government spending will be cut next year.  This scenario has been called the "fiscal cliff" and the CBO recently estimated it would lead to a recession in early 2013.

In the Hartford Courant, I suggest going over it, but gradually, when the circumstances are more favorable:

The tax increases could be made to occur at a more appropriate time by instituting triggering criteria that would delay them until the state of the economy has improved and then phase them in. For example, the tax changes could be set to begin once the unemployment rate has fallen to a more reasonable level, like 5.5 percent, and remained there for six months. At that point, the increases could occur in three or four steps, with each one occurring as long as the unemployment rate has remained below a specified level for six months.

This would minimize the risk of pushing the economy back into recession by waiting until the economy has recovered enough to bring the unemployment rate down to a level more consistent with a healthy economy. It would also create confidence that the U.S. is not headed for a debt crisis (though low interest rates suggest that financial markets are not worried about this now). An automatic trigger would take the guesswork out of deciding on an appropriate time frame for an extension of the tax cuts, and spare the country further political brinksmanship over renewing them again.

This is another form of "state contingent" fiscal policy that I've suggested previously on this blog.

In the piece, I asserted that allowing the 2001/03 income tax cuts and the 2010 temporary payroll tax cuts to expire would generate revenue "roughly consistent with the amount of spending required to maintain current programs." This is based on the idea that this would be pretty close to the "extended baseline scenario" in the CBO's projections where the US debt-to-GDP ratio gradually declines over time.  As Jared Bernstein notes, the implication is that the US can afford its current entitlement programs, if it allows scheduled tax increases to take place.

In addition to the tax increases - essentially a reversion to the tax code at the end of the Clinton administration (we did pretty ok back then, didn't we?) - the "fiscal cliff" scenario also involves some spending cuts under the "sequester" mandated by last summer's debt ceiling deal.  Since I was trying to keep the piece to op-ed length, I focused on the tax part because it is larger, but similar logic could be applied to the spending aspects.

The argument is not that this is an ideal economic policy - I'd like to see more stimulus now, and a simpler, more progressive tax code in the long-run; others would like cuts to entitlement programs and lower taxes - but rather that, as a modest change to existing law, it might be a politically feasible alternative to unrealistic hopes of a fiscal "grand bargain" that can achieve a "not bad" outcome in the short- and long-run.

No, Greg Mankiw, We're Not, and You Know It

On his blog, Greg Mankiw provides his readers a rather deceptive bit of information:

The reason that is misleading is explained further down in the very same yahoo finance article he links to:

But despite the headline number, the statutory rate only tells part of the story.

Loopholes and other special treatment for different kinds of businesses mean that businesses pay an effective rate of only 29.2% of their income, which puts the United States below the average of 31.9% among other major economies, according to analysis by the Treasury Department.

And the Organization for Economic Cooperation and Development, the multinational group that tracks global economic growth, estimates the United States collects less corporate tax relative to the overall economy than almost any other country in the world.

I know Greg Mankiw knows that.  The headline marginal tax rates do matter, because they effect incentives, but his selective quote creates the false impression that the US corporations face an unusually large tax burden, when, by many measures, the effective corporate tax rate in the US is relatively low.

Here's another way to slice it - the share of corporate "operating surplus" paid in taxes - calculated by the US Treasury, via this CBPP report:

Yes, that's a few years old and many countries have been lowering corporate taxes, but I doubt its changed that much.  Corporate taxes are indeed a mess, though, and tricky to measure; this NY Times story is informative about some of the issues.

I'm a fan of much of Greg Mankiw's work and responsible for quite a few sales of his Intermediate Macroeconomics textbook.  I know he knows better - and would probably do an excellent job if he attempted an honest explanation of the issues associated with the US corporate tax code, and how it compares internationally.  Sigh.

An Inconvenient Mankiw

Food for thought for all the would-be Romney administration Kremlinologists out there:

The National Journal's Jim Tankersley has an interesting article about Mitt Romney and his economic advisors.  The gist of the article is that Greg Mankiw and Glenn Hubbard are well-respected economists, but Romney's statements on the campaign trail suggest he's not listening to them much.  Tankersley writes:

This, then, is the Romney Conundrum—for conservatives, liberals, and everyone else. Even on the economy, Romney’s signature issue, it’s hard to know where his heart lies—and how he would govern in the White House. Would the former Massachusetts governor listen to his best and brightest? Or to his party base?

“Romney’s got Glenn and Greg advising him, and they’re both top-notch economists,” said Keith Hennessey, who ran the National Economic Council for President George W. Bush. “But there’s more to economic policy than just economics.”

Of course this isn't entirely unique to Romney - politicians often fail to follow through on politically inconvenient suggestions from economists (though the universe of what is inconvenient for a Republican primary candidate to say is pretty scary these days).

The article comes to my attention from Greg Mankiw, who linked to it on his blog, without comment.  Hmmmmm...

As if to illustrate... Mankiw has a column in today's Times about tax reform.  Among his suggestions:

Consider the tax on gasoline. Driving your car is associated with various adverse side effects, which economists call externalities. These include traffic congestion, accidents, local pollution and global climate change. If the tax on gasoline were higher, people would alter their behavior to drive less. They would be more likely to take public transportation, use car pools or live closer to work. The incentives they face when deciding how much to drive would more closely match the true social costs and benefits.

Economists who have added up all the externalities associated with driving conclude that a tax exceeding $2 a gallon makes sense. That would provide substantial revenue that could be used to reduce other taxes. By taxing bad things more, we could tax good things less. 

Well, if Romney proposed that, it would probably take the attention off his tax returns!

The American Jobs Act

The big ticket items in the $447 billion stimulus recovery jobs act that President Obama announced in his address at the Capitol on Thursday include:

1. $65 billion in cuts to employer payroll taxes
2. $35 billion for employment of teachers, police and firefighters
3. $30 billion for school modernization
4. $50 billion infrastructure investment
5. $175 billion in cuts to employee payroll taxes
6. $49 billion for extended unemployment insurance/UI reforms

The most straightforwardly effective components of the package for increasing aggregate demand are #2, #3, #4 and #6. Direct spending on school buildings (#3) and infrastructure (#4) increase the government purchases component of demand (and "Ricardian" or "crowding out" effects that would reduce the impact in some models are irrelevant now). Cutbacks by state and local governments have become a big drag on the economy - state and local governent employment has fallen by over 650,000 over the past three years. The funding for employing teachers and "public safety and first responder personnel" (#2) will put a brake on that trend. That is, it will be an increase in demand (again through the government purchases component) and employment relative to what would occur otherwise.

Extending unemployment insurance (#6) is effective because much of the money goes to people who will spend it (i.e., people who are "credit constrained" from smoothing out their consumption over time).  This increases the consumption component by raising disposable income.  The release from the White House discusses some possible reforms to the unemployment insurance program as well - these are not detailed enough to evaluate, but possibly they might help mitigate one of the downsides of unemployment insurance, which is that it can reduce incentives to work (though I don't think that is a really significant contributor to unemployment now).

There is more uncertainty about the effectiveness of the social security payroll tax components.  Payroll taxes are the "contributions" paid equally by employers and employees (although employees only observe half of the tax through the "FICA" line on their pay stubs, in the long run, the burden of the entire tax - the "incidence" - largely falls on employees because their wages would be higher if employers did not have to make their contribution).

The largest part of the act (#5) is a one-year reduction in the employee contribution to 3.1% - the standard contribution is 6.2%, but was temporarily cut to 4.2% for this year in the deal that was struck in late 2010.  So, basically, this extends the existing cut, and adds another 1.1% to it.  As with unemployment insurance, the effect of a tax cut in increasing consumption depends on whether it is spent.  Households that are credit-constrained (living "paycheck to paycheck") are more likely to change their behavior.  In this regard, it is less well targeted than the unemployment insurance extension, but it is superior to an overall income tax cut. Because the payroll tax is somewhat regressive, only applying to the first $106,800 of wages (and not at all to capital income), the benefits go largely to the "middle class."  Although the primary desired effect is to increase consumption demand, even the parts of the tax cut that are not spent do have the benefit of helping improve the financial position of households.  Large debt burdens are part of the reason recoveries from "balance sheet recessions" are typically slow, so if part of the tax cuts goes to pay down debt, that could serve to hasten the return to normal household spending behavior.

The employer part of the payroll tax cut (#6) can be thought of as a positive "supply shock" lowering unit labor costs (in the short run, with lots of labor market slack, it won't lead them to raise wages).  In a traditional Keynesian framework, this would shift out the aggregate supply curve (or, equivalently, shift down the Phillips curve).  In a "New Keynesian" model, this is a reduction in the real marginal cost term in the New Keynesian Phillips Curve.  Since the binding constraint on the economy is on the demand side, the usefulness of this part of the policy appears questionable.  Indeed, reducing costs is deflationary, and deflation is a very bad thing.  But it is a bad thing that the Fed is determined to prevent, and that is why this part of the package may have a positive effect.  The Fed seems very averse to letting inflation become negative, but also very careful to try to keep it from going above 2% (in doing so, its placing too much weight on the "price stability" part of its mandate relative to the "maximum employment" part, as this justly-praised speech by Chicago Fed President Charles Evans argued). By putting downward pressure on costs, and therefore prices and inflation, the employer-side tax cuts may create more space for the Fed to act more aggressively.

An important part of the proposal is still to come - President Obama said that he would deliver plans to "pay for" the jobs act (i.e., offsetting tax and spending changes, presumably within the standard 10-year window customarily used to assess budget proposals).  This may be politically necessary, but, as I argued recently, there is no economic urgency for doing this, and I worry that political gridlock over paying for the bill could derail taking action now, which is urgent.

Its also worth noting that, while the exact timing of some of the provisions is unclear, it looks like most of the effect occurs in 2012.  That's a good thing, but even under the optimistic assumptions that something like this bill is enacted, and the Fed finds a will and a way to take more effective action, the economy is in a very deep hole and unemployment will still be elevated at the end of 2012. The expiration of the tax cuts puts in place an automatic fiscal contraction for 2013 (this is where the idea of "state contingent" policies would help, but would raise the headline cost, which is politically unpalatable right now).

Private-sector estimates suggest the bill would have a significant impact: Macroeconomic Advisors says it will raise GDP by 1.3% and increase employment by 1.3 million next year; Moody's economy.com (via Brad Plumer) puts it at 2% of GDP and 1.9 million jobs.  See also: Gavyn Davies, Paul Krugman, Ezra Klein, Mark Thoma.

Marginal, at Best

In an Economix post about the Bush tax cuts, David Leonhardt writes:

The theory for why tax cuts should create growth and jobs is a strong one. When people are allowed to keep more of each dollar they earn, they are likely to work longer and harder. The uncertainty is the magnitude of this effect. With everything else that’s happening in a $15 trillion economy, how large of an effect on growth do tax cuts have?

Every available piece of evidence seems to suggest that the Bush tax cuts did little to lift growth.

Indeed, its fairly easy to demonstrate in simple economic models that higher marginal tax rates distort the economy and might lead to less labor effort and less saving (and hence a smaller capital stock).  To be careful, though, in most models the effect of a tax reduction would be on the levels of income and output, not on the long run growth rate.

Nonetheless, there are pretty solid economic theory reasons why economists - even those of us with generally liberal (in the contemporary American sense) political inclinations - would favor tax reforms that would broaden the tax base (i.e., reduce deductions and credits) and lower marginal tax rates.  But perhaps not as fervently as Glenn Hubbard, who recently wrote:

When I left my job as the deputy assistant Treasury secretary for tax policy in 1993, I left a message on my office blackboard for my successor. I wrote, “Broaden the base, lower the rates” repeatedly until I filled the entire space. I then had it covered with wax so it could not be erased. (Yes, the government charged me for my bit of vandalism. But it was worth it.) 

I share his instinctive sympathy for this aspect of the Simpson-Bowles proposal (though I basically agree with Paul Krugman that the package is bad overall).

However, as Leonhardt points out, as an empirical matter, its not clear that tax rates make that much of a difference to overall economic performance.  The best decade for growth in the postwar period was the 1960's, when the top marginal income tax rate was over 70% (as I noted in the second-ever post here).  The economy did well after the 1993 increase in the top marginal tax rates, and not particularly well after the 2001 and 03 rate cuts.

Of course, that doesn't prove anything - the effect of any policy should to be judged relative to a counter-factual. That is, perhaps the economy would have done even better in the 1990's without the tax increase, and even worse in the 2000's without the tax cuts.  Nonetheless, I think a brief glance at historical evidence is enough to convince us that lower marginal tax rates aren't some magical economic elixir.  As an economist, I'll never say that people don't respond to incentives, but, in the case of taxes, it looks like they don't respond very much.

Raise Greg Mankiw's Taxes, Please!

I should start out by saying that I'm a fan of Greg Mankiw.  He has written some important (and good!) papers that have made influential contributions to both business cycle and growth theory.  Moreover, he is a very good writer - his academic work is enjoyable to read (which is rare!) and he communicates well to a general audience (though sometimes his political biases - which are different from mine - do show through).  I've used several of his papers in classes I've taught, and I've been a (mostly) satisfied user of his intermediate macroeconomics textbook since I began teaching the course as a grad student back in 2003.

In a column for the NY Times, he uses himself as an example of how a change in marginal tax rates could reduce labor supply:

Suppose that some editor offered me $1,000 to write an article. If there were no taxes of any kind, this $1,000 of income would translate into $1,000 in extra saving. If I invested it in the stock of a company that earned, say, 8 percent a year on its capital, then 30 years from now, when I pass on, my children would inherit about $10,000. That is simply the miracle of compounding.

Now let’s put taxes into the calculus. First, assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes on that extra income. Beyond that, the phaseout of deductions adds 1.2 percentage points to my effective marginal tax rate. I also pay Medicare tax, which the recent health care bill is raising to 3.8 percent, starting in 2013. And in Massachusetts, I pay 5.3 percent in state income taxes, part of which I get back as a federal deduction. Putting all those taxes together, that $1,000 of pretax income becomes only $523 of saving.

And that saving no longer earns 8 percent. First, the corporation in which I have invested pays a 35 percent corporate tax on its earnings. So I get only 5.2 percent in dividends and capital gains. Then, on that income, I pay taxes at the federal and state level. As a result, I earn about 4 percent after taxes, and the $523 in saving grows to $1,700 after 30 years.

Then, when my children inherit the money, the estate tax will kick in. The marginal estate tax rate is scheduled to go as high as 55 percent next year, but Congress may reduce it a bit. Most likely, when that $1,700 enters my estate, my kids will get, at most, $1,000 of it.

HERE’S the bottom line: Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working.

So, if Mankiw's marginal tax rate reverts to its Clinton-era levels as scheduled under current law, when his editor calls to tell him its time for a new edition of his textbook, he would decline?

If we're doing a social cost-benefit analysis of changing Greg Mankiw's marginal taxes, we should account for externalities, positive and negative.  Following Mankiw's lead, I'll use myself as an example, and explain a benefit to reducing Mankiw's labor supply that should be accounted for in his analysis.

I would be better off if he decided the marginal benefit of an cranking out eighth edition was less than the marginal cost, and so would my students.  The churning of textbook editions (and this isn't Mankiw's fault, to be sure) is a real headache to instructors, and helps keep the cost high for students.  Though I'm sure it was well-intentioned (and thoroughly focus-grouped) a number of the changes from the sixth to seventh edition of his textbook made it worse from my point of view.  For example, I rather liked his discussion of New Keynesian and Real Business Cycle theory, which were supplanted by a "dynamic aggregate demand and supply" chapter that I'm not inclined to mess with.  And don't tell me I need my book "updated" for "current events." One of the fun things about teaching macroeconomics is that the world is always giving us interesting new examples to talk about.  But I can handle that quite well without some new "economics in the news" sidebars grafted into the textbook.

However, while the theoretical case that marginal tax rates can change behavior is clear, I'm not convinced, as an empirical matter, that Mankiw's would actually change.  After all, his book was first published in 1992, and he issued new editions in 1994 and 1997 when higher marginal tax rates on high levels of income (and capital gains and estates) were in effect.

Mark Thoma and Brad DeLong suggest some other possible shortcomings in his argument.

About That "Hastily Prepared Fiscal Blueprint"

In the Times, former Reagan budget director David Stockman writes:

This debt explosion has resulted not from big spending by the Democrats, but instead the Republican Party’s embrace, about three decades ago, of the insidious doctrine that deficits don’t matter if they result from tax cuts.

In 1981, traditional Republicans supported tax cuts, matched by spending cuts, to offset the way inflation was pushing many taxpayers into higher brackets and to spur investment. The Reagan administration’s hastily prepared fiscal blueprint, however, was no match for the primordial forces — the welfare state and the warfare state — that drive the federal spending machine.

Ahh, yes... three decades ago....

THE underlying problem of the deficits first surfaced, to Stockman's embarrassment, in the Senate Budget Committee in mid-April, when committee Republicans choked on the three-year projections supplied by the nonpartisan Congressional Budget Office. Three Republican senators refused to vote for a long-term budget measure that predicted continuing deficits of $60 billion, instead of a balanced budget by 1984.

Stockman thought he had taken care of embarrassing questions about future deficits with a device he referred to as the "magic asterisk." (Senator Howard Baker had dubbed it that in strategy sessions, Stockman said.) The "magic asterisk" would blithely denote all of the future deficit problems that were to be taken care of with additional budget reductions, to be announced by the President at a later date. Thus, everyone could finesse the hard questions, for now.

"Hastily prepared"?! To be fair, Stockman himself was an anti-government ideologue rather than a supply-side true believer, and the Reagan administration did change course and the tax cuts were partially reversed. But, nonetheless, three decades ago he entered into an alliance of convenience with the supply-siders and one can trace a pretty direct line between the policies he helped usher in and the nonsense he now laments. Of course, a return now to pre-Reagan Republican balanced budget dogma, as Stockman is calling for today, would be another kind of pernicious stupidity....

The quote above is from William Greider's famous 1981 Atlantic article "The Education of David Stockman." Stockman later wrote a book about his experience in the Reagan White House, which was reviewed by Michael Kinsley for the Times.

Update (8/6): Bruce Bartlett, who as a staffer for Congressman Jack Kemp also played a supporting role in the 1981 tax cuts, considers Stockman's "eclectic ideological journey."

Bush Tax Cut Time Bomb Ticking Louder

The Times reports that Congress is preparing to deal with the scheduled expiration of the 2001 and 2003 tax cuts at the end of this year. That is, without congressional action, tax rates will increase to their pre-2001 levels (more detail in this previous post). President Obama wants to extend the cuts for households earning less than $250,000, but EconomistMom suggests he rethink his position:

For all the complaining you have done on your Senate campaign trail, and then your presidential campaign trail, and now even as President about how unaffordable and unfair and in general not very smart the Bush tax cuts were, why is it that the centerpiece of your–emphasis on your–tax policy thus far is the deficit-financed extension of the vast majority of these very same (not very smart) tax cuts?

Why do you spend over $2 trillion in your budget–the most you spend on any single policy item–on your predecessor’s tax policy, which you repeatedly explain is to blame for the deterioration and unsustainability of our nation’s fiscal outlook? Meanwhile, you took back your own ideas for new tax policy–such as the permanent extension of the Making Work Pay tax credit–because you decided to put higher standards on your own tax cuts and actually pay for them (offset their cost with offsetting revenue increases such as climate change revenues), and Congress (even your own Congress) therefore balked.

I have news for you: you’re in charge now! You aren’t stuck with the (not very smart) Bush tax cuts–not any part of them! You are the one who will have to sign an entirely new piece of legislation in order to keep any part of the Bush tax cuts after this year. You hold the reins. You don’t have to stay on the Bush path. You don’t even have to stay on the Bush tax policy horse. You can switch horses altogether and go down a better path on your better horse.

From a cyclical point of view, letting the cuts expire (i.e., increasing tax rates) next year would not be a good idea because it would reduce demand at a time when unemployment is still likely to be elevated. However, permanently extending the cuts contributes significantly to the long-term deficit (see the graph in this earlier post). A reasonable stopgap might be to extend the "sunset" of the tax cuts a couple of years while working out a "reform" that would bring revenues more in line with spending, and hopefully simplify the tax code, too. That is why I was encouraged by this, from the Times' story:

[T]he White House and Democrats in Congress have given some thought to limiting an extension of the popular middle-class tax cuts to a year or two in the hope that they can overhaul the tax code in the meantime. That also would have the effect, at least on paper, of making projected big deficits look smaller over the long run than if the tax cuts for the vast middle class were continued indefinitely — an important political consideration when the nation’s debt is building to what many economists consider dangerous levels.

On the politics, see Jonathan Chait.

Misplaced Rectitude

In the FT, Jeffrey Sachs and George Osborne argue that governments need to deal with their budget woes sooner rather than later:

Virtually all policy analysts agree that the path to renewed prosperity in Europe and the US depends on a credible plan to re-establish sound public finances. Without such a plan, the travails which have hit Greece and which are threatening Portugal and Spain will soon enough threaten the UK, US, and other deficit-ridden countries. In the recent duel of macro-economists, one camp has called for early budget consolidation, followed by further measures over five years. We agree. Others want more fiscal stimulus, delaying deficit reduction. We believe delaying the start of deficit reduction would put long-term recovery at risk. Such an approach misjudges politics, financial markets, and underlying economic realities.

Blaming our predicament on financial markets, as some in the second camp do, ignores the awkward truth that governments have enabled, if not enthusiastically promoted, recklessness, through chronic deficits and lax financial regulation. Our predicament, in this sense, is a political crisis at least as much as a financial one. We can’t expect “credibility” by succumbing to temptation just one more time. What politicians like to present as saving the world economy from financial markets is in many cases simply responding to past errors while continuing to operate on a time horizon no longer than the next election.

Count me with the "others" in the "second camp." In the case of the US, there is still little evidence of a problem. If markets were losing their appetite for US government debt, it would be reflected in rising Treasury yields, which are not apparent (unless you read alot into that tick at the end): That's not to say that their concern is irrational. If government finances don't eventually improve, at some point borrowing costs will rise, and crowd out private investment. We're not there yet, but it would make sense to think about what we'll do before we get there.

A couple of things to bear in mind:

• The government budget will get somewhat better when the economy recovers, and spending cuts or tax increases now would serve to slow the recovery.
• In the US, the long term federal budget problem is driven by projected increases in health care costs, so the bill just signed by the president is a step in the right direction, to the extent it helps control cost growth.

Sachs and Osborne seem to think that any policy would not be "credible" - i.e., would not influence expectations about future borrowing - if it does not inflict some pain today. They may be right, but I don't think so. If enacted today, a tax reform that projected to yield revenues closer to spending at "full employment" (i.e., once cyclical effects are taken out) would be a significant step to pre-empting the problem, even if the current deficit remains large because of the downturn. This would be true even if the reforms were phased in or scheduled to take effect in a few years. Indeed, some of the tax changes could be written to be contingent on recovery. But, while we should take future deficits seriously, we should not lose sight of the fact that, right now, a large deficit is exactly what we need to help make up the shortfall in private demand.

At Economist's View, Mark Thoma has a similar opinion to mine.

Job Creation Tax Credit

One likely element of the second (or is it third?) stimulus jobs bill being kicked around in Washington is a tax credit for new hiring. Brad DeLong is circulating an economists' letter supporting the idea which says:

A well-designed temporary and incremental hiring tax credit is a cost-effective way to create jobs, and could work well in the current environment. At a time when GDP is beginning to rise and demand is starting to return, private firms are likely to respond to such a tax incentive by hiring sooner and more aggressively than they otherwise would have done. Such a credit could thus help put Americans back to work more quickly than otherwise. And by targeting firms that are growing, such a tax credit supports the businesses most likely to lead the recovery of employment.

In the Washington Post, Alan Blinder explains how to do it. Howard Gleckman, who is skeptical of the idea in general, says that the administration's version is much better than the proposal by Senators Hatch and Schumer.

Deficit Update

The Congressional Budget Office updated its budget outlook yesterday. They are estimating a $1.3 trillion federal budget deficit for fiscal year 2010 (9.2% of GDP), down from $1.4 trillion (9.9% of GDP) in FY 2009 (the federal "fiscal year" begins on Oct. 1 and ends on Sept. 30, so we are already about 4 months into FY 2010).

There are deficits as far as the eye can see, but they are projected to get considerably smaller over the next several years. In part, this is because the CBO is required to make projections assuming current law is followed, which means the 2001 and '03 tax cuts would expire. If they are extended, the deficit picture looks considerably worse, as can be seen in this picture I created using their nifty new website:

(The black line is the baseline forecast, the purple line adds the effect of making the Bush tax cuts permanent.)

As I suggested in the previous post, letting them expire as scheduled would probably not be a good idea given the current state of the economy, but making them permanent would make the government's long-run budget problem much worse.

Our Ballooning Government

Is the Value-Added Tax (VAT) an idea whose time has come to the United States? In the midst of an article about this interesting question in the Times, I come upon this:

Introducing such a tax would probably require an overhaul of the entire federal tax code, no small order, and something the government last did in 1986. At the time the goal was to simplify the tax system, to raise money more efficiently and with fewer headaches for taxpayers.

Since then, federal spending has ballooned, while the government’s ability to raise taxes has become increasingly inefficient.

Ballooned? I don't see any ballooning here: Yes, there is a bit of a jump at the end due to automatic stabilizers and appropriate (though not big enough) countercyclical fiscal policy, but there's clearly no upward trend in federal spending since the mid-1980s. Moreover, federal government purchases - i.e., the stuff that's in the G component of GDP - accounted for 7.5% of GDP in 2008, down from 9.8% in 1986.

Update: Actually, since the graph goes through 2008, the main countercyclical fiscal policy (i.e., the stimulus bill) isn't in there.

Incentives and Unknown Marginal Tax Rates

One effect of income taxes is to alter the incentives to work and save. Because income taxes change people's behavior - in theory, at least - they are said to "distortionary." What matters here is not the amount of taxation, but rather the marginal tax rate - e.g., a worker facing a 30% marginal tax rate will take home $70 for each additional $100 earned, so the tax reduces the benefit of working more (and decreases the cost of working less) by 30%. One of the central premises of the "supply side economics" that motivated the Reagan administration is that lower marginal tax rates would lead to an increase in work and investment (i.e., more "aggregate supply").

However, with our byzantine tax system it is difficult to calculate exactly what one's marginal rate is. An interesting post at TaxVox makes the point that effective marginal rates are altered by provisions tie benefits and tax breaks to income:

Many tax preferences are phased in or out according to income, and as a result, those who earn extra income may face either a hidden tax or a subsidy as their tax benefits change in value. For example, for those in the phase-in range of the earned income credit earning an extra dollar increases the credit and reduces their tax liability, driving their actual rate below their statutory rate. But once they make enough so the EITC begins to phase out, the opposite happens and the rate they actually pay climbs.

Altogether, half of taxpayers in 2009 face actual tax rates on additional earnings that differ substantially from their statutory rates. The tax on that last dollar – what economists call the effective marginal tax rate – is higher than the statutory rate for 32 percent of taxpayers and lower for almost 18 percent. Moreover, the difference between the two rates can be huge. For taxpayers whose effective rate is higher, the average discrepancy is almost 6 percentage points. For those with lower effective rates, the difference averages 11 percentage points....

Yet many don’t even know it. Statutory and effective rates differ so haphazardly that most taxpayers probably have no idea how much tax they owe on an additional dollar of income. What does this say about our current tax system? First, the phase-in and phase-outs of provisions really do bite. Second, in case you needed more proof that our current system is complex, here you have it. Finally, it suggests that many individuals are making decisions based on incorrect notions about the tax consequences of their behavior.

Not only does this remind us what a mess the tax code is, it also raises the question of how much we can depend on assuming that the incentive effects of taxes significantly alter behavior, if people cannot even determine what those incentives are.

From Dutch to Ike

In the Times last week, David Leonhardt writes about Bruce Bartlett, who was a staffer to Jack Kemp back when he was writing the legislation that eventually became Reagan's signature 1981 tax cut. According to Leonhardt:

[P]erhaps the most persistent — and thought-provoking — conservative critic of the party has been Bruce Bartlett. Mr. Bartlett has worked for Jack Kemp and Presidents Reagan and George H. W. Bush. He has been a fellow at the Cato Institute and the Heritage Foundation. He wants the estate tax to be reduced, and he thinks that President Obama should not have taken on health reform or climate change this year.

Above all, however, he thinks that the Republican Party no longer has a credible economic policy. It continues to advocate tax cuts even though the recent Bush tax cuts led to only mediocre economic growth and huge deficits. (Numbers from the Congressional Budget Office show that Mr. Bush’s policies are responsible for far more of the projected deficits than Mr. Obama’s.)

On the spending side, Republican leaders criticize Mr. Obama, yet offer no serious spending cuts of their own. Indeed, when the White House has proposed cuts — to parts of Medicare, to an outdated fighter jet program and to subsidies for banks and agribusiness — most Republicans have opposed them.

How, Mr. Bartlett asks, is this conservative? How is it in keeping with a party that once prided itself on fiscal responsibility — the party of President Dwight Eisenhower (who refused to cut taxes because the budget wasn’t balanced) or of the first President Bush (whose tax increase helped create the 1990s surpluses)?

“So much of what passes for conservatism today is just pure partisan opposition,” Mr. Bartlett says. “It’s not conservative at all.”

So Bartlett is now an advocate of "fiscal responsibility," and he is intellectually honest enough to say that this means higher taxes. In a recent Forbes column he wrote:

Everyone knows that fiscal discipline must be restored eventually, or we will face truly horrifying consequences--defaulting on the debt, nonpayment of Social Security benefits, a collapsing dollar, and double-digit inflation and interest rates. Everyone also knows that this will involve a combination of higher revenues and lower spending. The idea that we can restore fiscal health only with spending cuts is childish, as I tried to explain last week.

While there is some truth in his argument that the contemporary Republican anti-tax reflex is pretty far removed from the "supply side" principles of the Kemp-Roth bill (see, e.g., this post at Capital Gains and Games), it is a bit ironic to see an original Reagan revolutionary sounding like such an Eisenhower Republican (or Clinton/Rubin Democrat). EconomistMom likes what he's saying.

Update (10/16): Bartlett explains his thinking further in a blog post "Supply Side Economics, RIP."

Tax Cuts are Tricky

Jeff Frankel argues that the tax cut portions of the stimulus have not been effective, and notes an irony:

The Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03 were both explicitly designed to boost saving — hence their focus on capital income and higher income brackets — and yet in both cases private saving fell in their aftermath. The tax cuts of January 2008 and February 2009 were both explicitly designed to boost consumption; yet private saving rose in their aftermath !

Of course, their effects really should be judged relative to a counter-factual...

Redistribution, Cincinnati-Style

In Washington:

House Democrats have proposed an income surtax on the highest wage-earners to help pay for a sweeping overhaul of the nation’s health care system. The proposal, which has little support in the Senate, would generate roughly $550 billion over 10 years.

Meanwhile, in Cincinnati:

Cincinnati panhandlers would have to pay a fee to register, pay earnings tax on their collections and toss their hand-written “Please Help” signs under a plan to be proposed next month.

Saying panhandling is as much of a business as, say, selling hotdogs, Councilman Jeff Berding is working on a plan he says will help make the city more appealing to residents and tourists.

I'm beginning to understand why this area has a "conservative" reputation...

The Quarterback of Supply-Side Economics Passes

One should not speak ill of the recently deceased, but is it ok to be a little bit snarky? Perhaps if you're very good at it, like Michael Kinsley is. Of Jack Kemp, the late Republican Congressman who championed "supply-side" economics, Kinsley writes:

As a rule, there are two ways to get a reputation in Washington for being “thoughtful,” neither of which requires having a lot of ideas rattling around in your head. In fact one method is to avoid, as much as possible, any ideas beyond a general desire for everyone to sit down in good faith and a cooperative spirit and reason things out.

Alternatively, you can simply be “unpredictable.” The more you can surprise people with your position on an issue, more thoughtful you are considered to be. This technique has served Arlen Specter, to choose a currently newsworthy example, well over the years.

Jack Kemp was not unpredictable, and he did not strike poses of moderation and statesmanship. He might be accused of a third device: Like Gary Hart on the Democratic side, he was deeply committed to the idea of ideas, as opposed to ideas themselves. And if he mentioned, say, Say’s Law (a famous principle of economics), he was likely to offer up the author’s full name -- Jean-Baptiste Say -- as a way to establish his bona fides.

But Kemp did have one idea that he was introduced to in the mid-1970s, stuck with, and saw triumph.

That, of course, is supply-side economics, and in particular its policy prescription: cut taxes and you will increase government revenues. Among Republicans, this became more like a religion than a policy, with all the fixin’s: miracles, saints (Ronald Reagan, Arthur Laffer, Kemp) and total immunity from factual refutation. Kemp probably went to his grave believing that this victory was an intellectual one -- a triumph of persuasion. In fact, it was an example on the other side of the argument: that material forces, not ideas, are what move history.

After all, the idea that tax cuts pay for themselves is not a hard sell. It comes with a built-in bribe. The inherent implausibility -- not to mention 30 years now of experience to the contrary -- is no match for money in your pocket....

Brad DeLong is, more appropriately under the circumstances, quite gracious:

One of the few senior Republicans to try to undo the curse of Richard Nixon, Jack Kemp 1935-2009 was a pillar of and an ornament to the American republic.

Howard Gleckman emphasizes the positive: Kemp's role in the 1986 tax reform. Kemp's former staffer, Bruce Bartlett looks back at the Kemp-Roth bill, which became the centerpiece of "Reaganomics." The NY Times obituary has more on Kemp's football and political careers.

Whose Tax Cuts?

Last week, the Congressional Budget Office forecast much bigger deficits over the next ten years from the Obama budget proposal than the administration had projected. A large part of that difference is attributable to more pessimistic assumptions about economic growth (the OMB director responds).

EconomistMom makes an important point about the deficit: a significant part of it is attributable to Obama's planned continuation of most of the 2001 and 2003 tax cuts. She writes:

So the biggest single proposal in the Obama budget contributing to the deterioration in the 10-year budget outlook is, contrary to public perception, not big spending on bailouts or stimulus or even longer-term health care reform, and not temporary tax cuts that are designed to provide immediate stimulus to the economy at only near-term cost, but rather permanent extension of most of the Bush (2001 and 2003) tax cuts–with costs that grow dramatically over time. It explains why the Obama budget (according to CBO projections) will not only fail to make trillion-dollar-plus deficits an extraordinary and temporary phenomenon (with the 2019 deficit climbing back to $1.2 trillion), but will fail to stabilize the public debt as a share of GDP (with the ratio exceeding 80 percent by 2019).

President Obama doesn’t have to feel “stuck with” the Bush tax cuts. In fact, Congress will have to write and pass new legislation, which President Obama will have to sign, in order to keep any of the “Bush tax cuts” beyond December 31, 2010. So now that they’re so clearly a central part of the Obama budget, it’s probably time we stop calling them the “Bush tax cuts” and start calling them the ($2 trillion in deficit-financed) “Obama tax cuts.” But we’re still not “stuck with” them.

Under current law, income tax rates would revert to their pre-2001 levels in 2011. The 10% would be folded back into the 15% bracket, the marginal rates on the current 25%, 28% and 33% brackets would rise to 28%, 31% and 36% respectively, and the top rate goes up to 39.6%. While the administration proposes letting the rates rise as scheduled on incomes over $250,ooo, it would make permanent the rest of the current bracket structure, and add a number of other breaks that would apply mainly to low- and middle-income households.

One purpose of the administration's tax proposals is to lean against the trend of widening income inequality and stagnating middle-class incomes by raising taxes on the rich and cutting them for the middle class. In doing so, they seem to have taken a very narrow definition of rich: median US household income is roughly $50,000, so the administration is only allowing income taxes to rise on households making more than 5 times the median (this is a conservative calculation, since "taxable income" is considerably less than income). The administration is also making permanent the "patch" of the alternative minimum tax, which also mainly benefits households that are relatively well-to-do (if not truly wealthy). Moreover, even though incomes have ballooned at the very, very top of the distribution, the administration is not proposing a still higher rate on multimillion-dollar income levels.

Not really soaking the rich, just moistening them a bit...

Update: See also Howard Gleckman's summary of the Tax Policy Center's examination of the tax side of the Obama budget.