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

The Laffer Curve and the Kimel Curve

by Mike Kimel

People always talk about the Laffer curve, but have you ever seen it estimated? Have you ever wondered why you don’t? If you’re a quant guy, you know the answer to that. Because if you’re a quant guy, at some point curiosity must have gotten the best of you. That means you pulled out some data and you plugged it into whatever piece of software happened to be handy. What happened next depends on what sort of a quant guy you are. If you’re the sort that let’s the numbers do the talking, you spotted the joke and probably left it at that. If you have a strong ideological leaning in a certain direction, on the other hand, you might have tried to “fix” it. You tried a few times, failed, and kind of just left it there as something to get back to some time, but no hurry because your ideology tells you what the answer should be.

Today, by coincidence, I got two e-mails asking me about the Laffer curve. And it occurred to me… maybe someone should let non-quant people into the joke. Because the only people really discussing it are those who are driven by ideology, whereas it should be afforded the Hauser’s law treatment.

So here’s how it works. Putting numbers to the Laffer curve pretty much comes down to estimating:

(1) tax collections / GDP = A + B*tax rate + C*tax rate squared + some other stuff if desired

A, B, and C are estimated statistically using a tool such as regression analysis.

If you plug in numbers, and find that B is positive and statistically significant and C is negative and statistically significant, then it turns out that you can trace out a quadratic relationship between tax collections / GDP and tax rates. i.e., tax collections / GDP is a function of tax rates that looks like an upside down U. If you increase tax rates when tax rates are “low,” growth will increase. On the other hand, to increase growth when tax rates are “high”, you have to decrease tax rates.

When you have such a shape, you look for the top of the upside down U and there’s your maximum.

So I started with the obvious:

(2) tax collections / GDP = A + B*tax rate + C*tax rate squared

In other words, the simplest version of (1) possible. I plugged in data. That would be current federal tax receipts, line 2 from NIPA table 3.2, divided by GDP, from the BEA, and the top marginal tax rate from IRS’ historical table 23. You can go all the back to 1929—that’s when the GDP and current federal tax receipts begin.

The problem is… the data isn’t quite amenable to shoehorning into the desired shape. The fit of the model sucks, B is negative, C is positive, and neither coefficient is significant at the ten percent level.But they aren’t so far off either.

All that together means that maybe, just maybe, a slightly better specified model might do the trick. The simplest solution… find another variable that has some explanatory power and throw it in. Well, I’m supposed to be on a hiatus from blogging, so I don’t want to spend a huge amount of time at this, but it occurs to me that year is probably such a variable. There’s a good chance that over time, tax collection has become a bit more efficient.

So I reran (2) as follows:

(3) tax collections / GDP = A + B*tax rate + C*tax rate squared + D*Year

Here’s what the results look like:

B and C have the wrong sign. That means you don’t get an upside down U, you get a U. Here’s what it looks like when graphed:

The low point in tax collections happens to be about 32%. In other words… if the top marginal tax rate is below 32%, cutting it further will raise tax revenues. On the other hand, if the top marginal tax rate is above 32%, to boost revenues you have to raise tax rates.

Now this is quick and dirty, and it has boundary issues (i.e., 100% tax rate collects more than 99% tax rate – would it really? well, the model is extrapolating because its never observed tax rates of 99% or 100% in the wild). I should also throw in a few more variables to improve the fit. Worse, there’s autocorrelation. That means the error terms are correlated. The correlation between the residuals at time and the residuals at time t+1 is 75%. That in turn violates one of the assumptions of OLS regression analysis. Its fixable, but its also ignorable for our purposes since what it means is that the coefficient estimates are probably “correct” but merely less significant than they appear. Regardless, you won’t get anything that bears even a remote resemblance to what you hear from the crowd who perennially cites the Laffer curve so authoritatively.

Which brings up another piece of the joke. In the end, tax collections don’t matter. Its nobody’s goal to maximize tax collections. Taxes only matter because they pay for certain government services. They also take money out of our pockets. So there’s a tradeoff. But we’re made better off if the government services taxes pay for generate more value than they cost us. And at least to some extent, you can measure that by whether they generate more growth than they cost us.

Now, it turns out that the optimal tax rate for growth is easy to calculate. The data cooperates very nicely. There is a relationship, an easy to estimate curve which I’ve modestly called the “Kimel curve.” And the high point in the Kimel curve is somewhere around 65%. Now, the Laffer curve analysis shows us that getting to the level of taxation that produces the fastest economic growth rates would also increase our tax collections… not a bad thing at all in an era of rapidly rising national debts.

Which brings us to the biggest Laffer curve joke of them all: ain’t no way the folks who like to talk about the Laffer curve would support that.

As always, if you want my spreadsheet drop me a line. I’m at my first name (“mike”) period my last name (“kimel” – that’s with one m only!!!) at gmail.

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Admitting You’re a Tool Doesn’t Make You Less of One

Matt (Dalton, Harvard) Yglesias, via Aaron Carroll’s note that he should move into another line of work), accidentally gives the Education game away:

the Dread Evil Neoliberal School Reformer Barack Obama And His Lackeys At The Center For American Progress

Yep, Matt has been doing great things for education.

As, of course, has CAP, in spades.

As for Barack “Also Never Attended a Public School, But I Know All About Them” Obama, all that needs to be said was said by Dean Baker on Saturday:

Emanuel’s predecessor as mayor, Richard Daley, also placed an emphasis on reforming Chicago’s schools. From 2001 to 2009 he installed Arne Duncan, currently President Obama’s Secretary of Education, as head of the Chicago school system. If Friedman and Emanuel’s complaints about the current state of Chicago’s schools are accurate, this would imply that Duncan must not have been very successful in his tenure even though he was widely acclaimed as a reformer at the time.

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Perry Proposes (no surprise) a flat tax…

by Linda Beale

Perry Proposes (no surprise) a flat tax….

Rick Perry, one night after what has been termed an ‘invigorated’ debate performance, has climbed on the flat-tax bandwagon (presumably meaning a flat-rate consumption tax a la the national retail sales tax idea).  See Tumulty, Rick Perry to Announce Flat Tax as Part of Economic Plan, Washington Post (Oct. 19, 2011).

See prior posting on ataxingmatter regarding Cain’s 9-9-9 plan and generally about the flat tax, here and here and here and here and here and here and here and here and here and here…..

Put briefly, having as the sole source of revenue for the federal government’s environmental protection, disease control, anti-trust, bank regulation, securities regulation, tax enforcement, consumer protection, military and defense functions a regressive national sales tax that would stifle the consumerism that accounts for about 70% of our economy would likely be quite harmful to the U.S. economy and to the overwhelming majority of Americans who earn less than $100,000 a year.

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Don’t Hold Out for a Lasting German Economic Rebound

by Rebecca Wilder

German industry is plugging away. Ending in August, the 3-month average of the seasonally- and calendar-day adjusted volume of industrial production (excluding construction) maintained a quick 8.3% annualized pace. Even if this core measure of industrial activity falls another 1% in September, the Q3 quarterly annualized pace would be 10.5% – a robust acceleration from Q2 (6.3%). This suggests that the German economy quickened in Q3 – does that mean it’s all clear for the Euro area?

I think not.

According to The Wilder View Leading Economic Indicator (TWV-LEI), the annual pace of German manufacturing is set to slow quickly, if not contract, by the end of this year. (I constructed my own indicator since the OECD indicators are generally lagged by two months.) In September, five of the seven components that drive the index confirm a sharp deterioration in economic activity (the final two indicators have not been released yet). This downward trend in TWV-LEI for Germany has been in play since August 2010 and is yet to be fully reflected in industrial production (IP); that will change.

The chart above illustrates The Wilder View’s leading indicator for Germany (TWV-LEI, Germany). TWV-LEI is a composite of the following variables: PMI manufacturing, Ifo business climate index, manufacturing orders, employment opportunities index, inflation expectations, consumer confidence, and the terms of trade. I’ve found that these indices have the highest correlation with current economic activity, which is measured by industrial production. The r^2 of a simple univariate regression of annual industrial production growth on the 5-month ahead leading indicator (annual growth) reveals an 81% correlation – Implied IP is the fitted dynamics of this univariate regression. Unless leading surveys improve dramatically, I expect the German economy to soften much further in coming months.

Using the 1993-2011 time series, the precipitous drop in the TWV-LEI portends a sharp slowdown in German industrial activity, even contraction by December 2011. The implication is that German economic activity, while accelerating in Q3, is likely to contract in Q4.

The policy ramification is clear: It’s going to get a lot more difficult to sell a‘comprehensive solution’ if the leading Euro area economy is in recession.

originally published at The Wilder View …Economonitors

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What is Nominal GDP targeting ?

“Just when I thought I was out… they pull me back in” I tried to resist asking “what does “Nominal GDP targeting even mean.” I managed, but now Krugman is burying the hatchet and I am digging it up.

So what is the proposal ? That the Fed have a target for 2012 nominal GDP or first quarter of 2012 nominal GDP ? Even if it isn’t measured, the Fed could try to get the November 2011 nominal GDP it wants. As far as I know, advocates of nominal GDP targetting don’t even acknowledge this question.

I have some longer and more substantive thoughts below.

update: spelling of title corrected. I thank Brad DeLong

I think Krugman understates his case when he claims that the Fed can’t target nominal GDP when we are in a liquidity trap. I would define targeting X as making the conditional expected value of X equal to the target. There will be a disturbance, but if the expected value is different from the target no matter what one does, then on can’t target X. The concept of daily GDP is meaningful (although it would be crazy to try to measure it and correct accounting for inventories would be key). Do quasi-monetarists really think that the Fed can make the expected value of tomorrow’s nominal GDP whatever it wants ?

I admit I am being fairly twitty, but I think this question isn’t totally stupid, because I think it shows that they just don’t think about what monetary policy can and can’t do. The Fed can move the Fed funds rate very fast. The Fed can change the money supply quickly at least if it wants to reduce it or we are not in a liquidity trap. Nominal GDP can only jump if prices are flexible. Monetary policy is effective because they are sticky. We have a problem.

OK a more serious issue. Can the Fed get the 2012 annual nominal GDP it wants by buying Treasuries. Jah Hatsius (and Brad DeLong) argue that the Fed should declare its intention of buying whatever quantity it takes of long term Treasuries to achieve a nominal GDP target. But what if there is no such quantity ? Then the announcement would be a false claim.

Is there any such quantity ? I think not. Certainly not if one wants 2011-2012 growth to be well over the trend growth rate say 10% (Brad DeLong seemed to call for this when he said to target the level). I admit that I will go rational expectations and argue that if it can’t happen, then people won’t believe it can happen. So I assume model consistent expectations.

First the Fed can drive the risk premium on Treasuries to zero. The public will accept returns equal to the risk free rate if the Fed buys all the treasuries on the market. So far, I think this would be a small effect. There just isn’t much room for a risk premium even in 30 year rates. Importantly, a zero short term rate and a zero risk premium does not imply a zero long term rate. Even without a risk premium the long term rate would be equal to an average of current and future short term rates. We are discussing about a mega QE policy not a credible commitment to causing high inflation in the distant future when unemployment is normal (nor are we discussing a unicorn or a flying pig).

I would expect a small effect on interest rates — about on the order of the effect of operation twist (of course I predicted a smaller than observed effect of operation twist). Note this is for about $10 trillion of QE. The effect of the volume on the market on risk premia is not linear.

The risk is mostly inflation risk (not default risk — that is best hedged with canned food, bottled water and guns). But wait aside from the illusory wealth of Treasuries, total inflation risk adds up to around zero as there are nominal creditors as well as nominal debtors.

I have admitted I use rational expectations. And I have assumed that Fed policy now doesn’t have a big effect on expected Fed policy in 2020.

OK so mega QE if needed to target nominal GDP levels might work if it massively affects expectations somehow, even though there is a rational expectations equilibrium with a small change in expectations. But that sure sounds a lot like the confidence fairy to me.

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A little OWS, a little 99%, a little history

So today I read at the Yahoo Finance (it’s my home page because I can look at the stock numbers on the left and read the headline on the right for a guaranteed laugh) that  John Mauldin thinks the OWS would be better off if they occupiedCongress:
Mauldin believes America still has time to figure out a path out of what he says is the big problem worldwide: “We’ve over committed public monies and we don’t have them.” While some what sympathetic to the protestors’ frustrations, Mauldin says their anger is misdirected.
“My message to the ‘Occupy Wall Street’ guys: if they really want to If  they really want to go after the source of the problem, they should go occupy Congress,”
Instead of focusing on Wall Street,Washington and the protests should be focusing on reducing regulation and making it easier for new businesses to start, Mauldin says. To that end, he offers a new slogan I somehow doubt will showup at any Occupy Wall Street protest anytime soon: “Up with Entrepreneurs”
As I understand it, OWS is about economic equality. President Roosevelt referred to it as the economic royalty. I just don’t see how one can stop, look and listen to OWS and think “go tell congress to further deregulation”. John Boy can’t be this much of an idiot, can he?
My sweetheart gets home from the dentist. $4000 dollars worth of bridge work is down the drain because a tooth of the bridge went bad. 

For those who don’t know, we are the “Entrepreneurs” John Boy is referring to, thus we are paying for our health insurance, no dental. But, she was offered a payment plan. Has a nice dental name at 14.5% interest! This bit of private market solution to paying for health care is brought to you by GE Financial. Yes, the GE of Jeffrey Immelt, Obama’s job creating adviser. Hey Obama? Did you read my state of the union?  Obviously not or Jeffrey baby would not be your man.
Did you hear that JP Morgan was all blowed up? Yes, I’m not lying. People got pissed at Wall Street and blew up JP:
“During this period anarchists and socialists held protests on Wall Street out of a similar sense of frustration and rage at the banking system. The movement culminated in what was known as the greatest act of terrorism on American soil: the 1920 bombing outside J.P. Morgan and Company
Thirty eight people were killed when the horse and wagon bomb went off at noon on Sept 16, 1920. The perpetrators, thought to be anarchists, were never caught, but their exploits and the aftermath were captured by photographers.”
Check out the pictures here. 
Why do we not hear about this history considering the present times? I know, stupid question. To ask it is to give purpose to OWS. Though one sector of this nation seems to remember a portions of this history or we would not be hearing the pejoratives being slung a the 99%’ers. You know Anarchists, socialists, communists out to destroy the American Way (A catchy phrase brought to you by the National Association of Manufacturers via General Food’s CEO, the US Chamber of Commerce and AT & T’s monopoly is good all via Madison Ave, Time Magazine 9/28/1936) .
Which brings me to my original question since the shit hit the fan: HOW MANY TIMES DO WE HAVE TO DO THIS? HOW MANY FREAKIN’ TIMES DO WE HAVE TO LEARN THE LESSON?
Obviously from the above 3 subtopics, quite a few more times as we seem to have not learned the definition of Rat Race yet: A rat race is a term used for an endless, self-defeating or pointless pursuit…
I think I know what is wrong with US today. When I typed in Deja Vu at youtube,  amazingly this tune did not even come up in the suggestion list. 

No, I had to actually know that CSNY wrote what I consider the true musical capture of the concept of deja vu…the song that is most appropriate for the application of the concept today. I say this because they intentionally wrote the song so that it does not repeat any one section (heard years ago in an interview).

Get it?
(I haven’t forgotten the tax tables. It’s a coming.)

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In Related News, Lee Papa Will Be Selling Obscenity Insurance

Via Lindsay Beyerstein on Twitter, The Onion should now go out of business:

AIG knows a thing or two about bad publicity. Now, a subsidiary of the bailed-out insurer is offering a new type of coverage to defray the cost of bringing in outside experts when a company faces a potential public-relations crisis.

That’s right. AIG is selling “reputation insurance.”

And the best thing about it? All of those links, except Lindsay’s, are at least a week old! Talk about Stealth Marketing!

Maybe they have something to hide?

(For anyone who puzzled for a moment over the title of this post, here’s Lee Papa on Herman Cain. Which turned out to be even truer than he knew.)

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Graph That Explains Everything About Amity Shlaes

by Mike Kimel

Thanks to Linda Beale, I headed over here:

The George W. Bush Institute announced today that Amity Shlaes has been named director of the 4% Growth Project, a key part of the Institute’s focus on economic growth. Miss Shlaes will open the project’s office in New York. The aim of the project is to illuminate ideas and reforms that can yield faster, higher quality growth in the United States, and to underscore the importance of growth in America’s future. Part of that work involves finding ways to make growth and economics generally accessible to more Americans, especially younger Americans. The program will conduct and sponsor research on all aspects of economic growth, host conferences, as well as partner with other institutions in such endeavors.

The following graph, I think, illustrates you need to know about Amity Shlaes:

OK. I lied. The graph is actually missing something. See, we only have official data going back to 1929. And the Great Depression began very, very early in Hoover’s term. And Hoover had been a cabinet secretary under Coolidge, and ran for office under a platform which essentially called for continuing Coolidge’s policies. And Shlaes’ forthcoming book is in praise of Calvin Coolidge. It should be noted that the economy was in recession during over 38% of the months in which Coolidge took office, which makes much of the Coolidge era a dry run (so to speak) for the monster that would come in 1929.

Put another way… Shlaes is part of a movement to praise policies responsible for a lousy economy culminating in the Great Depression (i.e., those of Coolidge and Hoover). Shlaes is also part of a movement to praise the policies responsible for a lousy economy culminating in the start of the Great Recession and the mess we’re in today. (Yes, the Great Recession started in 2007, and no, Obama hasn’t made any substantial changes on taxes or regulation from the way GW Bush ran the country.) Conversely, Shlaes is a well-known critic of the policies that produced the fastest period of peace time economic growth this country has seen.

To me this feature of economics is kind of odd. For some reason, policies that have failed spectacularly over and over continue to have adherents. Policies that have worked spectacularly have critics. Debating the merits of a cavalry charge into the teeth of an armored column was barely excusable in August of 1939, but at least that debate was put to a rest by the German blitzkrieg. Its been generations since anyone argued that horsemen can go toe to toe with tanks.

Which leads me to a hypothetical. Say we lived in a parallel universe where Shlaes was a quisling, a real villain whose goal was to harm this country as much as she could by convincing the nation to commit economic suicide. How would the graph above and the two paragraphs that followed it look any different?

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A Warm Wind At the Backs of Some, Generated Off the Backs of Others

This piece offers an understandable comparison between wages and dividend income and neatly summarizes the cost to wage earners. (h/t Mike Kimel)

by Peter S. Meyers

Myers Urbatsch PC

A Warm Wind At the Backs of Some, Generated Off the Backs of Others Yesterday, I learned in this Mother Jones article that workers have increased their contribution to government revenue disproportionately since 1980.  In other words, payroll tax (paid by workers) is a larger portion of government revenue than it used to be.  That’s a macroeconomic analysis, which still doesn’t answer the question of whether rich people are being treated “unfairly” by the current tax system.

So to elaborate a little, let’s take two people who make exactly the same amount:  $100,000 in taxable income (after the standard deduction – let’s not get complicated).  “Worker Taxpayer” earns her money by working (getting compensation by way of a W2) and “Investor Taxpayer” earns her money from dividends in a $4 million stock portfolio she holds (its about 2.5% in yield – about right).  Let’s say they are both unmarried.  Investor taxpayer does not work and has no compensation income.  They are otherwise “equal,” right? (except that investor taxpayer fits the description of those who vituperate about lazy welfare recipients who sit on the couch all day and watch TV, right?)  I’ll keep the rhetoric down, because the facts are outrageous enough to speak for themselves.

Worker taxpayer will pay $7650 in payroll tax, plus $21,617 in income tax (2011 brackets), for a total tax burden of $29,267.

Let’s look at investor taxpayer.  You would think they would be taxed at the same rate as worker, right?  Wrong.  Because investor taxpayer receives all of her income from qualified dividends, they get a “special” tax treatment.  Bear with me, we’re almost done.  Generally, the maximum tax rate for qualified dividends is 15%, BUT HERE it is actually 0% because investor’s other income (remember she doesn’t work) is taxed at the 10% or 15% rate.

To refresh:  worker making $100K pays about $30K in tax.  Investor making $100K in qualified dividends pays $0 – no – tax.  Huh?  Yup. 

What this means is that rich people – who are incented by tax policy to remain on their couches (too much earned income would otherwise trip them into the 15% dividend tax bracket) – are now getting off their couches and going to tea-party rallies to maintain this unfair redistribution of wealth in their favor.  For if they work, they risk having their dividends taxed at 15% (still half of what, say, worker taxpayer paid in taxes, but confiscatory in their view).  Perverse incentive?  Yup.  Does it sound like the rhetoric of the right wingers about unemployed persons and welfare recipients laying on couches and not incented to work?  Hm. . . .

Now let’s say you didn’t work, or you worked very little, and instead you made all of your income from qualified dividends.  The “magic number” (the income threshold you need to stay under to avoid paying any tax on your dividend income) is $69,000 (married), $34,500 (single or married filing separately) or $46,250 (head of household).  Thus, you can actually work a little, and you have all this extra time – to attend rallies, political functions, cook your food, clean your house or do other things that people who actually earn their income from working have to: (a) pay someone else to do (which is not deductible), (b) do in the evenings or on weekends, or (c) simply let it slide.

I will now illustrate how it is almost impossible for someone who is already rich to not get richer, in fact much richer.  Both working taxpayer and investor taxpayer have identical lifestyles and thus spend the exact same amount of money (not likely, given that worker has to pay for commuting expenses – again NOT deductible).  Let’s assume that’s $70,000 per year.  We know that worker taxpayer already paid $30K in tax, so let’s see what they have left to save:  uh, nothing.  Investor taxpayer paid no tax, so what do they have left over to save: $30K.  Exactly the same amount that worker taxpayer paid in taxes.

The rationale for the tax policy you see illustrated above is George W. Bush’s.  In 2003 he said that “double taxation is bad for our economy and falls especially hard on retired people.” He also argued that while “it’s fair to tax a company’s profits, it’s not fair to double-tax by taxing the shareholder on the same profits.”

Its odd to me that the above disparate treatment of otherwise similarly-situated earners is defended on the basis of “fairness.”  Is this 1984?  And I also wonder whether there is a joke in there somewhere – i.e., given that a zero-percent tax bracket would apply to someone who made all of their money from dividends and capital gains, why wouldn’t they retire?  I sure as hell would.  Working too much would bump all of their dividend income into the 15% tax bracket.  Volunteering for the tea-party rally, or perhaps some other Republican cause, would be a far better use of one’s time.

reposted with permission of the author July 23, 2011 post

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