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

Tax expenditures, tax cuts, and IOUs (bonds)

We have seen the argument from some commission participants (Peterson for one) that Social Security is too expensive for those who need it and pay for it because it is an ‘entitlement’. We also have read from some Congress members (Senators Kyl and McConnel) that tax cut extensions of the Bush presidency are not deficit producing and need not be part of pay go.

The Fiscal Times has an article on considerations being undertaken by the Commission for Deficit Reduction. (H/t coberly).

The main theme in this article is that the “tax expenditures” home mortgage deduction and health insurance premium deductions are actually government spending (I assume in relation to the deficit) and thereby letting these taxpayers keep their money is bad. (Because these are “tax expenditures” and not “tax cuts”?)

I see a pattern here unfolding in this series of electioneering statements. Maybe politicians can put it altogether for us before the elections so we know who should pay and who should not in a less confusing way.

Quote is below the fold, bolding is mine:

As the 18-member bipartisan panel met in public for the fifth time, it was becoming clear that the tax system is under its microscope and there are many ideas under review for the long term. The commission’s success has always hinged on whether its leaders could muster support among Republicans for changes to the tax system, and agree to major spending cuts and changes in Social Security, Medicare and other entitlement programs that dominate the budget. So far, the GOP members are still at the table.

The most obvious target is recovering the huge amounts of revenue lost to federal tax loopholes known as “tax expenditures,” which include the home mortgage interest deduction and tax-free health premiums for employees. Proponents of rolling back these breaks say they are essentially government spending via the tax code. But health care premiums and mortgage deductions have long histories and are considered untouchable by some.

Erskine Bowles, one of the commission’s co-chairmen, pointed out that these loopholes cost the Treasury as much as $1.3 trillion per year, which is larger than total tax revenue. Bowles, citing an op-ed by Reagan White House economist Martin Feldstein, suggested that tax expenditures must be part of any serious attempt to limit spending.

Maya MacGuineas, president of the Committee for a Responsible Federal Budget, told the commission that the current system of tax expenditures is “one of the most detrimental things to the country.” But she also pointed out that they would be among the more difficult programs to touch.

Senate Budget Committee chairman Kent Conrad, D-N.D., who leads the commission’s working group on taxes, said that he has become convinced that more comprehensive tax reform is necessary to update a system that was built for an era in which the United States did not face global competition. “My own conclusion from this [working group review] is that we really have a tax system that is badly outdated,” he said. “It no longer relates to a world that we are in today.”

In addition to massive lost revenue through tax expenditures, the Treasury loses another $340 billion or so each year in taxes that people owe but simply do not pay, Conrad pointed out. “These are things that require a focus in our work.”

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Second quarter real GDP was reported to have increased at a 2.4% rate so that the four quarter growth was 3.2%. As the chart shows this is a very weak first year of recovery compared to the old historic norm before the “great moderation” emerged when growth averaged 7.6% in the first year of recovery. But it was stronger than the 2.6% and 1.9%
increase in the weak recoveries of 1991 and 2001.

This leaves real GDP 1.1% below the prior peak in the fourth quarter of 2007. To regain the prior peak in the third quarter real GDP would have to grow at a 4.5% rate. By historic norms this is easily doable, but in today’s world it is unlikely.

Within the data real exports grew at a 14.1% annual rate, about the same as the 14.0% rate in the first quarter. But real imports surged at a 28.8% annual rate compared to a 11.2% rate in the first quarter.

Real final sales to domestic purchasers accelerated to a 4.1% annual rate compared to 1.3% in the first quarter. But because trade was a major negative, real final sales of domestic product only expanded at a 1.1% and 1.3% rate in the first and second quarter, respectively. Domestic stimulus is working, but because of the international leakages it is being dissipated abroad and the economy is not responding. This is the real structural problem the economy is facing and reflects the major hurdle that did not exist before the US started borrowing abroad to live beyond its means in the early 1980s.

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Megan McArdle Disappoints Me

Robert Waldmann

I thought the only thing she knew was that she is a libertarian. Now I realize she doesn’t even know what the word “libertarian” means. She wrote

Will the new head of the CFPA crack down on mortgages that offer prepayment options? [skip]

Of course not. There is no constituency for such a thing except for a few crazy libertarians.

So libertarians think that the government should crack down on a product that consenting adults buy from consenting banks ? McArdle has some addled idea that she supports the market, by which she means, she opposes everything Democratic policians do. If one invented a product (the 30 year fixed rate mortgage with a prepayment option) with great success in the market, respect for the market requires banning it.

She thinks banning contracts that parties chose to sign is “libertarianism.” She has learned nothing and forgotten the one thing she learned once.

Amazingly the thorough takedown at the Irvine Housing Blog, didn’t mention this howler (target rich environments and all that). It does note that McMegan makes a plainly false claim about a time series, but that’s birdie for the course.

Two full paragraphs long McMegan quote in case I distorted meaning by removing context after the jump.

As of this writing, are we rethinking any of it? Will the new head of the CFPA crack down on mortgages that offer prepayment options? Will lawmakers finally break up Fannie and Freddie and cut off the flow of cheap capital they glean from the implicit government guarantee? Will it get the FHA out of the business of propping up the conventional loan market?

Of course not. There is no constituency for such a thing except for a few crazy libertarians.

OK so two out of three policies which she described as “libertarian” don’t display more love of regulation for the sake of regulation (or FDR bashing) that I’ve ever had. Is that a good average ?

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Double Dips

Michael Boskin writes that double dip downturns are more the rule than the exception.

I find this to be a very misleading article. What he is writing about is what happens in an actual recession when sometimes real GDP does bounce up for one quarter before resuming its fall.

But that is not the impression the article actually presents. Most readers will think he is talking about a recovery — when the economy experiences several quarters of sequential growth and surpasses the prior peak before quickly falling into a second recession.

As he correctly points out this happened once, after the 1980 recession when the economy rebounded strongly and surpassed the prior peak two quarters after the bottom.

But it is the only example of a double dip recession in the post WW II US history –as this table demonstrates. It is a table of real GDP in recoveries with real GDP at the economic trough set equal to 100. the quarters where real GDP is less than the prior quarter are in red. The red quarters in the 1980 column are the 1981-82 recession.

As the table shows the only double dip is the 1980-81 recovery that was only four quarters long before the 1981-82 recession started. Also note that before 1982, when the great moderation emerged, the norm was for a four year business cycle of three years of recovery and one year of recession. The Fed tightened sharply during the 1980-81 recovery because they thought the 1980 recession was too mild and did not generate sufficient economic slack to sharply dampen inflation. This deliberately aborted recovery — when real GDP surpassed the prior peak — is the only example of what I would call a double dip recession. The Feds tightening also generated recessions in other OECD countries that Boskin cited to demonstrate that double dip recessions are more the norm than the exceptions.

I’m still trying to make up my mind if this article was; one, just a rapidly written article that is accidentally misleading; or two, an article designed to justify the NBER recession committee not having ruled that the 2009 recession is over; or three, something else.

If second quarter real GDP comes in as expected it will be about the same as the prior peak so the US economy should surpass the prior peak this year. In my book that qualifies this past year as a recovery and the NBER should declare the 2009 recession to be officially over.

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"Brother can you spare an economist?"

by Bruce Webb

One raging argument that needs to be settled by the end of this year is what to do about the sunsetting of Bush tax cuts. Now it seems there are three general end points here: one, do nothing and they all expire at year’s end; two, extend them all, perhaps permanently; or three do the Obama thing and selectively extend cuts for couples making under $250,000 while letting higher income households revert to Clinton era standards. Well I am perfectly ready to debate the political and social justice aspects of any of these but maybe am not equipped to answer the following technical question.

The argument against allowing tax cuts to expire on the top 2% is that it would be counter-productive in a time of recession presumedly because it would serve to cut back on investment by that same top 2%. But if they are all sitting on their money anyway, resisting personal spending and as the controllers of capital sitting not only on piles of corporate cash but also on huge banking reserves hence choking off liquidity via loans to smaller banks and small businesses how exactly is nicking them an extra 3% or so in top marginal rates actually creating a net retreat in investment? It seems the argument that “If you tax the rich in a recession they won’t lend/invest” kind of fails somewhat if they aren’t lending/investing to start with. What does Kent Conrad know about this equation that I don’t know?

Gosh, if I only knew some smart, forward thinking economists to pose this question to.

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Dropping $100 Bills on the Sidewalk, or Even More on Excess Reserves

The sarcasm of the title of my recent post notwithstanding, there are some things economists understand to be true that are. Among those:

  • People respond to incentives

As with the Supreme Court, economists extend this principle to organizations, on the (generally correct) idea that organizations are made up of people who act in their own best interest.  (It isn’t, pace the old joke, that they wouldn’t pick up a $100 bill lying on the sidewalk; it’s that they would never believe someone would drop one there in the first place.)  This is how you get to teach courses in “Organizational Behavior” and the like—it’s not the madness of crowds if they all act “rationally” on an individual basis. (More Skinner than Ballard, but I sidebar.)

In economic models, as I obliquely ,mentioned last post, there is no risk-free arbitrage: if there were, “the market” would eliminate it, because it would mean someone was dropping $100 bills on the sidewalk, and the “the market” would make certain that person (or organization) was bankrupted, or at least suffered enough of a loss to change its behavior.

If you need proof of that:


Note that there were a nominal amount of excess reserves being held by some institutions even before interest was paid. We can treat them basically as rounding errors and systemic inefficiencies; given the skewness of the risk-reward, it has always been safer to put an extra $20,000 or so “in reserve” for late transactions, counterparty failures to deliver, or just plain calculation errors. Think of it as the equivalent of taking $60 out of the ATM when you only expect to need $40; the ability to pay taxes you forgot to calculate, upgrade a shirt from poly to cotton, or buy a bottle of water “on impulse” is more valuable (utile) than the day’s interest on that $20 (currently, just over 1/100,000th of a cent from one of my TBTF financial institutions; half that from the other). And so it goes for reserves.

But in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money.  The Fed is, essentially, leaving $100 bills on the sidewalk.

Hasty disclaimer: it’s doing so for all the right reasons: the banks need to rebuild strengthen their balance sheets, and nationalization is off the table.  Every little bit helps. Conceptually, economic theory indicates that one should pay “interest,” in some form, for the right to use another’s capital. (That this breaks down in the details is subject for a discussion over tonics.)

I’m using monthly, blended data—nothing so clear as the BarCap analyst examined in the last post—but it’s fairly easy to see what happens even on that trend. Excess Reserves in October are two orders of magnitude higher than they were a few months. They more than double for November, and then stay in a fairly narrow band until around the time the “recovery” began. From August of 2009 until the end of the year, they rise again, just missing the magic $1 Trillion mark in October, breaking it in November and not dropping below again.

It’s free money; why wouldn’t the people who run the banks take it?

And they do.  So the number of $100 bills being dropped on the sidewalk would be expected to decline—save that the Fed has no liquidity constraint, even if we’re ignoring a right of seignorage. And the participants come by each night, picking up more.

The externalities of such a situation are obvious.  The most direct solutions are two: either (1) stop dropping the bills or (2) show the banks that there are better investment opportunities on a risk-adjusted basis.

Joe Gagnon (h/t Brad DeLong) advocates the former.  It is unclear (to me) whether Gagnon is advocating the full cessation of paying 0.25% on reserves or just a temporary cessation until market rates rise, but in either case he recognizes the perils of risk-free arbitrage. (Bruce Bartlett is shriller—and possibly more extreme—than I am on the matter.)

The other option is rather more problematic, not so much because the pump hasn’t been primed as that the water used was rather dirty, with a significant underestimation of the amount of rust that needed to be addressed only compounding the issue.

The result is approximately what one might have reasonably predicted in the goods and non-financial services economy: the Federal G(f) barely compensated for the State –G(s), and only the multiplier effect of that spending actually happening “expanded” anything. (Or, more accurately, some businesses did not fail so rapidly and the cost of some services did not rise so quickly as they would have ex-“stimulus.”)  The good news is that there was a barrel of water between the diving board and the ground; the bad news is that the barrel wasn’t full, so the dives had to be better than excellent, with minor injury virtually a best-case scenario.

The non-financial private-sector, in short, has not been able to recover, while the financial sector—propped up by those $100 bills—shows evermore “strength” on the back of dicey assets being held by the Fed, higher fees and lower interest rates for their “customers,” and—of course, $2.5 Billion a year in from the taxpayer.

Sooner or later, we’ll be talking about real money. For now, though, we’re just talking about the real economy.  What we have here isn’t (quite) a dead shark—as I said earlier, the private sector has performed amazingly well in the face of opposition to it from the Fed and the banks—but it has a diving tank in its mouth and Tim Geithner et al. taking shots at it will a high-powered rifle. We can only hope that former NYC “financial cop” Geithner isn’t as good a shot as another former NYC cop transplanted to a land he doesn’t like or understand.

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Another illustration of the struggling US labor market: teen employment

This recession caused a severe disruption in the labor market for teen employment. The chart below illustrates the unemployment rate alongside the employment-to-population ratio for those aged 16-19 years.

The visual is quite striking: at the peak of the business cycle, December 2007, the difference between the employment-to-population ratio over the unemployment rate was roughly 17.3 percentage points (pps). In June 2010, however, the difference narrowed fully to -0.3 pps.

This is a growing problem for our youngest workers. In April, the OECD issued a press release (featuring related research) calling for government support for “youth” unemployment across the member countries:

The report’s message is that governments need to do much more to help young people. Some have benefitted from broader efforts to help the unemployed. But more policies are needed that target young people, especially those with poor education and skills. These “at-risk” youngsters now account for between three and four out of ten of all young people in the OECD and are at risk of long-term joblessness and reduced earnings.

Back in June, the LA Times argued that young workers in the US, workers aged 16-19, are being displaced by college graduates and other skilled workers; in better times these workers would not take jobs normally filled by teenagers.

The recession has been particularly cruel to those aged 16-19. However, the chart above illustrates that the downward trend is both secular and cyclical, as the employment-to-population ratio has trended down since 2000.

At the turn of the century, the employment to population ratio for teens aged 16-19 years was 45% (average over the year), and just 35% in 2007. There’s a problem here. Workers aged 16-19 generally earn low hourly wages (unless they invented Facebook, of course); and in some cases, even the small monthly sum supports family income. And as the OECD report suggests, often young workers do not qualify for unemployment insurance when displaced.

The Federal Reserve’s latest Survey of Consumer Finance (2004-2007) indicates that much of the mean income growth is accumulating at the top 10% of the income distribution (Table 1). Spanning 2004-2007, the bottom 20% experienced 3.4% income growth, while the top 10% saw near 20% gains. And every bracket in between saw either negative or near-zero income growth.

Here’s the bigger picture: teen income is likely becoming increasingly important to the families at the bottom of the income distribution, while the jobs are becoming increasingly scarce.

Without entry level jobs, aggregate work experience starts to decline, which translates into lower skill overall; and then productivity declines. Bad stuff.

Rebecca wilder

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