Relevant and even prescient commentary on news, politics and the economy.

Immigration Summary

Well, I could have saved myself and all of you a lot of time and energy if I had just started off the week linking to Max Sawicky on the topic of immigration. The post would have been entitled “Immigration: Just See Max.” In one concise post, he made all of the points on immigration that I made in several long posts this week. To my shame, I didn’t discover his post until this afternoon.


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Are We Near Full Employment?

David Altig says yes. He also reviews a recent paper by Stephanie Aaronson, Bruce Fallick, Andrew Figura, Jonathan Pingle and William Wascher entitled The Recent Decline in Labor Force Participation and its Implications for Potential Labor Supply that gives evidence that David may have a point. David cites a couple of paragraphs that might support the premise that the fall in labor force participation was driven by real business cycle factors, but also note the opening paragraph of the paper’s conclusion:
In this paper, we have reviewed an array of evidence pertaining to the sources of the persistent decline in the aggregate labor force participation rate since 2000.

In broad terms, this evidence suggests that the business cycle initially played an important role in this decline, contributing to the sharp run-up in labor force participation in the late 1990s and to both the subsequent drop-off during the 2001 recession and the ensuing period of weak labor market performance over the next couple of years. However, the evidence also highlights a number of more structural factors that have contributed to a potentially longer-lasting downtrend in labor force participation.

In other words, the authors are not dismissing the Keynesian explanation as at least part of the story for the past few years. The debate continues.

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On the Incidence of the Earned Income Tax Credit

Max Sawicky takes on this comment from Michael Lind:

Why do right-wing Republicans, and conservative Southern Democrats like Lloyd Bentsen, love the EITC? Because it is a taxpayer subsidy to employers which enables them to pay below-poverty wages to their workers. In other words, the EITC is corporate welfare, a massive redistribution of wealth to the very employers that treat their workers the worst.

More from Michael Lind:

The greatest challenge to the formation of a powerful liberal-centrist bloc in favor of a living wage is the seductive alternative of the earned income tax credit (EITC). Many moderates view it not as a supplement to high wages but as a substitute for them … It is unlikely that the EITC would have received the enthusiastic support of many pro-business conservatives and moderates, however, if it did not disguise a business subsidy … The EITC permits them to do something for low-wage workers without threatening their donors in industries that rely on cheap labor. In effect, it is a double subsidy. By aiding the worker the EITC enables the employer to continue paying far less than is needed to survive at or above the Federal poverty line. The Southern cotton mill owner pays his workers a pittance—and you and I, fellow taxpayers, cough up an additional “social wage,” the EITC. The consumer, who otherwise would have to forgo the good or service or pay more for it, also benefits. Make that a triple subsidy. In addition, the EITC is probably an interregional corporate welfare program. To my knowledge nobody has studied the issue, but it is a fair guess that the South, with the lowest wages, the lowest levels of employment benefits, and the lowest rate of unionization in the United States, receives a disproportionate share of Federal EITC money.

OK, Lind goes too far – but EITC is a subsidy as noted by Jared Bernstein, who noted:

The EITC is clearly raising the living standards of low-income working families. Furthermore, the fact that it is tied to work has largely insulated it from partisan attack and has even allowed for its expansion in this era when social welfare spending is so highly scrutinized. Yet the EITC is not perfect. Some of its benefits surely end up subsidizing employers, who would likely have to raise their wage offers in the absence of the program. More important (since this wage effect is probably small), relying solely on tax policy to raise the incomes of low-wage workers is a serious mistake. We also need policies that focus directly on raising pretax wages. Otherwise, we face the likelihood of a perpetually expanding low-end labor market, with jobs that fail to pay a living wage and thus require ever-increasing taxpayer subsidy.

It would be interesting to analyze the economics of the policies that would “focus directly on raising pretax wages” in addition to discussing the incidence of the EITC. Since Lind concedes that some of the incidence of the EITC accrues to workers, let’s also concede that some of the incidence of this subsidy accrues to workers. However, if the elasticity of labor supply is smaller than the elasticity of labor demand, then most of the incidence of the subsidy accrues to workers – not employers.

Bernstein also notes:

In 1997 the IRS paid out $30.6 billion in EITC claims to about 18.5 million persons. That’s up from $6.6 billion in 1989 and $1.3 billion in 1975 (in nominal dollars). And we’ve gotten a lot for the money. As the Center on Budget and Policy Priorities has shown, in 1998 the EITC was responsible for lifting nearly 5 million persons out of poverty … We have a low-wage labor market problem in this country, and the EITC is an essential part of the solution. But it cannot be the sole solution. Unless we rely on other strategies for improving pretax earnings in the low-wage sector, the living standards of low-income families will be largely dependent on the tax system.

If Bernstein is saying that we should supplement the EITC with other policies designed to lift low wage workers out of poverty, I agree and I suspect Max and Michael Lind do as well.

Update: A Max reader alerts us to The Mid-1990s EITC Expansion: Aggregate Labor Supply Effects and Economic Incidence by Jesse Rothstein.

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Tax Progressivity and Income Inequality

In thinking about the merits and faults of the VAT, I came across some interesting data. The first source is a paper by Timothy Smeeding entitled “Public Policy and Economic Inequality: The United States in Comparative Perspective“. Professor Smeeding used a unique data set from a project called the Luxembourg Income Study to gain various perspectives on differences in income inequality across developed countries and over time. The result that I found most interesting in the context of thinking about the VAT was his calculation of income inequality both before and after taxes. The graph below presents his results.

Notes: The Gini coefficient is measured from 100 (complete inequality) to 0 (total equality).
Figures are from the mid- to late-1990s, depending on the country. See Smeeding’s paper for details.

The striking thing to me is how little the US’s tax code changes income inequality in the US. Yes, the US tax code is progressive, so that disposable income after taxes is a bit less unequal than it was before taxes… but the progressivity of the US tax code is quite modest compared to other developed countries.

Pairing this result with the tax structure of other developed countries thus reveals an important point, which I briefly mentioned in my previous post about the VAT: having a VAT doesn’t mean that the tax code need be regressive. And conversely, the absence of the VAT doesn’t meant that you have a progressive tax code.

The following table ranks the countries in the graph by how much their tax codes reduce income inequality (the first column). The other columns give a broad sketch of how taxes are raised in other countries: the proportion of taxes raised through consumption taxes and income taxes, the VAT rates, and the maximum marginal tax rate on income.

Sources: The first column’s data is from Smeeding; the rest from the OECD Tax Database.
Note: Tax data for the year 2002.

All developed countries collect more – usually far more – of their tax revenue through consumption taxes than does the US. Yet their tax codes are far more progressive. And surprisingly, other countries do not create that tax code progressivity by simply levying high marginal income tax rates on the rich; in general, their top rate is on par with that of the US. Instead, they generate progressivity in the tax code through generous low-income tax exemptions or credits, and top marginal tax rates that kick in at much lower levels of income than in the US.

I take two major lessons from this data. First, the lack of progressivity in the US tax structure is striking, and in my opinion, disgraceful. For those who think something needs to be done to ameliorate the US’s income inequality problem, making the tax code more progressive should clearly be one of the first lines of policy attack. There’s a tremendous amount of room for improvement there.

Secondly, the data suggests that the degree of progressivity of a country’s taxes is determined not by the mix of types of taxes collected, but rather by the political will to make the tax system progressive. Countries that like a progressive tax code can make that happen regardless of whether they have a VAT, income taxes, social insurance taxes, or any other specific type of tax. And countries like the US that haven’t seemed to favor a particularly progressive tax system also are able to implement that preference despite the use of more income taxes and fewer consumption taxes.

I find this oddly reassuring when considering a VAT in the US. Every country that has implemented a VAT has been able to maintain a much greater degree of tax progressivity than the US. It seems very plausible that the introduction of a VAT in the US could therefore be paired with changes in income taxes to keep the US tax code as progressive as it already is.

That’s why I worry less about whether there is or isn’t a VAT in the US, and much more about trying to change other features of the tax code that could make the tax system far more progressive in the US. The tax code will be progressive or not regardless of the existence of the VAT, depending on how much political will exists to make it progressive. So developing that political will is exactly where I think we should focus our efforts in the fight against excessive income inequality.


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The Current Account Debate: Dark Matter as Statistical Manna from Heaven

Via Brad Setser comes a very nice summary of the competing views on the sustainability our massive trade deficit from Barry Eichengreen. While I’m not buying the “savvy investor” view of John Kitchen, his paper is worth the read. Kitchen notes the Dark Matter thesis and adds:

Cline (2005, p. 262), one of the few analysts to explicitly recognize and account for these “other” valuation changes, identifies them as “statistical ‘manna from heaven.’”

That would be William R. Cline’s The United States as a Debtor Nation (Institute for International Economics, Washington, DC, 2005).

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Abandoning Monetary Policy Altogether

Imagine waking up in Chicago on some cold wintry morning, putting on your heavy overcoat – only to have someone tell you that the coat will not keep your any warmer. After all, who in Hawaii ever wears a heavy overcoat? Now, I know this tale sounds absolutely stupid but check out the latest from John Tamny:

The Federal Reserve announced a quarter-point rise in the federal funds rate on Tuesday and futures markets have priced in another quarter-point hike for May, which would bring the key overnight interest rate to 5 percent. The positive or negative economic impact of continued rate hikes aside, the price of gold is what many Fed-watchers will study to gauge the effect of the rate increases. Yet, perhaps surprisingly, nominal fed funds rate increases have rarely succeeded in bringing down the price of gold. While this phenomenon in part can be explained by the fact that rate hikes have often occurred amidst inflationary episodes, economist Alan Reynolds has made the point that the “Fed should remember that countries with sustained low inflation never have high interest rates, so high interest rates cannot be the route to low inflation.”

I’m not sure if Mr. Reynolds was ever this guilty of confusing cause and effect. And I’m certainly not happy with tighter monetary policy given my view is that we are still below full employment. Then again – I do not equate gold prices with the general rate of inflation.

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Long-term Perspective on House Prices

In the new issue of The Economists’ Voice, Robert Shiller has a piece on house prices: “Long-Term Perspectives on the Current Boom in Home Prices.” Here’s the picture that tells a thousand words:

Despite massive population growth over the periods shown in all three countries, there’s very little upward trend in home prices. Fluctuations in the real price of houses are clearly driven by other factors, and seem to be temporary; between 1900 and 2000 the real price of houses in the US was virtually unchanged. The rapid price appreciation of the past 5 years certainly looks odd…


UPDATE: For much more on this article, see Mark Thoma.

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Immigration and the Politics of the Left

The issue of immigration has been well-documented as exposing a rift among Republicans in recent days; articles in the Washington Post, The Economist, and the Financial Times are but a few examples.

But the political left seems to me to be nearly as split on the issue. Numerous readers of this blog have expressed serious concerns about illegal immigration; on the other hand, others on the left (like me) are concerned about illegal immigration only in the sense that we would like to allow many more of those individuals to be in the US legally. Ezra Klein shared similar sentiments on The American Prospect Online yesterday, as did Brad Plumer in Mother Jones the day before. Because the interests of immigrants and the Democratic party are pretty well aligned (who is closer to the archetypical “little guy” than a poor immigrant, after all?), it’s not surprising that immigrants tend to lean Democratic.

Yet there are at least two good political reasons why people on the left might be concerned about immigration, as well. The first is immigration’s impact on income inequality. Illegal immigration in particular may have some effect in depressing wages for low-skill native-born Americans. But as Plumer and Klein both articulate better than I can, concerns about the impact of illegal immigrants on low-skill wages in the US actually provide a good reason for liberals to want to give illegal immigrants legal status, rather than send them home.

More generally, as I’ve tried to argue, if you’re concerned about low wages for relatively unskilled native-born Americans (which I am) then you need to address that problem directly, by advocating changes in minimum wage laws, tax laws, the strength of organized labor, the educational system, and so forth. Immigration is only a very small part of the much bigger problem of low wages for unskilled workers in the US, and so restricting immigration is a lousy way to try to address that particular problem.

A second reason for liberals to be wary of immigration has been highlighted by Paul Krugman. He is concerned that more immigrants in a country may tend to undermine the political support for that country’s social safety net. The logic is simple: why should I pay taxes to support social programs that immigrants just come and take advantage of? More immigrants could thus cause more native-born citizens to vote against the social safety net that liberals like.

This strikes me as a potentially serious problem, particularly in European countries with a very generous safety net. In fact, there’s even some evidence that suggests that such a political change has started happening in Europe as the result of immigration.

However, I’m not convinced that it poses such a big problem for the US. Many aspects of the US’s social safety net (such as it is) are already off-limits to immigrants, and those social benefits that are available to immigrants are not particularly generous, and so can’t realistically be cut by much. Furthermore, if the concern is that illegal immigrants are using social services while evading the taxes to pay for them (which they often don’t evade, by the way – for example, illegal immigrants contribute pay tax on earnings of about $50bn per year to the Social Security trust fund, even though they get no SS benefits) then once again the obvious solution seems to be to give those illegal immigrants legal status.

In short, it is quite possible to address the hesitations that some liberals have about allowing more legal immigration through the use of other policies. Furthermore, those other policies would do a much better job at addressing the concerns of liberals than any new restrictions on immigration would. From a political standpoint, therefore, it seems that the optimal policy for Democrats might be to advocate a mix of increased legal immigration, better protections for workers, and a stronger social safety net.


UPDATE: I’ve fixed my sloppy statement about illegal immigrant contributions to the Social Security trust fund. Sorry about the confusion.

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Corporate Profits in 2005

The BEA released its final estimate of GDP growth and the national income account for 2005. The figures on GDP show no surprises. But the news release also highlights corporate profits in 2005. The figures show that 2005 was a good year to be an owner of a corporation:

Profits from current production increased 16.4 percent in 2005, compared with an increase of 12.6 percent in 2004. Domestic profits increased 17.4 percent, compared with an increase of 14.1 percent. The rest-of-the-world component of profits increased 11.2 percent, compared with an increase of 5.1 percent.

Taxes on corporate income increased 39.5 percent in 2005, compared with an increase of 16.8 percent in 2004. Profits after tax with inventory valuation and capital consumption adjustments increased 9.4 percent, compared with an increase of 11.3 percent.

The one strange thing, however, is that the managers of corporations in the US are choosing to retain more of those profits in the company, rather than spend them or give them back to shareholders:

Dividends increased 4.3 percent [in 2005], compared with an increase of 16.5 percent [in 2004]; current-production undistributed profits increased 15.7 percent, compared with an increase of 5.5 percent.

The dividend payout in 2004 was significantly distorted by Microsoft’s special $30bn dividend payout in December of 2004… but even so, corporate managers seem to be keeping a lot of 2005’s profits on hand until they decide what to do with all of that money.


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The VAT as Solution to the Fiscal Nightmare

In my previous post, I suggest one possible rationale for levying a VAT: if you think that the US needs to raise more tax revenue, and if you think that political opposition to significant increases in income taxes is strong, then adding a new VAT on top of existing income taxes is one important option to consider. Let me take this chance to go into the pros and cons of a VAT in more detail. (For a brief primer on what a VAT is, you might want to see Wikipedia, or Bruce Bartlett’s latest post.)

Advantages of a VAT:

  • It can raise lots of new tax revenue with relatively low tax rates. A reasonably broad-based 10% VAT in the US would raise several hundred billion dollars of tax revenue. (Obviously, this is only an advantage if you think that we need to raise more tax revenue in the first place.) Raising the equivalent revenue through income taxes would require far higher marginal tax rates.
  • Tax evasion is a relatively small problem. Because a VAT requires each step in the production process to report what the previous step in the production process sold to them, there’s a degree of automatic enforcement in VAT administration, unlike with sales or income taxes. Furthermore, since a VAT is so broad-based, the rate can be set very low, which means that each individual business has relatively little incentive to try to cheat. The experience of countries with VAT is that compliance is higher than for most other types of taxes (much higher than for sales taxes, for example), and the costs of enforcement are lower.

Disadvantages of a VAT:

  • As is the case of all consumption taxes, a VAT is regressive; lower-income people pay a larger fraction of their income in taxes than higher-income people do.
  • Since a VAT taxes consumption rather than income, it hits those who consume but don’t earn income harder, e.g. retirees.
  • A VAT may alter international competitiveness.

The advantages of imposing a VAT are fairly straightforward. I tend to think that the US government will indeed need to raise more revenues as a fraction of GDP in future decades, and that a VAT would be a less painful way of doing so than most alternatives that I can think of.

Sure, there are other ways to raise revenue; so the test is whether the VAT does it more efficiently (i.e. imposing fewer economic distortions and creating fewer incentives to cheat) and more equitably than the possible alternatives. Regarding efficiency, the answer seems pretty clear. That’s why every other developed country around the world has concluded that the VAT is indeed a better way to raise the additional needed revenue. Equity, however, is another story…

So let’s get to the problems with a VAT. They are potentially substantial, and deserve careful scrutiny. When AB first started this blog, he devoted several posts to explaining the regressivity problems of consumption taxes. To get a good overview of those problems, take a look at his posts under the topic heading “Consumption Taxes” in the left-hand column of this blog.

Put simply, consumption taxes, including a VAT, are regressive. It’s hard to get around that fact. But there are a couple of things that you can do to mitigate these effects. For example, you can exempt certain items that poor people spend a larger fraction of their income on (food is a popular example). Even better, however, would be to couple the imposition of a VAT with changes in income taxes to make them more progressive.

This is a crucial point: a VAT by itself is surely regressive; but a VAT coupled with income taxes does not have to be. As an example, simply note that all European countries have a VAT. Yet all of them have a total net tax system that is far more progressive than the US’s tax system. I’ll have more to say about this in another post that I’m working on.

The potential problem of the VAT hitting retirees harder is probably less of a problem than one might think. First of all, since the “fiscal nightmare” is almost completely the result of health spending on retirees, if they ended up paying a higher share of the VAT than others that might only be fair. But secondly, the disproportionate impact on retirees is likely to be substantially mitigated in the first place. A VAT has the effect of raising overall price levels in the economy, as businesses incorporate the VAT in their sales price. But that means that the cost of living adjustment that retirees receive on their Social Security benefits would also go up by the same amount. The net effect is a wash for those retirees who depend primarily on their Social Security benefits as income.

The last potential drawback of a VAT also turns out not to be a problem. Economic theory suggests that a “destination VAT” – that is, a VAT imposed on all goods, but only those goods, consumed in the country – should not affect international competitiveness one way or another, in and of itself. (Note that a destination VAT requires that all imports are taxed at the regular VAT rate, and that exporters receive a rebate on all VAT taxes that the exported item has incurred during production.) As a slight twist on this result, note that if a VAT falls more heavily on traded goods than non-traded goods due to some items being exempted, then a VAT would be expected to cause a fall in both imports and exports. For a paper explaining the logic, see the classic Krugman and Feldstein paper “International Trade Effects of Value Added Taxation”.

The empirical evidence seems to confirm the economic theory. A paper by Mihir Desai and James Hines suggests that the VAT does have a small effect on trade, but that it simultaneously reduces both imports and exports with no substantial net effects. On the other hand, an even more recent paper by the IMF, “Domestic Taxes and International Trade,” was unable to find any effect of the VAT on trade. Either way, the effects of a VAT on trade seem to be small and neutral, in the sense of not really changing the balance of trade or a country’s competitveness.

To sum up, I would therefore offer this assessment of a VAT: it has some distinct advantages, and it has a huge potential disadvantage (regressivity) that can be overcome with the right other policy changes. So personally, I could possibly get behind the idea of a VAT to raise more taxes… but only if combined with changes to the income tax code to make them significantly more progressive.

But before we do that, my preferred solution to the fiscal nightmare would be this: enact a sweeping change in how health care is paid for, and adopt single-payer health insurance. Give it 10 years, and see how health care spending and the growth in spending adjust. I suspect that such a change by itself would solve much or all of the fiscal problem. If there’s still a fiscal problem after that (and there might be, I realize), then consider a VAT – but only in tandem with changes in income taxes to make them more progressive. The fact that every developed country in the world has a more rational health care system and a more progressive tax code, and also has a VAT, may be a sign in the VAT’s favor.


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