…because I’m an economist and a mom–that’s why!

We Can’t Entitle Our Way Out of Paying Taxes

August 23rd, 2008 . by economistmom

Thursday’s Wall Street Journal contained an opinion column by Glenn Hubbard, arguing that ”We Can’t Tax Our Way Out of the Entitlement Crisis.”  Glenn, whom I worked closely with as his resident tax-policy antagonist at the Council of Economic Advisers for the first 100 days of the Bush Admininstration (my being a staff holdover from the Clinton Administration CEA), uses the column to criticize what seems to be Senator Obama’s tax-heavy approach to entitlement reform (or at least Social Security reform). 

Glenn argues that with combined spending on Social Security, Medicare, and Medicaid projected to rise by nearly 10 percentage points of GDP over the next 40 years (he cites CBO numbers for this), relying on revenues alone to keep deficits from expanding would require revenues to increase by 10% of GDP.  With revenues/GDP currently around 19%, a boost of 10% of GDP would take us to 29%–which is the “simple arithmetic” Glenn refers to here:

…Social Security and Medicare spending left unchecked would, after a generation, consume about 10 percentage points more of GDP than it does today.

Simple arithmetic suggests that with this much more of GDP eaten up by the two programs, all federal taxes on average would have to be raised by more than 50% to make up the shortfall…

But enough of my “fact checking.”  I don’t work for Glenn anymore.  Glenn goes on to point to some academic research that demonstrates the danger of Obama’s taxes-only approach (emphasis added):

Research by economists Eric Engen of the Federal Reserve Board and Jonathan Skinner of Dartmouth suggests that such a tax increase would reduce long-term GDP growth by about a full percentage point. This is no small matter: Think of it as reversing all of the gains in our long-term growth rate from the productivity boom of the past 15 years. 

Coincidentally, I know Eric Engen and Jon Skinner pretty well, too.  Eric and I were the only students in Jon Skinner’s Ph.D. public finance class at U. of Virginia back in the mid-1980s.  And I know something about this research that Glenn cites, the first thing being that this was a paper written 12 years ago, before we even saw the evidence (data points!) from the later years of the Clinton Administration that growth in revenues as a share of the economy could coexist with–and even encourage–strong growth in the economy overall.  The second thing I know about this paper (and you can see for yourself here) is that the “full percentage point” drop in GDP growth Glenn cites is derived from an Engen and Skinner conclusion about the effect of marginal tax rate changes, roughly translated into a “corresponding” range of average tax rate changes.  From the National Bureau of Economic Research summary of the paper (again, my emphasis added):

Engen and Skinner take two different approaches to discerning how taxes affect growth. First, they look at cross-country experiences. …A number of [cross-country] studies…have found that cutting marginal tax rates increases economic growth. Based on these cross-country studies, Engen and Skinner conclude that cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of U.S. GDP by 0.3 percentage points per year.

Second, Engen and Skinner turn to others’ research on the effect that changes in tax rates have had on the capital stock, labor supply, and R and D in the United States. They use the results of these studies to estimate the likely effect of cuts in tax rates. A hypothetical 5-percentage point cut in marginal tax rates, they conclude, would cause long-run economic growth to increase by 0.2 percentage points.

Both sets of studies suggest about the same answer: a 0.2 to 0.3 percentage point increase in growth rates in response to a major change in the tax structure, defined here as a decline in the average tax burden of 2.5 percent of GDP or a 5 percentage point marginal tax cut (for example, from a 15 percent marginal tax rate to a 10 percent marginal tax rate).

You see, the way economists view the importance of tax rates on economic growth is that it’s the marginal tax rate (the tax rate on the next, or marginal, dollar of income) that matters for economic incentives–the supply-side behaviors of labor supply and saving, which are what combined produce national output.  When we study the beneficial economic effects of what we think of as “tax reform,” the mental exercise is usually the following:  how would economic efficiency improve if marginal tax rates could be reduced (through base broadening), holding revenues (and hence average tax rates) constant?  Hence, the studies that Eric and Jon used in their 1996 paper to glean a relationship between tax rates and economic growth, were all largely based on the premise that the relationship that matters is between marginal tax rates and economic growth, not average tax rates and economic growth.  In fact, many of the studies Eric and Jon cite in their paper explicitly hold constant the average tax rate, the national saving rate, or the capital stock.  Why?  Because the studies try to isolate the incentive (or substitution) effects of tax policy.  But Eric and Jon made the mistake of providing the reader (to be helpful?) with a loose translation of what a given marginal tax rate change would imply for the average tax rate (in “real life” that is, where we tend to shun revenue neutrality), and then suggesting (unintentionally?) that their results based on the marginal tax rate, revenue-neutral changes, and economic growth, could translate directly into a connection between the average tax rate and economic growth.   Nope–you can’t do that.  (I thought Jon Skinner had taught both me and Eric that.)

And if you check out the paper, you’ll see that even with the connection between marginal tax rates and economic growth that Eric and Jon were really trying to emphasize, Eric and Jon weren’t exactly confident in the statistical ”robustness” of their empirical conclusions–from either the cross-country studies or their “sectoral, bottom-up” simulation approach.  They were very upfront about that, but that sort of language doesn’t get put into the NBER digest summary of a paper that has such a clean and precise conclusion and potential policy implication. 

So then Glenn comes along, 12 years later, with the claim that an Obama Administration is proposing to increase taxes by enough to fully cover the growth in entitlement spending over the next forty years, which implies that more than 50% increase figure, and a boost in the average tax rate from 19% of GDP to 29% of GDP.  That 10% of GDP increase in the average tax rate happens to be four times the 2.5% of GDP change in the average tax rate said by Eric and Jon’s 1996 paper to imply a corresponding 0.2 to 0.3 percentage point change in the GDP growth rate.  Hence, Glenn says the Obama “tax plan” would reduce GDP growth by four times 0.25 (0.2 to 0.3) percentage points, or voila –”a full percentage point.”  (Whoops, I said I was done with the fact checking, didn’t I?…)

So, get to my point?…  Besides the fact that Senator Obama has far from proposed to raise federal revenues as a share of GDP to 29% (he’s barely budging it from the 40-year historical average of just over 18% from what we’ve seen so far), even if anyone were to recommend such an increase in taxes, it would be an increase in the average tax rate we’d be talking about, not the marginal tax rate.  And for any given average tax rate, there are many different marginal tax rates, and schedules and patterns of marginal tax rates, that could correspond to that average rate.  Ideally, if deficits are deemed too large for the health of the economy, we do want to raise revenues/GDP (the average tax rate) and reduce spending/GDP, and we want to do that in a thoughtful way that weighs costs against benefits (i.e., maximizes the net benefit to our economy and our society).  Doing more on the tax side makes more sense if we can find ways to raise the average tax rate without raising marginal tax rates (or without raising too many marginal tax rates or the ones that people are most sensitive to).  That is, if we can combine our goals for deficit reduction with our goals for tax reform, raising the average tax rate doesn’t have to involve trading off economic growth.  In fact, raising the average tax rate without raising marginal tax rates is likely to boost national saving (as public saving would rise without adverse offsetting effects on private saving) and hence boost economic growth. 

But how is it possible to raise revenues as a share of GDP (the economy-wide average tax rate) without raising marginal tax rates?  Start by realizing our current income tax system applies to far from a “comprehensive” tax base (i.e., far from all of GDP).  If we could broaden the tax base, we could raise revenues without raising marginal rates.  Then it’s certainly possible to think about reducing the deficit through better tax policy; you don’t necessarily have to turn to “bigger” tax policy in terms of marginal tax rates.

Glenn Hubbard knows a lot about tax reform, and I know he believes in it.  That’s why I’m disappointed that he would forget about tax reform when it comes to how he thinks we ought to balance the budget.  Glenn says (my emphasis added):

Balancing the federal budget without a tax increase is possible, but will require strong fiscal restraint. To achieve full-employment budget balance by the end of the next president’s term in office, federal nondefense spending growth needs to be restrained to [a nominal] 2% per year instead of the currently projected 4.5%. And modest defense spending increases to fund costs of needed improvements in national security are possible.

We can also secure a firm financial footing for Social Security (and Medicare) without choking off economic growth or curtailing our flexibility to pursue other spending priorities. Three actions are essential: (1) reduce entitlement spending growth through some form of means testing; (2) eliminate all nonessential spending in the rest of the budget; and (3) adopt policies that promote economic growth. This 180-degree difference from Mr. Obama’s fiscal plan forms the basis of Sen. McCain’s priorities for spending, taxes and health care.

Glenn forgets what I know he knows:  there’s a lot of “entitlement spending” on the tax side of the budget, commonly referred to as “tax expenditures,” but what we at Concord view and refer to as “tax entitlements.”  I could easily edit Glenn’s three essential actions to apply to the tax side of the budget:

  • Three actions are essential: (1) reduce tax entitlements growth through some form of means testing (and better scruntiny of tax expenditures); (2) eliminate all nonessential (and often counterproductive) tax expenditures in the rest of the budget; and (3) adopt fiscally-responsible policies that promote national saving and economic growth.

Glenn should recognize that without these three actions tacked onto his list of essential actions on the spending side, there’s no guarantee that we can “tax cut” our way to a strong economy.

Useful Lessons from CBO’s New Report on Social Security

August 22nd, 2008 . by economistmom

Yesterday CBO released an updated analysis of the Social Security program, with lots of interesting ways of characterizing the range of uncertainty in the projections of benefits and taxes.  The cover graphic (which is also Figure 1 on page 9) tells us the “bottom-line” story:  it’s almost certain that Social Security revenues will start to fall short of scheduled Social Security benefits in 10-20 years.  The report and the CBO Director’s Blog highlights several useful lessons that come out of what they see as their most interesting numbers.

First, while a shortfall in Social Security is almost certain, a shortfall larger than 2 percent of GDP is unlikely:

[T]he likelihood that outlays will exceed revenues in 2030 is about 97 percent, CBO projects, and there is almost a 50 percent chance that the gap will be larger than 1 percentage point of GDP; the chance of its being 2 percentage points (or more) of GDP is only 6 percent.

(This is what makes Social Security a relatively “small” problem compared with the challenges facing Medicare.)

Second, the shortfall threatens the net benefit of the program to younger generations, not older ones:

According to CBO’s projections, the 1940s cohort, for example, is virtually certain to receive all of its scheduled first-year benefit. The 1990s cohort has only a 32 percent chance of receiving all of its scheduled first-year benefit but an 84 percent chance of receiving at least 70 percent of that benefit.

So one could interpret this intergenerational distribution as the Social Security program providing less “insurance” to younger generations. 

But third, what is considered a “fair return” to those younger generations depends on what measure of benefits one considers most relevant–which is a value judgment.  So this is where many of us have (and will continue to have) disagreements… 

  • Based on the first-year benefit highlighted above (see Figure 5 on page 13), the “unfairness” can be characterized as younger generations facing a larger divergence of payable benefits compared with scheduled benefits.  On the other hand, first-year payable benefits, in thousands of real (2008) dollars, are still higher for younger generations than older generations. 
  • Based on replacement rates (or how much of career-average annual earnings are “replaced” with first-year benefits–see Figure 7 on page 15), the shortfall in Social Security significantly reduces the (payable) replacement rate to younger generations below the scheduled benefits that would otherwise provide a replacement rate similar to that given to older cohorts.
  • Based on lifetime benefits (see Figure 9 on page 17), even with the shortfall under the payable benefits scenario, median lifetime Social Security benefits to younger generations are still higher in real dollar terms than the median lifetime benefits to older cohorts.  And there’s really no uncertainty about this in CBO’s analysis (based on Figure 12 on page 20).
  • But based on the ratio of lifetime benefits to lifetime taxes (see Figure 13 on page 21), younger generations are likely to get a lower “lifetime return” on the taxes they paid into the system, compared with older cohorts.  For example, the shortfall makes it more likely than not that middle-income individuals born in 1990-2000 (i.e., many of our kids and grandkids) will receive lifetime Social Security benefits that fall short of their lifetime Social Security taxes paid (providing negative lifetime return).

A fourth useful lesson, featured in Box 1 on page 3 of the report, is that the Bush income tax cuts worsen the outlook for the Social Security program–and not just the outlook for general revenues.  Extending the tax cuts would reduce projected revenues from the taxation of Social Security benefits and hence increase the Social Security 75-year shortfall, to -0.47% of GDP or -1.30% of taxable payroll, compared with -0.38% of GDP or -1.06% of taxable payroll under the “extended baseline” used in the main projections.  Yet another reason why we ought to think carefully before extending any of the Bush tax cuts and why our mental starting point ought to be the level of revenues achieved under the current-law baseline.

I’m sure they’re many other useful lessons from this CBO report, which I’m likely to focus on with greater detail in future posts, especially with input and feedback from some of you readers.  And others will no doubt take away different highlights and different lessons.  (Andrew Biggs has already commented on the report with a couple different posts on his blog.) 

Tonight: I.O.U.S.A. “Live”

August 21st, 2008 . by economistmom

Tonight’s the special, one-night “live” showing of IOUSA the Movie with the post-movie simulcast town hall meeting with Warren Buffett, Pete Peterson, and Dave Walker.  Go see it if you can.  (Check the link on “live” for further information on locations.)  Then come back here to post your comments/instant reviews.  I’ll be back on here late tonight with a report of the experience from the northern VA theatre where I will be attending.

Steven Pearlstein Points to Central Park as a Public Success Story

August 20th, 2008 . by economistmom

Today’s Washington Post has an excellent column by Steven Pearlstein, inspired by his recent trip to NYC where he was impressed by the condition of the now-privately-financed-and-managed Central Park. 

He finds important lessons for economic policy in Central Park’s success (my emphasis added):

The first is a reminder of the importance of creating and sustaining public facilities that are accessible to everyone and nourish a sense of community. Over the past 20 years, the tendency has been for those who can to abandon public schools, public transportation, public recreation, with the result that American society has become increasingly segregated by class and polarized by political ideology…

The second big lesson is that investment in public infrastructure can have big payoffs

That doesn’t mean that all spending on public purposes can be characterized as investment (an old liberal trick) or that all investments can be expected to have the same payback as Central Park. But it does put the lie to the idea that Americans no longer have the money to build and maintain the quality schools, libraries, parks, roads and public transportation systems required for an advanced economy. Collectively, we have the money. What we haven’t had is the political will to raise the taxes necessary to make these high-payoff public investments.

Conservatives and Republicans see in the Central Park success story further confirmation of their belief that government is inept. After all, it took a private organization, relying primarily on private donations, to turn things around. Liberal Democrats would no doubt reply that if New Yorkers hadn’t been scared away by tax-cutting ideology and had been willing to raise and spend $350 million of public funds for Central Park, the city’s parks department could have accomplished the same feat.

There’s something to both arguments.

Because of the power of special-interest groups and public employees, government spending priorities are too often misplaced and too many government agencies fail to use the money they have to deliver quality, efficient service. That’s why outsourcing has become so prevalent, why charter schools have become so popular, and why so many state and local officials are turning to public-private partnerships and social entrepreneurs to tackle some of their toughest challenges. What Democrats in Washington have yet to realize is that this isn’t about rejecting government or shrinking it — it’s about redefining it.

At the same time, it’s important to remember that in terms of economic impact there isn’t a big difference between a nonprofit raising $350 million in private donations to fix up Central Park or city government raising $350 million through a well-designed tax system to accomplish the same purpose… The idea that every dollar collected in taxes is a dollar lost from the economy is nothing but political propaganda.

the candidates most likely to prevail this fall will be those who figure out how to tap into the yearning to tackle and solve a big problem, to restore pride in the public realm and to reaffirm that sense that we’re all in this together.

Steven is making the important point that just because Central Park is a success story in “privatization” to some extent, doesn’t negate the fact that it’s a much larger testament to our society’s desire to continue to benefit from such inherently public projects.  And realizing how much we value such public goods is the start to being willing to pay for them.

I Won a 2001 Budget Battle! (Not!)

August 19th, 2008 . by economistmom

Hey, Stan! Look at what I found while I was “excavating” my bedroom last week.  I’d always treasured this t-shirt for the delicious irony of its message…Given that I had spent 2000-01 at the Council of Economic Advisers writing about President Clinton’s legacy of fiscal responsibility and (unsuccessfully) working against the idea of the Bush tax cuts, how ironic that during that period I would win one of Stan’s weekly “Budget Battles” trivia contests to receive this shirt claiming a 2001 budget victory.  It’s one of my favorite mementos…I’ll keep it stored next to my high school varsity cheerleading sweater from now on.  ;)

More Conversations with Pastor Rick on Fiscal Responsibility

August 18th, 2008 . by economistmom

(photo by LA Times)

Now that I’m on a better internet connection (spending a night back home from the beach before heading back tomorrow) and have found a better transcript to work from (courtesy of CNN), I thought I’d do a better side-by-side on the two candidates’ references to fiscal policy in their Saturday evening interviews with Pastor Rick Warren.  (This is what interests me way beyond the “cone of silence” controversy.)

Here is the exchange between Pastor Rick and Senator Obama on tax policy and what defines “rich” (my emphasis added, and my edits in italics):

WARREN: OK. Taxes, this is a real simple question. Define rich. [ laughter ] I mean give me a number, Is it $50,000, $100,000, 200,000? Everybody keeps talking about who we’re going to tax. How can you define that?

OBAMA: You know, if you’ve got book sales of $25 million, then you qualify.

[ laughter ] [ applause ]


WARREN: No, I’m not asking about me.

OBAMA: Look, the - here’s how I think about it. Here’s how I think about it. And this is reflected in my tax plan. If you are making $150,000 a year or less, as a family, then you’re middle class or you may be poor. But $150,000 down you’re basically middle class, obviously depends on the region where you’re living.

WARREN: In this region, you’re poor.

OBAMA: Yes, well - depending. I don’t know what housing practices are going. I would argue that if you’re making more than $250,000, then you’re in the top three percent, four percent of this country. You’re doing well. Now, these things are all relative. And I’m not suggesting that everybody is making over $250,000 is living on easy street. But the question that I think we have to ask ourselves is, if we believe in good schools, if we believe in good roads, if we want to make sure that kids can go to college, if we don’t want to leave a mountain of debt for the next generation. Then we’ve got to pay for these things, they don’t come for free, and it is irresponsible [to act as if they come for free].

I believe it is irresponsible intergenerationally for us to invest or for us to spend $10 billion a month on a war and not have a way of paying for it. That, I think, is unacceptable. So nobody likes to pay taxes. I haven’t sold 25 million books but I’ve been selling some books lately, and so I write a pretty big check to Uncle Sam. Nobody likes it. What I can say is under the approach I’m taking, if you make $150,000 or less, you will see a tax cut. If you’re making $250,000 a year or more, you’re going to see a modest increase. What I’m trying to do is create a sense of balance, and fairness in our tax code. One thing I think we can all agree on, is that it should be simpler so that you don’t have all these loopholes and big stacks of stuff that you’ve got to comb through, which wastes a huge amount of money and allows special interests to take advantage of things that ordinary people cannot take advantage of.

And here’s the exchange with Senator McCain on the same issue (again, my emphasis added):

WARREN: Ok, on taxes, define “rich.” Everybody talks about taxing the rich, but not the poor, the middle class. At what point - give me a number, give me a specific number - where do you move from middle class to rich?

Is it $100,000, is it $50,000, is it $200,000? How does anybody know if we don’t know what the standards are?

MCCAIN: Some of the richest people I’ve ever known in my life are the most unhappy. I think that rich should be defined by a home, a good job, an education and the ability to hand to our children a more prosperous and safer world than the one that we inherited.

I don’t want to take any money from the rich — I want everybody to get rich.


I don’t believe in class warfare or re-distribution of the wealth. But I can tell you, for example, there are small businessmen and women who are working 16 hours a day, seven days a week that some people would classify as - quote - “rich,” my friends, and want to raise their taxes and want to raise their payroll taxes.

Let’s have - keep taxes low. Let’s give every family in America a $7,000 tax credit for every child they have. Let’s give them a $5,000 refundable tax credit to go out and get the health insurance of their choice. Let’s not have the government take over the health care system in America.


So, I think if you are just talking about income, how about $5 million?


But seriously, I don’t think you can - I don’t think seriously that - the point is that I’m trying to make here, seriously — and I’m sure that comment will be distorted — but the point is that we want to keep people’s taxes low and increase revenues.

And, my friend, it was not taxes that mattered in America in the last several years. It was spending. Spending got completely out of control. We spent money in way that mortgaged our kids’ futures.


My friends, we spent $3 million of your money to study the DNA of bears in Montana. Now I don’t know if that was a paternity issue or a criminal issue…


… but the point is, it was $3 million of your money. It was your money. And, you know, we laugh about it, but we cry - and we should cry because the Congress is supposed to be careful stewards of your tax dollars.

So what did they just do in the middle of an energy crisis when in California we are paying $4 a gallon for gas? Went on vacation for five weeks. I guarantee you, two things they never miss - a pay raise and a vacation — and we should stop that and call them back and not raise your taxes. We should not and cannot raise taxes in tough economic times.

So, it doesn’t matter really what my definition of “rich” is because I don’t want to raise anybody’s taxes. I really don’t. In fact, I want to give working Americans a better shot at having a better life, and we all know the challenges, my friends, if I could be serious.

Americans tonight in California and all over America are sitting at the kitchen table — recently and suddenly lost a job, can’t afford to stay in their home, education for their kids, affordable health care. These are tough problems. These are tough problems. You talk to them every day…

WARREN: All the time.

MCCAIN: … everyday. My friends, we’ve got to give them hope and confidence in the future. That’s what we need to give them, and I can inspire them. I can lead, and I know that our best days are ahead of us.


Stark contrast, indeed.  And it would be so even if both candidates had received this question ahead of time and prepared all they wanted for this question–”cone of silence” or not.  These exchanges are just the latest clarification of the two candidates’ fundamentally different views on:  (i) the role of government in income redistribution (determining what’s “fair”); (ii) the ideal size of government; and (iii) what happens to tax revenues when you cut tax rates. 

And here’s a better copy of the text of Senator Obama’s response to his last question, which Pastor Rick for some reason did not ask of Senator McCain:

WARREN: OK. I’ve got 30 seconds. What would you tell the American public if you knew there wouldn’t be any repercussions?

[ laughter ]

OBAMA: Well, you know what I would tell them is that solving big problems, like for example, energy, is not going to be easy and everybody is going to have to get involved. And we are going to have to all think about how are we using energy more efficiently and there’s going to be a price to pay in transitioning to a more energy-efficient economy and dealing with issues like climate change. And if we pretend like everything is free, and there’s no sacrifice involved, then we are betraying the tradition of America.

I think about my grandparents’ generation, coming out of a depression, fighting World War II; you know, they’ve confronted some challenges we can’t even imagine. If they were willing to make sacrifices on our behalf, we should be able to make some sacrifices on behalf of the next generation. 

Obama Speaks with Pastor Rick on Fiscal Responsibility

August 17th, 2008 . by economistmom

Last night CNN broadcast the “Saddleback Civil Forum on the Presidency,” live from the church of Pastor Rick Warren (of Purpose-Driven Life fame).  Here is the CNN story that contains links to the video (in four parts).  And here is a link to the written transcript, now available on Rick Warren’s website.

The whole forum–back to back interviews of the two candidates separately, but on the same tough questions–was really well done.  It seems this format is really effective at helping the public really get to know how the candidates think on the issues–I mean how they really think and deeply feel about the issues, and not just how they debate with their opponent about them.

Two highlights for me:  (i) the question on “who is rich”–i.e., at what income level does the candidate consider a family “rich”–and I believe it was asked with reference to taxes, or at least was answered that way by both; and (ii) Obama’s response to the very last question on what he would tell the American public if he “knew there wouldn’t be any repercussions.”

On the question of who’s rich regarding taxes, the candidates answered very differently, as to be expected.  Obama made reference to his $250,000+ standard.  McCain began with a flippant mention of $5 million, but eventually got to his supply-side (really, Laffer Curve) claim that you have to cut taxes to raise revenue, and that the deficit problem was due to spending, not to tax cuts.  (This AP story by Charles Babington and Beth Fouhy highlights part of that McCain response.)

I was moved by Obama’s answer to Pastor Rick’s last question, on what he would tell the American public (in 30 seconds) if he knew there wouldn’t be any “repercussions.”  In his response, Obama made reference to shared sacrifice and fiscal responsibility–the (moral) issue of what we leave for future generations (I’m cutting and pasting from the all-caps text and then editing/correcting here, so sorry this isn’t very pretty):



AEI’s Brill & Viard on the Obama Tax Plan: Not Dishonest, Just Not That Interesting

August 16th, 2008 . by economistmom

Last Friday, the American Enterprise Institute’s Alex Brill and Alan Viard published this column on “The Folly of Obama’s Tax Plan,” in which they point out that all of Senator Obama’s proposed tax cuts for the middle class have the unfortunate side effect of raising marginal tax rates–effective tax rates on the next dollar earned–over certain ranges of the “middle-income” spectrum.  They were chastised by pgl over on Angry Bear for their “basic dishonesty.”  (UPDATE:  here’s the link to Jonah Gelbach’s post that inspired the thread on AB.)

But in defense of Alex and Alan, their column is not dishonest, and is probably not even intended to “distort” or even “confuse” (characterizations of the column used on Angry Bear and the Economists for Obama site that pgl quotes from).  It’s just that Alex and Alan are trying to make a big deal out of a small point, and a small point that has hardly any policy relevance. 

That point is that adding greater progressivity to a tax system (raising relative tax burdens on the rich or lowering relative tax burdens on the poor)–something Senator Obama is clearly trying to do–necessarily means raising marginal tax rates somewhere along the income distribution, in order to increase how steeply average tax rates rise with income.  In the case of refundable tax credits, these introduce progressivity by creating negative average tax rates (i.e., net income received rather than net taxes paid) at low income levels, but as income rises and the credits are phased out, the effective marginal tax rate equals the rate of reduction of the credit.  And if you boost the value of any existing tax credit but keep its qualifying ranges of income the same, well, you’re necessarily going to be phasing out more benefits faster, i.e., boosting the effective (positive) marginal tax rate.  Economists sometimes obsess about these phaseout marginal tax rates, because we like to worry about the adverse incentive effects of these tax rates on labor supply and saving–the idea that people might not work as hard or as many hours if they know that in earning more income, the value of their refundable tax credits will go down.  Even if the credits don’t go down by anywhere close to the amount of extra income–i.e., even without an effective marginal tax rate that’s less than 100%–economists worry that the “substitution effect” of this higher marginal tax rate (caused by the negative average tax rate) could be a decline in how much people work.

But this is a “problem” with any tax preference that’s targeted to a certain range of income (it doesn’t just apply to refundable tax credits), so there’s no way to avoid it without “de-targeting” the preference and spending a heck of a lot more money, on tax cuts for everybody.  The adverse economic effects of a much more costly tax cut, going to more people than is really justified given the purpose of the tax cut, far outweigh any potential benefit from reducing marginal tax rates and the possible substitution effects associated with the phaseouts of tax benefits.

This marginal tax rate criticism is often levied against the Earned Income Tax Credit (EITC) when economists feel like getting negative (i.e., insist on staying “dismal”) about a tax credit that otherwise delights most economists.  The EITC is a refundable tax credit that phases in at lower income levels, plateaus over a range of income, and then phases out over a higher range of income, as explained on this Tax Policy Center page.  Economists like the phase-in range of the EITC, where the rising credit with income means the marginal tax rate is negative–creating an incentive, rather than a disincentive, to work.  Economists dislike, however, or at least fret about, the phase-out range of the EITC, where the phasing out of the credit adds to the effective marginal tax rate.

But I say it’s much ado about nothing.  Theoretically, for the phaseout of a tax preference to adversely affect work incentives, it must be true that the worker is able to choose his or her hours of work in a continuous manner–that is, that I could choose to work 30 hours per week instead of 35, for example.  Some workers can do this, but many cannot.  It must also be the case that the worker is aware of the positive marginal tax rate faced at each decision point–aware that if he or she works an hour more, or 5 hours more, that his or her tax credit will go down by $__.  Most people are much more keenly aware of their average tax rates and their take-home pay, than their marginal tax rates and their net wage rates “at the margin.”

Empirically, studies on the EITC have shown that there’s just not much to worry about in terms of disincentive effects associated with the phasing out (i.e., the targeting) of tax credits.  A summary of recent empirical research on the EITC by the National Bureau of Economic Research explains that (emphasis added):

In Behavioral Responses to Taxes: Lessons from the EITC and Labor Supply (NBER Working Paper No.11729), NBER researchers Nada Eissa and Hilary Hoynes review a large number of economic studies of the EITC and conclude that the main lesson from the accumulated evidence is that real responses to taxes are important. The second lesson is that, while the EITC stimulates people to join the work force, there is no evidence that it prompts them to work fewer hours. This difference, the authors write, “has several important implications for the design of tax-transfer programs and the welfare evaluation of taxation.

In other words, the implications for policy design are that we don’t need to worry about these potentially high marginal tax rates when tax credits are phased out, because:  (i) there’s no way to avoid them when targeting a tax credit, and (ii) there’s no evidence that the disincentive effects are significant (regardless of the theoretical potential).

So the point that Alex Brill and Alan Viard make in their column is not dishonest.  It’s just not very interesting (outside of a course in the microeconomics of public finance) and certainly not very policy relevant.

Take My Stuff…Please!

August 15th, 2008 . by economistmom

One 20′ dumpster (rented from Home Depot), parked in front of my house for 9 days, then hauled away today:  $525.00.

One almost-full truckload of old furniture, moved out of my house today by 1-800-GOT-JUNK:  $571.00.  (They did a great job, by the way, hence the “plug” here.)

A half a front porch full of toys, books, and clothes, to be picked up by Goodwill tomorrow:  FREE.

Sitting on the floor of my living room because I can (and don’t care that I don’t have new furniture yet), and basking in my semi-decluttered bliss:  PRICELESS.


I still have a lot left to do before Labor Day and am headed off to the beach tomorrow (until IOUSA comes out on Thursday, because it’s not showing there…), but I’m bound and determined to pretend we are moving so that I fool myself into actually getting rid of maybe 1/3 to 1/2 of my “stuff.”  Seriously.  As the 1-800-GOT-JUNK guys were moving out my old living room furniture today, I was ecstatically sweeping up the dust and remarking to them how “liberating” it felt.  Do I really need to replace the old furniture?…  I can sit on the floor just fine, what with all the yoga I do!

Anyone else get giddy over getting rid of stuff?  I think it feels even better than the opposite “retail therapy.”  Of course, that’s my problem…I think I’m clearly a “binge-and-purger” when it comes to “stuff.”  (I know, totally irrational and not in keeping with my economist upbringing.)

The Obama Tax Plan (or How to Look Good at the Dance)

August 14th, 2008 . by economistmom

I may be kind of old and past my dancing days now, but I still remember the trick to looking good at those school dances, even when you’re not “the total package”…

When you’re just standing there, stand next to the ugly person.

When you’re dancing, dance near the klutzy person.

And when you’re engaging in conversation, converse around the stupid person.

Now, it may still be that the Obama tax plan would be voted the “belle of the ball,” but it wouldn’t be because of its beauty in an absolute sense, only because of its beauty measured relative to some less attractive standards.  The Obama campaign likes to compare different aspects of their tax plan to the different less attractive standards around the room.  This is what’s known among budget geeks as a “baseline issue”–but what might be easier to understand as ”how to look good at the dance.”

(In a nice article by Lori Montgomery in last Sunday’s Washington Post, Len Burman of the Tax Policy Center referred to this as a “yardstick” issue.)

So I bring this up because in today’s Wall Street Journal, Obama advisors Jason Furman and Austan Goolsbee speak of the beauty of the Obama tax plan.

The Obama tax plan is both a net tax cut, relative to (ugly) current law…

Overall, Sen. Obama’s middle-class tax cuts are larger than his partial rollbacks for families earning over $250,000, making the proposal as a whole a net tax cut and reducing revenues to less than 18.2% of GDP — the level of taxes that prevailed under President Reagan.

…and a fiscally-responsible, tax plan, relative to (stupid) Bush tax policy extended…

Sen. Obama is focused on cutting taxes for middle-class families and small businesses, and investing in key areas like health, innovation and education. He would do this while cutting unnecessary spending, paying for his proposals and bringing down the budget deficit.

And the Obama tax plan is fair in its redistribution of income, relative to the unfair (klutzy) tax changes since 2001

Sen. Obama believes a focus on the middle class is appropriate in the wake of the first economic expansion on record where the typical family’s income fell by almost $1,000. The Obama plan would cut taxes for 95% of workers and their families with a tax cut of $500 for workers or $1,000 for working couples…[H]e would repeal a portion of the tax cuts passed in the last eight years for families making over $250,000…In an Obama administration, the top 1% of households — people with an average income of $1.6 million per year — would see their average federal income and payroll tax rate increase from 21% today to 24%…

…yet also keeps top tax rates relatively low (beautiful) compared with the tax rates of the (already beautiful) late 1990s…

But to be clear: He would leave their tax rates [those of families over $250,000] at or below where they were in the 1990s…[T]he top 1%…would see [an] average…tax rate…less than the 25% these households would have paid under the tax laws of the late 1990s.

So I have to wonder when Jason and Austan hint at the economic smartness of the Obama plan by citing a Brad DeLong estimate of the economic cost of the (dumb, or at least “fiscally reckless”) McCain tax plan due to its effect on the federal debt:

Sen. McCain has put forward the most fiscally reckless presidential platform in modern memory. The likely results of his Bush-plus policies are clear. As Berkeley economist Brad Delong has estimated, the McCain plan, as compared to the Obama plan, would lower annual incomes by $300 billion or more in real terms by 2017, costing the typical worker $1,800 or more due to the effect of large deficits on national savings and thus capital formation.

… If that’s really ”as compared to the Obama plan”, then isn’t there an extra economic cost (beyond the revenue cost) associated with the level of debt added by the Obama plan, too?… in other words, relative to current law?  If this calculation is linear, for example, and if we use Tax Policy Center estimates for the cost of the McCain and Obama tax plans (I know the Obama campaign is using a much larger figure for McCain), then the Obama tax plan adds “just” $2.8 trillion to the federal debt over ten years (not counting interest), while the McCain tax plan adds $4.2 trillion.  So Obama’s plan costs two-thirds what McCain’s plan does.  Does that mean (doing the algebra) that Brad DeLong would calculate that the Obama tax plan would involve $600 billion in reduced annual incomes due to the reduction in national saving–which is $300 billion less than the perhaps $900 billion under the McCain tax plan?

So I guess I need to ask Brad:  is the Obama plan still “smart” and “pretty” on the economic growth front in an absolute sense, and not just compared with the McCain plan–you know, that ugly, dumb thing?  ;)

« Previous Entries Next Entries »