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.

All the Sugar and Twice the Caffeine

Social security payments rise automatically with inflation through a mechanism known as the cost of living adjustment (COLA). The adjustment is asymmetric - social security payments adjust upward for inflation, but not downward with deflation. This year, the index that the COLA is based on - the CPI for urban wage earners and clerical workers in the 3rd quarter - was 2.1% lower than a year ago, which implies that there should be a COLA of zero.

CPI-W (CPI for Urban Wage Earners and Clerical Workers)

Although deflation is generally bad news for the economy as a whole, one group that benefits are those who have fixed nominal incomes. Since prices have fallen over all, a given dollar income has greater purchasing power. That is, the real value of social security payments would rise, even if the nominal level (i.e., the dollar amount) stayed constant.

But that's apparently not good enough: through some confluence of money illusion, pandering and self-interest, the zero COLA has come to be viewed as unfair to seniors. The administration is proposing to add an artificial sweetener in the form of a $250 extra payment to social security recipients.

Normally, that's not very good policy - EconomistMom, for one, is not happy - but as Ezra Klein points out: "The economy needs more stimulus and this is good stimulus."

Potentially, a bad precedent. But hopefully we won't see deflation again.

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."

Too Soon to Tell

Marginal Revolution picks up my favorite quotation.

September Employment Report

The latest report from the Bureau of Labor Statistics is a bummer:

Total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with losses averaging 645,000 per month from November 2008 to April. Since the start of the recession in December 2007, payroll employment has fallen by 7.2 million.

The unemployment rate also ticked up, from 9.7% to 9.8%, and that somewhat understates the badness of the situation, because labor force participation fell, suggesting that people were giving up on finding a job. While the NBER may later tell us we are indeed technically out of the recession, the time has not come let up on efforts to stimulate demand, Paul Krugman writes in his Times column:

[T]he administration’s own economic projection — a projection that takes into account the extra jobs the administration says its policies will create — is that the unemployment rate, which was below 5 percent just two years ago, will average 9.8 percent in 2010, 8.6 percent in 2011, and 7.7 percent in 2012.

This should not be considered an acceptable outlook. For one thing, it implies an enormous amount of suffering over the next few years. Moreover, unemployment that remains that high, that long, will cast long shadows over America’s future.

See also Brad DeLong.

Van Customs

The US imposed a 25% tariff on imported trucks and commercial vans ("motor vehicles for the transport of goods," in the words of the Harmonized Tariff Schedule) in 1963 as retaliation for European tariffs on chicken. However, "motor vehicles principally designed for the transport of persons" face a much lower (2.5%) tariff rate. Via Autoblog, we learn of some cleverness on the part of the folks at Ford. They manufacture Transit Connect vans in Turkey and then:

They actually ship the Transit Connects here with the vans classified as wagons. Then, once they reach a processing facility in Baltimore, they are transformed into cargo vans, totally side-stepping the Chicken Tax. Smart, huh?

The process of transforming a passenger "wagon" into a cargo van works like this. The rear windows are removed and replaced by a sheet of metal that's quick cured in place. The rear seats and seat belts are then removed and a new floorboard is screwed into place. Voila – five minutes after they start as five-passenger wagons, Ford has a bunch of two-seater panel vans. The seats are then shredded and the material is used as land fill cover. No word on what happens to the glass.

Hmmm... I never expected that my reading of Autoblog would yield an example for my international trade class. All that time I was working, after all.

The Wall Street Journal has more.

Global Warming: Easy Economics but Hard Politics

The Times reports:

While virtually all of the largest developed and developing nations have made domestic commitments toward creating more efficient, renewable sources of energy to cut emissions, none want to take the lead in fighting for significant international emissions reduction targets, lest they be accused at home of selling out future jobs and economic growth.

The negotiations for a new climate change agreement to be signed in Copenhagen in December are badly stalled. With the agreement running more than 200 pages — including what negotiators estimate are a couple of thousand brackets denoting points of differences — diplomats and negotiators fear that the document is too unwieldy to garner a consensus in the coming months.

Sigh. The darn thing is, the costs of dealing with this are likely to be quite low. Further evidence of this comes from estimates by the CBO:

For example, CBO concludes that the cap-and-trade provisions of H.R. 2454, the American Clean Energy and Security Act of 2009, would reduce GDP below what it would otherwise have been—by roughly ¼ to ¾ percent in 2020 and by between 1 and 3½ percent in 2050. By way of comparison, CBO projects that real (that is, inflation-adjusted) GDP will be roughly two and a half times as large in 2050 as it is today, so those changes would be comparatively modest. In the models that CBO reviewed, the long-run cost to households would be smaller than the changes in GDP because consumption falls by less than GDP and because households benefit from more time spent in nonmarket activities. Moreover, these measures of potential costs do not include any benefits of averting climate change.

EconomistMom notes their reluctance to quantify the benefits, which makes the whole "cost benefit" thing a little hard:

What I see as the trouble with CBO–known as the official “scorekeeper” for legislation being considered by Congress–doing a quantitative analysis of the “economic effects” of climate change policy, is that all their qualifying statements about their inability to quantify (in dollar terms) the main point of climate change policy (avoiding environmental damage and what that means for the broader well-being of our society) will be lost on the policymakers, and hence on the public as well. People look for the numbers in a CBO report and will surely use the numbers about what’s bad about climate change policy as a reason not to enact that policy, as long as there are no concrete numbers to support the merits of the policy. In other words, it’s hard for CBO to be the unbiased arbiter on policy evaluation if they’re only “tooled up” on one side of the debate.

Indeed, the expected value is calculated as the probability weighted sum of the various outcomes. If we assign a value of infinity to "avoid complete destruction of human civilization" then, even if the probability is small, the expected benefit is infinite.

Also on the subject of global warming, Mark Thoma points us to this WSJ column by Robert Stavins of Harvard.

China's Cares for our (Fiscal) Health

The New Republic's Noam Scheiber reports that our largest creditor is, understandably, taking an interest in issues that affect the US government's future fiscal position:

To his surprise, when [Budget Director Peter] Orszag arrived at the site of the annual U.S.-China Strategic and Economic Dialogue (S&ED), the Chinese didn't dwell on the Wall Street meltdown or the global recession. The bureaucrats at his table mostly wanted to know about health care reform, which Orszag has helped shepherd. "They were intrigued by the most recent legislative developments," Orszag says. "It was like, 'You're fresh from the field, what can you tell us?' "

As it happens, health care is much on the minds of the Chinese these days. Over the last few years, as China has become the world's largest purchaser of Treasury bonds, the government has grown increasingly sophisticated in its understanding of U.S. budget deficits. The issue has become all the more pressing in recent months, as the financial crisis and recession pushed the deficit to record levels. With nearly half of their $2 trillion in foreign currency reserves invested in U.S. bonds alone, the Chinese are understandably concerned about our creditworthiness. And this concern has brought them ineluctably to the issue of health care.

The United States' dependence on foreign purchases of Treasury bonds means that no issue that affects the deficit is solely "domestic." The US has an interest in China's health care system, too, as it contributes to the high savings rate that fuels China's side of the current account imbalance. Scheiber writes:

The Chinese save such freakish amounts because consumer credit is scarce, insurance is rudimentary, and their social infrastructure is threadbare. They must often pay for houses in cash, and for medical procedures out of pocket.

Update (8/20): Ilian Mihov suggests (with evidence) that healthcare and education costs played a key role in the rise of US consumption.

Some Freshwater Saltiness

The navel-gazing turns nasty....

Paul Krugman's NY Times Magazine article "How Did Economists Get it So Wrong?" (see this earlier post) has generated quite a volume of reaction, usefully rounded up by Mark Thoma. Representing the "freshwater" school, John Cochrane is not happy. He asks "How Did Paul Krugman Get it So Wrong [.doc] ?" and part of his answer is:

So what is Krugman up to? Why become a denier, a skeptic, an apologist for 70 year old ideas, replete with well-known logical fallacies, a pariah? Why publish an essentially personal attack on an ever-growing enemies list that now includes practically every professional economist? Why publish an incoherent vision for the future of economics?

The only explanation that makes sense to me is that Krugman isn’t trying to be an economist, he is trying to be a partisan, political opinion writer. This is not an insult. I read George Will, Charles Krauthnammer and Frank Rich with equal pleasure even when I disagree with them. Krugman wants to be Rush Limbaugh of the Left.

Yikes. On his blog, a semi-response from Krugman.

A Tiresome Tariff?

President Obama has imposed "safeguard" tariffs for three years on Chinese tires, but at a lower level than the ITC recommended, the Times reports:

The International Trade Commission, an independent federal agency, ruled in late June that Chinese tire imports had indeed disrupted the domestic industry.

The panel recommended that the president impose tariffs for three years, starting at 55 percent and then declining. Mr. Obama, who was required by law to decide on the recommendation by Sept. 17, announced slightly lower tariffs that will start at 35 percent and drop to 25 percent in the third year.

Economists are mostly nonplussed... Brad DeLong says "really stupid." But not unusual, notes Douglas Irwin:

Regardless of party, every president, at some point, and often for political reasons, has imposed restrictions on imports. George Bush did, Bill Clinton did, Ronald Reagan did (a lot), Jimmy Carter did, and so forth...you get the drift. With some exceptions, most of these restrictions were not too costly or too important: they usually involved small industries, and the restrictions eventually expired. So on the broad canvas of presidential trade policy, Obama’s decision is unexceptional. Of course, the timing of the administration’s action, coming off the economic crisis and increasing fears of protectionism, makes it a bit riskier than most. And China’s response could make a bad situation worse; let us hope that it is posturing for its domestic audience. Still, the disruption to world trade is significantly less than Bush’s steel safeguard action early in his term.

Also, Dean Baker notes:

When China was admitted to the WTO it agreed to allow the United States to impose tariffs to temporarily counteract the disruptive effects of an import surge. The agreement did not require the United States to show that China had in any way acted unfairly, simply that the growth of imports had seriously disrupted the domestic market.

This clause was an important factor in selling China's entry to the WTO to interest groups in the United States. Therefore, it should not be surprising that the government would occasionally take advantage of a clause that it had demanded.

Real Time Economics rounds up more reaction.