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Nevada is Biggest Loser of Tesla Auction

On September 4, Nevada Governor Brian Sandoval announced that electric car-maker Tesla had chosen Nevada for the location of its much sought-after Gigafactory. Contrary to its claim that it wanted $500 million, Tesla in fact wanted speed plus the highest bidder. As I analyzed last month, a $500 million subsidy would have been relatively low as measured by the benchmarks of cost per job and aid intensity (subsidy divided by investment).

Instead, Nevada gave Tesla subsides worth $1.25 billion over 20 years. This is not a good deal, as I will detail below.

First, of course the cost was far higher than Tesla had hinted; it clearly was just trying to squeeze extra incentives out of the “winner” by conducting a five-state auction. Using a discount rate of 2.5% (the 10-year Treasury bond yield on Sept. 4 was 2.45%) the $1.25 billion in nominal value has a present value of about $1.1 billion, by my calculations. In fact, it is probably quite close to the full $1.25 billion because the sales tax breaks based on the actual investment in plant and equipment will be heavily front-loaded, not spread evenly over the 20-year period.

According to the Reno Gazette-Journal article linked above, the incentives break down as follows:

$725 million in sales tax abatements over 20 years
$332 million in property tax abatements over 10 years
$120 million in investment tax credits
$75 million in job creation tax credits for up to 6000 (note: not 6500) jobs
$27 million in a 10-year business tax abatement
$8 million in discounted electricity rates for 8 years

Note by the way that we should, in this instance, count the sales tax breaks as a subsidy. Because Nevada does not have either personal or corporate income tax, sales tax becomes more important to the state, though of course not as much as for a state lacking Nevada’s taxes on gambling revenue. More specifically, though, this is for sales of plant and equipment to be used in the factory, so it is directly tied to the investment.

Second as pointed out to me by Richard Florida in a draft article for CityLab, while these jobs pay $25 per hour, the facility will be relatively self-contained, and will not create spinoff jobs on the scale that, for example, an automobile assembly facility does. Tesla’s research and development will still be conducted at its headquarters in Palo Alto, California, not at the Gigafactory. One way we can tell: Tesla is giving a whopping $1 million to the University of Nevada-Las Vegas for research on batteries. (I’ll be linking to Professor Florida’s article when it appears.)

In terms of our usual metrics, a $1.1 billion subsidy for a $5 billion investment is 22% aid intensity, certainly not Boeing territory but higher than would be allowed in the European Union. It is lower than the typical U.S. auto assembly plant aid intensity of about 33%. However, the cost per job is $183,333, about 20% higher than an auto plant typically receives in the United States, for a project that is not as good as an auto plant. Thus, while it is hardly the worst deal we’ve seen, the incentive package is far too high for what the state is getting.

Moreover, this is quite a risky deal, too. As the Reno Gazette-Journal points out, this incentive package is 13 times larger than Nevada’s previous biggest incentive, a mere $89 million for Apple. Talk about putting all your eggs in one basket!

Finally, we should note that if the Tesla project is successful, it will mean that we will see job losses at competing facilities (mainly engine plants) elsewhere in the country, so that national net job creation will be less than 6500. This will raise the true cost per job of the project.

Thus, we see yet another bad incentive deal, but at a much larger scale than usual. The package does need legislative approval, so it’s not quite a done deal. But assuming it passes, Nevada taxpayers will take on a tremendous burden to lighten CEO Elon Musk’s load.

Cross-posted from Middle Class Political Economist.

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Understanding Piketty, part 4

We now come to the exciting conclusion of Thomas Piketty’s monumental work, Capital in the Twenty-First Century. This is not an exaggeration: the final part of the book contains findings that I consider to be simply bombshells in their significance.

In Part 4, “Regulating Capital in the Twenty-First Century,” Piketty calls for a new “social state” for the new century, as well as a new way of taxing, a progressive tax on capital. Highlighting the United States, France, the United Kingdom, and Sweden as representative, he shows that all followed similar trends in taxation. Until World War I, all four collected less than 10% of gross national income in taxes. By 1980, the figures had increased to levels ranging from about 30% in the United States to 55% in Sweden. Since 1980, those levels are essentially unchanged.

As discussed by Alan Krueger, countries with high inequality tend to have lower inter-generational income mobility. This holds true in particular for the United States. In fact, Piketty says “the most firmly established result” of research on this question is that the U.S. has the highest correlation of income from one generation to the next (lowest mobility), and the Nordic countries the lowest correlation (highest mobility). The fable often told by conservatives that “we may have inequality, but that changes over generations” is not true today and, more surprisingly, was not true in the twentieth century when the U.S. had lower inequality than Europe.

One reason for this lack of mobility could be the high cost of college, especially among top schools. According to the Harvard financial aid website, tuition and fees come to $43,938 per year. Piketty estimates that the average (mean) income of Harvard students’ parents is $450,000 per year, which is enough to put you in the top 2% of U.S. incomes. Harvard notes that “>70% of our students receive some form of aid,” which isn’t surprising when you run the cost calculator. A family of three with just the one child going to Harvard can receive financial aid even with an annual income of $240,000.

While I have written before about the coming retirement crisis, Piketty points out that it’s not just the United States where Social Security is the only thing standing between seniors and poverty. He writes (p. 478), “in all the rich countries, public pensions are the main source of income for at least two-thirds of retirees (and generally three-quarters).” Ending senior poverty which, as he says, was “endemic as recently as the 1950s,” is the third main outcome of the expansion of the social state (after education and health expenditures). As I’ve said before, we need to keep senior poverty from reappearing.

Piketty considers the future of pensions in a low-growth environment. He notes that in pay-as-you-go (PAYGO) systems, such as Social Security was before the creation of the Trust Fund in the 1980s, “the rate of return is by definition equal to the growth rate of the economy.” Thus, he says, it would be wise to promote rising wages, for example through increased education funding and even policies to increase the birth rate (pp. 487-88). When r>g, however, it seems logical that money for future pensions should be invested to take advantage of the higher return on investment. That was one of the arguments for privatizing Social Security. However, transitioning to a PAYGO system runs into the huge problem that “an entire generation of retirees is left with nothing.” Of course, this is exactly what has happened in the United States and why we are looking at a looming middle class retirement crisis. However, it has not taken place in the Social Security system, but in the area of private pensions. That is, while public pensions in continental Europe equal 12-13% of national income (p. 478), they are only 7-8% in the United States so, traditionally, private pensions picked up the slack. But we now face a situation where 49% of private-sector workers have no pension at all, 31% have been stuck with a defined-contribution plan (401-k, 403-b, etc.), and only 20% have a true pension. Since the 1980s, workers have been transitioned off of defined-benefit pensions and on to — nothing! Well, almost nothing, as we can see from the $6.6 trillion shortfall between what people need to maintain their current standard of living and what they’ve actually saved for retirement.

Moreover, investment-based systems suffer from having much higher variance in their returns, a problem that is magnified when investment accounts are individual rather than collective, i.e. as with the Trust Fund. Indeed, as Piketty says, “the rate of wage growth may be less than the rate of return on capital, but the former is 5-10 times less volatile than the latter.” This is especially a problem, I would argue, when the level of retirement benefits is low relative to pre-retirement income, as it is in the United Kingdom and the United States. Piketty’s preferred solution is to keep PAYGO pensions, but supplement them with guaranteed rates of return for small savers that are closer to r than to g. However, this may have problems of its own. First, where will lower-income people get the money to save in the first place, with falling real wages and all? Second, how will government finance the guarantee in a way that is cheaper than just expanding Social Security? Expanding Social Security has the advantage of shielding individuals from the volatility of the market (and the fact that small investors earn lower rates of return than large investors) while offering a risk-free return (the Trust Fund is invested in Treasury bonds).

Piketty next turns to the progressive income tax, which he calls “the major twentieth-century innovation in taxation” (p. 493). However, in the twenty-first century, it faces two related challenges. First, it is being undermined by international tax competition, including from tax havens. Second, at the very top of the income hierarchy, the income tax is turning regressive, i.e., having lower rates than for those further down the income scale. This is the point Warren Buffett refers to when decrying the fact that he pays taxes at a lower rate than his secretary.

Piketty argues that one reason the progressive income tax is coming under intellectual attack today is that it was adopted chaotically, without time for all its implications to be debated. The tax, he says, “was as much a product of the two world wars as it was of democracy” (p. 498). That is, while many countries had adopted income taxes before World War I, it is only in the aftermath of the war that the top tax rate in major countries exploded. For example, the U.S. top marginal rate went from 7% in 1915 to 77% in 1918. In the United Kingdom, it went from 8% to 60%; in Germany from 4% to 40%, and in France, from 2% to 50%, all in the space of a few years.

Indeed, in both income and estate taxation, the United States was a leader with high rates. Piketty points out that the top marginal rate in the U.S. averaged 81% for the 48-year period from 1932 to 1980. While Britain had similar rates over a long period of time, no other European country did.

Okay, now for the bombshells. As you probably know, top marginal tax rates fell after 1980 everywhere among developed OECD (Organization for Economic Cooperation and Development) member countries. This seems to have increased the incentive for high earners to increase their compensation. In fact, in all 18 countries in the World Top Incomes Database, “the two phenomena are perfectly correlated: the countries with the largest decreases in their top tax rates are also the countries where the top earners’ share of national income has increased the most (especially when it comes to the remuneration of executives of large firms)” (p. 509).

Having the incentive to try for bigger pay raises, managers took advantage of the fact that “it is objectively difficult to measure individual contributions to a firm’s output” and persuaded their employers to give them big raises, often helped by the fact that their compensation committees were composed of people like themselves. So, Piketty says, it is really a question of bargaining power at the top (and don’t forget that he already told us that there is no correlation between executive compensation and firm performance).

Not only did the countries with the biggest cuts in their top marginal tax rate see the greatest increases in top income shares, but at the same time they did not show any greater increase in productivity growth. So top managers were not creating some generalized increase in productivity that they had some kind of moral claim to. In fact, as Piketty points out, productivity growth was 2.3% annually from 1950-1970 but only 1.4% per year in 1990-2010. Yet it is the latter period in which executive pay mushroomed, not the former.

You can probably see where this is going. The entire idea that people’s pay level is based on their marginal productivity, such that they “merit” the incomes they earn, is bunk. It is innately hard to measure marginal productivity, and some people have more bargaining power than others (not to mention greater incentives to bargain hard) for reasons that have nothing to do with productivity. In fact, Piketty, Saez, and Stantcheva found that executive could achieve big raises without great performance most easily in countries with the lowest top marginal tax rate. Thus, the theoretical edifice for the claim that inequality is “fair” collapses.

What can counter the massive increase in incomes at the very top of the distribution? If we stick with income tax, Piketty says that the optimal top marginal rate in the United States is 82% (p. 512). This would apply to the top 0.5% or top 1% of incomes only. This would not affect productivity because it would largely wipe out some economically useless activities. Because those activities would disappear, a tax that high would not raise much revenue. If the United States wanted to raise revenue, Piketty suggests a marginal tax rate of 50-60% on incomes in the top 5%. It’s important to note that while the United States could do this because it is the world’s largest national economy, it is not possible for European countries unless they achieve fiscal coordination. This is extremely difficult due to EU rules requiring unanimity on votes affecting direct taxation (personal and corporate income tax).

The ideal solution, he argues, would be a global tax on capital plus “a very high level of international financial transparency” (p. 515). Piketty recognizes that this is infeasible right now, although he says it might be possible “incrementally,” at the European level, for example (which would still run up against EU voting rules). He argues, though, that the alternative could well be worse: If people view inequality to have reached unacceptable levels, the response might be a breakdown of the global economy via widespread protectionism. (I offer a similar argument at the end of Competing for Capital.) A tax on capital allows high levels of trade to continue while directly addressing the problem of inequality.

One important element of achieving international financial transparency is shutting down bank secrecy. For Piketty, without solid information on inequality (and hence on individuals’ ownership of capital), it is impossible to have a democratic debate about the type of taxation and government services that individuals want. Tax havens and their defenders will whine about this being an intrusion on people’s privacy, but Piketty’s response is compelling (p. 522):

No one has the right to set his own tax rates. It is not right for individuals to grow wealthy from free trade and economic integration only to rake off the profits at the expense of their neighbors. That is outright theft.

For this reason, he advocates the automatic exchange of bank information to ensure transparency.

Piketty argues that we should not rely solely on an income tax. The fact of the matter is that capital ownership generates much economic income (such as capital gains) that doesn’t have to be declared year-to-year. As a result, income tax filings grossly understate rich people’s true income. This means that the problem of tax regressivity at the top is even worse than he discussed under the income tax. He goes back to the example of L’Oréal heiress Liliane Bettencourt. Her wealth exceeds €30 billion, and her rate of return is somewhere between 6% and 7% a year (€1.8-€2.1 billion in economic income). Yet she herself has said that she has never declared more than€5 million per year in income. Even if she’s paying 50% of this figure in income taxes (France’s top bracket is currently 53%), that €2.5 million is barely 0.1% of her economic income. It is hard to get taxation more regressive than that.

Not only would a tax on capital create financial transparency while raising a modest amount of revenue (Piketty envisions 2% of European GDP), but Piketty argues that an extraordinary tax on capital on the order of 15% could wipe out Europe’s current debt problems. As he says (p. 540), “From the standpoint of the general interest, it is normally preferable to tax the wealthy rather than borrow from them.” The alternatives are inflation, which governments have frequently used, and austerity, which Europe is currently using with predictably bad results. Moreover, he says, it is possible to get more precise targeting of the distributional consequences you want with a wealth tax than with debt repudiation or inflation.

I mentioned before that Piketty believes that the United States is large enough by itself to levy an 82% top income tax rate, whereas Europe isn’t. The same is true, in his view, on a capital tax (he also thinks China might be able to effectively tax capital). Europe’s problem is that tax competition is particularly intense, a problem he lays at the feet of the smaller economies, particularly Ireland (no surprise there). Piketty sees the creation of fiscal union (with EU-wide corporate income taxes apportioned to each country by formula) as no more utopian than the idea of creating the euro. Indeed, he seems to think that political union is ultimately necessary to end destructive tax competition, though he is pleasantly surprised at the traction gained for instituting a European financial transaction tax. He proposes a “budgetary parliament” for the Eurozone that could make democratic decisions on fiscal matters, and argues that it should not be bound by any fixed rules limiting deficits or debt — which will be nearly impossible to get Germany to agree to.

He concludes by reminding us that we cannot escape the possibly infinite concentration of capital that follows from r>g unless governments take proactive policies, most importantly an annual progressive tax on capital. The inequality r>g does not follow from market imperfections, so it cannot be solved simply by making markets more competitive. While he acknowledges that there is a real risk that increased European integration could lead to the shriveling of the social states constructed in each nation, the problem is that this is inevitable in the absence of creating a political entity large enough to regulate capitalism. “If we are to regain control over capitalism, we must bet everything on democracy — and in Europe, democracy on a European scale.”

For those of us in the United States, we already have a political entity big enough to battle the pressures for greater inequality. But of course we have numerous obstacles in our way as great wealth buys high levels of political influence, especially in the Citizens United era.

My next post will provide a summary and critique of the book (after a chess tournament break).

Cross-posted from Middle Class Political Economist.

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Understanding Piketty, part 2

In my last post, I gave an introduction to the massive data work underlying Capital in the Twenty-First Century, as well as two clear results from Piketty’s work. First, he showed that the optimistic Kuznets view after World War II that inequality was well on its way to being conquered was wrong, based on putting too much stock into a short-term trend. Inequality in fact has been increasing in the industrialized world since about 1980. Second, Piketty showed that a slow-growth economy is ripe for an increasing concentration of wealth in society, absent government action to counter that trend. He introduced the relationship r>g, which says the private return on capital is greater than the economic growth rate. When this holds true, as it has for most of history, inequality is likely to increase.

In this post, I address Part Two, “The Dynamics of the Capital/Income Ratio. The next two posts will address parts Three and Four, followed by a summation and critique of certain aspects of the book.

One important observation that Piketty makes is that in Europe, capital in the form of agricultural land accounted for 300-400% of gross national income (GNI), and total capital reached about 700% of GNI in the early 1700s. In Britain (Figure 3.1), France (Figure 3.2), and Germany (Figure 4.1), total capital fell below 300% of GNI in the period encompassing World War I and World War II. By 2010, total capital was back up to about 600% of GNI, but its composition had changed, with agricultural land falling to vanishingly low levels, replaced by housing and other domestic capital. In the United States (Figure 4.2), by contrast, farmland in 1770 was plentiful and cheap, making up about just 150% of GNI. Total capital also was much lower than in Europe, only about 300% of GNI. In the twentieth century, however, the U.S. did not suffer the devastation of the World Wars, so it had fewer and smaller dips in the value of total capital, which had risen to about 450% of national income in 2010; like in Europe, however, the value of U.S. agricultural land had also fallen to a tiny fraction of national income. Piketty points out if one includes the value of slaves, total U.S. capital in 1770-1810 rises by another 150% of national income (Figure 4.10), meaning that the capital/income ratio in the United States has been even more stable than it appears at first blush.

For Piketty, the resurgence of the capital/income ratio in the late 20th century is a consequence of slow growth. One important result of this is that capital’s share of national income has increased since 1975, and labor’s share has consequently fallen. According to his data for eight rich countries (the United States, the United Kingdom, Germany, Japan, France, Canada, Italy [the G-7, as they are usually called] and Australia.), “Capital income absorbs between 15 percent and 25 percent of national income in rich countries in 1970, and between 25 percent and 30 percent in 2000-2010” (Figure 6.5, p. 222). Notably, he raises the important point, central to my own academic work, that the increasing mobility of capital increases capital’s bargaining power vis-a-vis both labor and governments (p. 221). He considers it likely that this factor has been mutually reinforcing with  the ability to substitute capital for labor. I would consider it not merely likely, but close to self-evident. Moreover, he omits (though I am sure he is aware) that one use capital mobility has been put to is to substitute less expensive for more expensive labor.

This increase in capital’s share of national income shatters another comforting standard economic view, that the relative share of capital and labor is fixed. This assumption is built into a workhorse of neoclassical macroeconomic analysis, the Cobb-Davis production function. Piketty shows that, as with Kuznets work, the results of Cobb and Douglas generalize from a data sample that is far too short in term (p. 219).

My next post will analyze Part Three, “The Structure of Inequality.” See you soon.

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Understanding Piketty, part 3

Part 3 of Thomas Piketty’s Capital in the Twenty-First Century is the longest section of the book (230 pages out of 577), providing his analysis of inequality at the level of individuals. Notably, Piketty largely avoids the use of the familiar Gini index because, in his view, it obscures the issue by combining the effects of inequality based on income with those of inequality based on wealth. He treats the two sources of inequality separately throughout this analysis.

The first point Piketty emphasizes is one regular readers will be familiar with from my previous discussions of the Crédit Suisse wealth reports: Wealth is always more unequally distributed than income. The disparity is stark (p. 244):

…the upper 10 percent of the labor income distribution generally receives 25-30 percent of total labor income, whereas the top 10 percent of the capital income distribution always owns more than 50 percent of all wealth (and in some societies as much as 90 percent). Even more strikingly, perhaps, the bottom 50 percent of the wage distribution always receives a significant share of total labor income (generally between one-quarter and one-third), or approximately as much as the top 10 percent), whereas the bottom 50 percent of the wealth distribution owns nothing at all, or almost nothing (always less than 10 percent and usually less than 5 percent of total wealth, or one-tenth as much as the wealthiest 10 percent).  One finding from his data which impressed me is that the inequality of wealth is virtually the same in all age cohorts, refuting the view that advanced industrialized societies are riven by inter-generational warfare (pp. 245-6). In other words, Baby Boomers may be less wealthy than their parents, but their incomes are just as unequally distributed, on average, and will continue to be so after they build up a few more assets and retire.

For my American readers, it is worth noting that Piketty claims that the United States today (meaning 2010) has the highest level of wage inequality ever seen in history, with 35% going to the top 10% and only 25% going to the bottom 50%. If current trends continue, though obviously an iffy proposition, the share of the top 10% would rise to 45% vs. just 20% for the bottom 50% (Table 7.1). In terms of wealth inequality the U.S. has as of 2010 almost reached the astronomical levels only seen by Europe circa 1910, with the top 10% owning 72% of all wealth, versus a 90% share in 1910 Europe (p.257). As this is survey-based data, Piketty says that 75% is a more likely figure, since surveys understate the top income and wealth shares. The bottom 50% of Americans own just 2% of the country’s wealth. As I noted before, if r>g, this concentration of wealth is likely to become even more uneven over time.

Piketty then turns to the evolution of inequality over the course of the 20th century. He takes the French case and the U.S. case as representatives of “two worlds,” one where inequality is largely caused by differentials in capital income (France) and one where it is caused more by wage inequality.

In France in 1910, the top 10% received over 45% of total income from both labor and capital, whereas its share of labor income was under 30%. Over the course of World War II, the share of the top decile (10%) dropped by about 15 percentage points, which rose and fell between 1945 and 1982, but since then is on the upswing once again (Figure 8.1). Wage inequality has been much more stable for France from 1910 to 2010. The higher you go in the income hierarchy, particularly within the top 1%, income from capital becomes more and more important, fully 60% of the income of the top .01%  of the French population (Figure 8.4). Piketty points out that while the upswing in capital income since 1982 does not yet appear large (only a few percentage points), it is built on an increase of capital as a percentage of national income, of inherited wealth, that will cause capital income to explode in the near future.

In the United States, we see the same decline in the income share of the top decile after 1940 as in France, but unlike France, since 1980 the United States has seen the share of the top 10% fully restored (Figure 8.5). Moreover, the vast majority of that recovery in the wealthy’s share of income is due solely to the increasing income share going to the top 1% (Figure 8.6). Behind this is an increase in what he calls “supersalaries,” the vast majority (60-70%) of which come from top managers and less than 5% from superstars in sports, acting, and the arts. Of course, though the route is different from that of France, it again causes an increase in capital’s share of national income, making it likely that inherited wealth will rise in importance in the United States as well.

What caused this explosion of labor income inequality in the United States? Piketty cites several factors. First, he highlights the findings of Claudia Goldin and Lawrence Katz that wage inequality began to grow in the 1980s, “at precisely the moment when for the first time the number of college graduates stops growing, or at any rate grows much more slowly than before” (p. 306). Second, institutions matter in the labor market. The biggest factor holding down the low end of wages in the United States is the low level of the minimum wage, which peaked in 1969 at $10.10 in 2013 dollars (p. 309).

However, these factors do not explain what is going on at the very top of the wage distribution, according to Piketty. One piece of evidence is that the supermanager phenomenon is a characteristic of the Anglo-Saxon countries after 1980, whereas there are only very small increases for the top 1% in Continental European countries or Japan (Figures 9.2-9.4). But another important point is that, among the English-speaking countries, the United States has the largest increase in the income of the top 1%, and the same is true for the income share of the top 0.1% of incomes (Figures 9.5-9.6). So, something is going on specifically in the United States. It is not, however, that there is some fantastically higher level of productivity growth in the U.S. All of the countries considered are at the world’s technological frontier; indeed, the evidence suggests that telecommunications infrastructure and cost are worse in the United States than many other industrialized countries.

Instead, what appears to account for the sharply divergent incomes of supermanagers are the difficulty of determining the marginal productivity of top managers (Piketty cites evidence that firms with the highest-paid executives do not better than those with lower-paid executives); the ability of top managers to “set their own salaries,” for example by appointing the compensation committees that will judge them; and, as Part 4 will show, the decrease in top marginal tax rates and the change in compensation norms related to that (pp. 334-5).

Piketty then turns to inequality in capital ownership, beginning with the treasure trove of data compiled in France since 1790. One of his most amazing findings is that in France, despite the 1789 Revolution, the inequality of wealth increased throughout the 19th century, to the point where the top 1% owned 60% of all wealth on the eve of World War I (Figure 10.1). As noted before, the World Wars, the Great Depression, and higher taxation brought about a dramatic fall by 1970 in the share of of both the top 10% (to 60%) and the top 1% (20%). Here, too, the data yield a striking finding: essentially none of this went to the bottom 50% of the wealth distribution, but was redistributed downward only to those below the top 10% but in the top 50% (p. 342). This “patrimonial middle class,” as Piketty calls it, has largely maintained its wealth share, with the top 10% and top 1% gaining a few percentage points from their 1970 low point.

Contrasting with France and other European countries for which there is reasonable wealth inequality data, the United States has seen a stronger recovery of the top shares of wealth holders, and in fact U.S. wealth inequality passed European wealth inequality in the mid-1950s, and has been higher ever since. In none of these countries, however, has wealth inequality returned to its highest levels. Piketty has three main explanations for why we have not (yet) seen a return to 1910 levels of wealth inequality. First, there simply hasn’t been enough time to rebuild from the 1945 low point; indeed, wealth inequality did not even start increasing again until the 1970s in most industrialized countries. Second, the decline in wealth inequality was accompanied and intensified by a sharp increase in taxation on capital. Third, there was a high rate of economic growth for thirty years after 1945. However, all these factors may reverse in this century. 1945, obviously, is steadily receding from view. Tax competition may well spell the end of capital taxation. Finally the slowdown of demographic growth will reduce economic growth as well, exacerbating the key r>g relationship.

Piketty then turns to inheritance, again with data going back to 1790. Here his foil is economist Franco Modigliani, who posited that people save in order to finance their retirement, but bequeath essentially 0 wealth. Piketty finds that “the desire to perpetuate a family fortune has always played a central role” in savings decisions (p. 392). As evidence, he points out that “annuitized wealth” (non-heritable, such as Social Security but not a 401-k account) makes up a tiny fraction of private wealth (under 5% in France, and 15-20% in “English-speaking countries, where pension funds are more developed”). In other words, the desire to leave a bequest to one’s heirs is the predominant fact behind large-scale savings behavior.

Piketty contends that a society dominated by inherited wealth becomes less democratic over time. Not only do the wealthy have increased mechanisms to influence political outcomes, but unearned income is an “affront” to the meritocratic story we tell ourselves. If high incomes are not based on merit, an important justification for this inequality disappears. He goes on to note that “rent” is not originally a pejorative term (as in, for example, “monopoly rent”). If capital is used in production, it yields income, and this is not due to monopoly and cannot be “solved” by greater competition. As Piketty says, universal suffrage [which in the 19th century had often been posed as fatal to the economy – KT] “ended the legal domination of politics by the wealthy. But it did not abolish the economic forces capable of producing a society of rentiers” (p. 424).

I have left out some of the technical detail of Piketty’s argument, but one more point here needs emphasizing. As he shows (Figure 11.12), inheritance flows are increasing in Europe, and have been since 1980. The situation is not quite as bad in the United States, because the U.S. population is still growing, while Europe’s is stagnating. However, long-term forecasts point to an eventual slowdown in population growth in the United States as well, in which case inherited wealth would emerge just as strongly as it already has in Europe.

Piketty’s final points refer to global dimensions of inequality of wealth. His argument here is that while most people’s instinct is to object less to entrepreneurial fortunes than to inherited ones, in fact there is less difference between the two that meets the eye. This is because, he argues, the largest fortunes are able to command the highest rates of return. He gives the example of the fortunes of Bill Gates, who obviously worked to build Microsoft, and that of Lillian Bettencourt, the heir of the L’Oréal fortune, “who never worked a day in her life” (p. 440). As it turns out, from 1990 to 2010, both saw their wealth increase at by a factor of 12.5 times in that period. Large fortunes command the highest rate of return. However, the data Piketty presents do not fully support this. Gates’ fortune was twice that of Bettencourt in 1990 and 2010, yet his rate of return was no more than hers. Furthermore, when Piketty reports on the returns made by sovereign wealth funds, we can see that Abu Dhabi’s, the world’s largest, worth more than all U.S. university endowments combined, nonetheless had lower earnings than did Harvard, Princeton, and Yale on their endowments. I think there is much merit to his overall claim, but it would appear to be a little more complicated than he lets on.

Last but not least, a couple of international wealth quick hits. First, will sovereign wealth funds own the world? No, but they could wind up amassing 10-20% of global capital by 2030 or 2040, which would be a much greater percentage of liquid global assets. Second, will China own the world? The short answer is no. Third, why do rich countries so frequently have negative asset positions? Are these counterbalanced by positive asset positions in poorer countries overall? The answer to this last question is no, so the answer to the previous question is that so much wealth has been diverted to tax havens, it makes the rich countries look poor, even though they aren’t. Indeed, even the relatively low estimate of tax haven assets by Piketty’s colleague Gabriel Zucman comes to more than twice the negative asset position of the rich countries.

This long section of the book is the necessary set-up for Part Four, where Piketty takes on still more received theories, and proposes his own recommendations for what can be done about inequality. I will turn to those questions in my next post.

Cross-posted at Middle Class Political Economist.

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Understanding Piketty, part 1

Thomas Piketty’s (CV) Capital in the Twenty-First Century is the most important book on economics published in this century. The book has made a huge splash, and drawn the ire of conservatives, for its straightforward argument that recent increases in inequality in numerous countries are likely to rise to unprecedented heights unless governments can reach democratically based solutions to this problem.

As I mentioned previously, the book’s success is built on a mountain of data that a multinational team of researchers has been compiling for 10 years, the World Top Incomes Database, as well as long-term wealth records dating back to 1790 in the case of France. Piketty, in fact, has been working on inequality issues for 20 years. As he remarks in the book, until the creation of these datasets, debate on inequality was a “dialogue of the deaf” with precious few facts to back up anyone’s arguments. A lot of this work has been taking place out of sight of most pundits, as Piketty’s early books and papers are published in French, with the exception of the reasonably well-known papers he co-authored with Emmanuel Saez on U.S. inequality.

Most notably, there has been only one significant challenge to Piketty’s data, and it was easily swatted down. Chris Giles of the Financial Times claimed that wealth inequality in the United Kingdom had declined since 1980, not risen as given in Piketty’s book. But Giles made the error of taking survey-based wealth data (which sharply underestimates the wealth of the rich) and splicing it on to much more accurate estate tax-based data, to get a declining share of wealth for the top 10% and the top 1%. As Piketty says in his response:

Also note that a 44% wealth share for the top 10% (and a 12.5% wealth share for the top 1%, according to the FT) would mean that Britain is currently one the most egalitarian countries in history in terms of wealth distribution; in particular this would mean that Britain is a lot more equal that Sweden, and in fact a lot more equal than what Sweden has ever been (including in the 1980s). This does not look particularly plausible.

Obviously I agree with Piketty, but don’t take my word for it. According to Eurostat, the Gini index for income inequality (which runs from 0 to 1, but is often multiplied by 100, as here; higher is more unequal) in 2012 was 32.8 for the United Kingdom versus 24.8 for Sweden. (For comparison, the United States was at 45.0 in 2007, according to the CIA World Factbook.) Combine that with the fact that wealth is more unevenly distributed than income in every country, and it is impossible for U.K. wealth to be more equally distributed than Sweden’s is today, let alone at its most equal point in the 1980s. Moreover, according to Piketty’s data on Sweden, which Giles does not dispute, the top 10% there owned just a tad under 60% of wealth, and the top 1% fully 20% of wealth, in 2010 (Figure 10.4, p. 345).

So what does all this new data show? First of all, the data show that the optimistic post-war notion that inequality had been solved for good was an illusion. As Piketty points out, economist Simon Kuznets had posited that as countries developed from very poor to very rich, as their GDP per capita increased, countries became more unequal at low levels of income (think China today). However, after a certain tipping point was reached, as countries raised their per capita GDP, their income distribution would become more equal. This was based on what Kuznets saw in the 1950s, a situation where income inequality was indeed declining in the industrialized countries. Many people expected that as more countries developed, they would pass the tipping point, and income inequality would decline in more and more countries. Alas, since 1980, we have seen a resurgence of inequality in the wealthy countries, turning the second half of Kuznets’ story into a “fairy tale.”

According to Piketty, the reasons we saw a sharp decline in wealth inequality in the wealthy countries from 1910 to 1980 are that there were substantial destructions of capital in the two World Wars, plus high taxes levied on the wealthy to finance the wars, which could not be paid for otherwise. Then, after World War II, there were very rapid growth rates possible as the various countries played catch-up to get back to their pre-war growth trends.

This brings us to a second major point of Piketty’s book. He argues that the relationship between the rate of return on investments (r) and the country’s growth rate (g) is a critical determinant of how concentrated wealth becomes in a society. If r exceeds g, over time capital ownership becomes more concentrated and society less equal. In all probability, developed countries can only expect to see growth, after inflation, of 1% to 1.5% per year. Of course, China and some other developing countries are growing more rapidly, but as they reach the technological frontier, their growth will slow. Meanwhile, the return on investment is more on the order of 4-5% annually. Thus, for industrialized countries, there is considerable danger that the wealth will become significantly more concentrated, and Piketty considers it obvious that high inequality is dangerous to democracy.

Alas, it’s late; I have to stop for the night (but not at Hotel California). I’ll have more to say very soon.

Cross-posted from Middle Class Political Economist.

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Tesla wants $500 million for its Gigafactory

Leigh McIlvaine (@Leigh M.) of Good Jobs First alerted me to this article on what Tesla Motors wants in incentives to land its $5 billion Gigafactory: $500 million. This massive 6500 worker facility will produce the next generation of batteries in order to introduce a less expensive line of cars in 2017, the Tesla Model 3. This would be a more affordable vehicle than the widely praised Model S, which starts at $69,900.

I’m not joking about the praise: Consumer Reports, my go-to source for product testing due to the fact that it does not accept ads and thus has complete independence, gave the Model S its best-ever score of 99 out of 100 when it tested the car earlier this year. It also leads the magazine’s subscriber survey of customer satisfaction, with 99% of owners saying they would buy the car again. This is a vehicle, and a company, that is generating some serious excitement.

It’s no surprise that the Gigafactory is generating serious excitement, too. 6500 jobs, a $5 billion investment, and cutting-edge technology is a heady mix for an economic development official. San Antonio, where Toyota makes pickup trucks, jumped into the auction quickly, offering “almost $800 million in incentives.” Although Tesla has broken ground at a location near Reno, Nevada, last week CEO Elon Musk announced plans to break ground at one or two other sites as well. The company clearly considers speed to be of the essence.

It’s unclear exactly what the company wants financially, and Tesla did not respond to my request for an interview to seek clarification of some important points. To be specific, does it want that $500 million in cash, in the form of property tax breaks over some number of years, land and infrastructure, or what? Most importantly, is Tesla’s goal speed plus $500 million, or speed plus the highest bid? The company has sent mixed signals on this question.

As Forbes wrote, “Last week, Musk said that Tesla wanted to make sure a package was right for the winning state, as well as for Tesla.” In the article’s very next sentence, however, Tesla VP for communications and marketing, Simon Sproule, said, “Any publicly traded company has a fiduciary responsibility to get the best deal for its investment.” Musk’s comment seems to imply that $500 million is all the company wants. By contrast, fiduciary responsibility has often been used to justify a company going after the maximum incentives possible. Forbes quotes the business editor of the San Antonio Express-News that it was hard to tell if Tesla is conducting “a search (or) a shakedown.”

Sproule disputed the shakedown thesis, despite invoking “fiduciary responsibility.” How should we think about this project?

On the one hand, we could take Musk’s comments as meaning that the company wants $500 million, no more, no less. Given that he expressed it as a percentage of the investment, my intuition is that we should assume that means $500 million in cash or cash equivalents like free land (my guess is that San Antonio’s “$800 million” was mainly tax breaks, which would have a lower present value). If that’s true, Sproule’s contention that the incentive is not really so expensive is actually true in a comparative sense. A 10% aid intensity (subsidy/investment) would be the second-lowest for a large automotive facility in the modern history of megadeals. It would even probably be legal in the European Union under its Regional Aid Guidelines, if it were located in one of the EU’s poorer regions. Moreover, the cost per job would be $76,923, substantially below the $100,000-$150,000 level common for most U.S. automobile assembly plants.

Of course, cost alone doesn’t make a deal a good one. In particular, if Tesla wants its incentives up front, there is a substantial risk that the project won’t ultimately produce 6500 jobs, or that changes in the market could even lead to the Gigafactory closing. New Mexico lawmakers have certainly recognized the importance of this vis-a-vis Tesla. In my email to Tesla, I asked what taxpayer protections, like clawbacks, the company is prepared to accept. Alas, no response, but I will update if I do hear back from Tesla.

On the other hand, if $500 million really is just meant as the minimum acceptable opening bid, all bets are off for saying how (comparatively) good a deal it might be.

Once again, we are confronting the issue of information asymmetry: government officials have less information about what the company really wants than the company has about the various governments, and of course its own intentions. This is a major source of bargaining power for companies shopping around for an investment location. If Musk really means that Tesla will voluntarily limit the incentives it requires, that would be a refreshing change from the typical bidding wars we have seen in so many industries. Or, it could just be business as usual, with the highest bid (adjusted for cost structure at the different locations) winning. We just don’t know, but the decision is expected by the end of the year.

Cross-posted from Middle Class Political Economist.

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Illinois’ next governor may make Romney look like a saint

Does the name Bruce Rauner ring a bell? No, me neither. It turns out he’s the Republican nominee for governor in Illinois, which under normal circumstances would mean he’s a nobody. But he’s been leading incumbent Democrat Pat Quinn in polls all summer, and could actually end up as the state’s next governor.

This is a problem, because he is even more out of touch with the middle class than Mitt Romney (Rauner is a private equity near-billionaire) whose idea of transparency is to release the first two pages of his 1040 tax return for 2010-12, and nothing else. Romney at least released his full tax return for each of two years. As Think Progress points out, Rauner is also a big fan of the Cayman Islands as a tax haven, just like Romney. In fact, Rauner is invested in at least five funds there. Also like Romney, Rauner takes full advantage of the “carried interest” tax break that lets him treat his fees, which should be ordinary income taxed at 35%, as capital gains, subject only to a 15% tax rate.

Rauner’s agenda is insistent on the need to spur job growth, but somehow misses the fact that Illinois’ unemployment rate has fallen from 9.2% (seasonally adjusted) in June 2013 to 7.5% in May 2013 (the figure Rauner used) and even more since the agenda was published, to 7.1% in June, the third-largest drop in the country year-over-year. Still a full point worse than the June national unemployment rate, but a lot better than it was.

One place where Rauner is worse than Romney is the minimum wage. Romney, rather surprisingly, supports an increase in the minimum wage, though he did not specify a number. Rauner, in both December and January, called for Illinois to lower its minimum from $8.25 to $7.25, the national rate. After getting a tremendous amount of blowback, he now claims to support an increase.

His agenda says the state “should implement a phased-in minimum wage increase, coupled with workers’ compensation and lawsuit reforms to bring down employer costs.” No mention of what the rate would be, or the period over which it would be phased it. He references an op-ed he wrote in the January 9th Chicago Tribune (now only available through the Nexis subscription service), where he clearly buys into the “job-killer” meme and drops a reference to the futility of a “$20 per hour” minimum wage, for good measure. Somehow I don’t think he really supports an increase.

Not only that, but Rauner proposes turning the Illinois Department of Commerce and Economic Opportunity, the state’s investment promotion agency, into what he calls a “public-private partnership.” He doesn’t say it, but this means there will be less public oversight into the agency’s affairs. As Good Jobs First has shown, such privatized agencies have exhibited high levels of abuse in recent years.

Rauner is a living, breathing example of how we have one tax system for the 1%, and another one for the rest of us. His flip-flop on the minimum wage is as phony as the concern he professes for the middle class. Yet there’s a very good chance he will be the next governor of Illinois.

Cross-posted from Middle Class Political Economist.

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Medicare report shows Obamacare is bending the cost curve

The 2014 Medicare Trustees Report has just been released, and it shows that the program is on noticeably sounder financial footing than it was just a year ago. One of the biggest signs of this is that the projected depletion date of the Hospital Insurance (Part A) Trust Fund has been pushed back by four years just since last year’s report.

Indeed, Sarah Kliff points out that Part A actually spent $600 million less in 2013 than in 2012, even though it insured 1.6 million more people. As she emphasizes, the big news in this is that per capita Medicare Part A spending has been falling. This is a great sign that there is forward movement in controlling the actual cost of care.


Source:, link above

This is a big deal because not only are Baby Boomers like myself inching towards Medicare eligibility in large numbers, but hospitals and other providers (unfortunately, these two groups are merged in OECD statistics) account for most of the excess of US health care spending compared to other industrialized nations. In fact, comparing the United States to Canada, specifically, I found that payments to providers made up 85% of the per capita cost difference between the two countries.

Moreover, as Kliff points out, even when you include Part B and Part D into the calculation, Medicare’s per capita cost showed no increase in 2013. Zero.

Indeed, if you want to see a very graphic demonstration in the change in the cost curve, Louise Sheiner and Brendan M. Mochouk of the Brookings Institute (h/t Matt Yglesias) have just what you’re looking for.

Source: Brookings Institute, link above

Yes, in just five years, the estimated federal health expenditure has dropped by more than 2 percentage points of GDP by 2035, what would be a difference of $320 billion per year today.

Of course, the Patient Protection and Affordable Care Act cannot take all the credit for this improvement. But, as the Washington Post reported, the law “is slowing payments to Medicare Advantage” and, as also mentioned here, the penalty for hospitals with high re-admission rates has produced a substantial fall in the 30-day re-admission rate, from about 19% in 2011 to less than 18% in 2013. With better care, fewer re-admissions means lower costs.

Thus, while no phenomenon this complex can have a single cause, it is clear that Obamacare is having an impact beyond insuring 10.3 million uninsured, working as designed to improve health outcomes and reduce costs.

Cross-posted from Middle Class Political Economist.

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Fun and games with transfer pricing

ProGrowthLiberal in his comments on my last post and in his own post at EconoSpeak highlights the fact that drug-maker AbbVie already makes most of its profits outside the United States, about 87% in fact over 2011-2013 by his calculation. For PGL, then, AbbVie is not the best example of an inversion because the horse is already out of the barn in terms of escaped profits.

I see things a little differently on this, but the case is also highly illustrative of a principle we have discussed before, transfer pricing. Let’s take a look at AbbVie’s Form 10-K Annual Report, downloadable here, to see what I mean.

Pre-tax profits ($millions)    2013    2012    2011    3-year total

U.S.                                           -581      625     626     670

Foreign                                    5913    5100    3042     14,055

Total                                        5332    5725    3668     14,725

Source: AbbVie Annual Report, p. 92

I actually calculate the foreign percentage for these three years as 95%, given that AbbVie claims to have lost money in the United States in 2013. In any event, this is a very strange division of the company’s profits given where its sales were made.

Net sales ($billions)    2013    2012    2011

U.S.                                 10.2     10.4     9.7

Foreign                             8.6       7.9     7.7

Total                               18.8     18.4    17.4

Source: AbbVie Annual Report, p. 40. Totals may not sum due to rounding.

As you can see, in each of the three years, over half of the company’s sales were made in United States, but the company reports that only 5% of its profits are in this country. This is pretty funny math, if you like dark humor. Especially since Humira, AbbVie’s biggest-selling drug by far, was developed in the United States. So with the patents in the U.S., and most of the sales in the U.S., the profits have to be in the U.S., right?

In reality, of course they are, but not in the Alice’s Wonderland world of transfer pricing. In this byzantine world, the patent for Humira is almost certainly owned by a subsidiary in Ireland, where royalty payments are tax-free. How else could the company show a loss in the United States in 2013 when 54% of its sales are here? Despite this, the company reports paying about 39% of its worldwide income taxes ($226 million of $580 million worldwide, see p. 92), although we have seen that what companies report in taxes on their 10-K annual report is largely fiction

So what can we do? The answers remain simple, though as politically difficult as ever. First, require companies to publish what they pay, country-by-country. No more hiding behind consolidated accounts. Second, enact unitary taxation, using apportionment formulas to make transfer pricing irrelevant. Third, end the deferral of U.S. corporate income tax on foreign profits. Finally, despite what “everyone,” including the President, says, don’t reduce the corporate income tax rate. We’ve gone long enough with tax policies that exacerbate inequality; there’s no reason to continue down that road when we have the world’s largest economy.

Oh, and my tiny disagreement with ProGrowthLiberal: It seems to me that if a company is already draining giant chunks of its profits abroad, then allowing an inversion ratifies losing a bigger amount of tax money than it would for a company like Walgreen’s that has not moved its profits offshore yet. But I imagine the IRS could still go after AbbVie post-inversion if it wanted to question its pre-inversion transfer prices, so this is a minor point indeed.

Cross-posted from Middle Class Political Economist.

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Unintentional tax humor at Forbes

David Cay Johnston emailed me that there were errors in Forbes contributor Tim Worstall’s recent criticisms of the linked article. Indeed there are, but the biggest one (or at least the funniest one) isn’t the one Johnston pointed me to.

Worstall writes that AbbVie’s pending inversion will not, by itself, reduce the taxes the company owes on its U.S. operations, though it could be a preparatory move to drain profits from the United States. I’ll come back to that point, but Worstall then gives the example of how AbbVie might sell its patents to a foreign subsidiary and pay royalties to that unit, thereby draining U.S.-generated profits to a tax haven subsidiary, for instance Bermuda (though Ireland is more germane in the real world for intellectual property). But then comes the zinger:

However, do note something else that has to happen with that tactic. That Bermudan company must pay full market value for those patents when they are transferred. Meaning that the US part of the company would make a large profit of course: thus accelerating their payment of tax to Uncle Sam. This tax dodging stuff is rather harder than it sometimes looks: if you’re going to place IP offshore you can do that, certainly, but you’ve got to do it before it becomes valuable, not afterwards. [link in original]

“Must pay full market value”? I’m falling off my chair! It’s like Worstall doesn’t think transfer pricing abuse exists. If patent, copyright, and other intellectual property transfers had to be made at full market value, they would never happen. As I explain in the linked post, academic research has shown that transfer pricing abuses, in this case underpricing the intellectual property transferred from the United States to Bermuda (again, really Ireland), are quite common when no arm’s-length market exists for a good. Since companies aren’t going to sell their crown jewels to strangers, how can a tax authority know what will be a fair price for a Microsoft patent going from the U.S., where it was derived, to its Irish subsidiary?

Let’s be a bit more precise. What would it take for Apple to buy all of Microsoft’s patents? In return for whatever lump sum Apple paid, it would need the equivalent back in terms of the present value of all Microsoft’s future royalty payments. But if Microsoft sold its patents to its Irish subsidiary at that price, Worstall would be right that there would be no tax benefit. And it’s not like it’s cost-free to organize such a transaction. Not only would Microsoft incur the costs of drawing up the contract and so forth, but nowadays companies are taking reputational hits as a result of their tax shenanigans: Ask Starbucks, Google, and Amazon. So if the transaction created no true savings, yet hurt a company’s reputation, we know that it wouldn’t make the transaction. The fact that multinationals are flocking to sell their intellectual property to Irish subsidiaries where the royalties are tax free tells us that the transfer price is not the “full market value” Worstall claims.

Moreover, contra Worstall, it isn’t a question of transferring the intellectual property before it’s valuable. If you’re a multinational drug company, you can make estimates of FDA approval, how much you think a drug will earn, and so forth. And you’ve got inside information! To take the simplest possible example, let’s say AbbVie has two drugs it thinks are each 50% likely to generate revenues with a present value of $500 million each. If you believe Worstall, it will sell one of the patents to its Bermudan subsidiary for only $250 million. But it will sell its other patent for another $250 million, so the supposed cost will still be $500 million and the subsidiary will expect to earn revenues equal to a present value of $500 million off whichever drug turns out to be successful. It’s inescapable that there is no point for a multinational company to sell the patent to its subsidiary at a fair price. There would be no tax benefit, and we wouldn’t be seeing Microsoft with $76.4 billion offshore or Apple with $54.4 billion offshore in 2013. Or a total of $1.95 trillion for 307 companies. Heck, even AbbVie has $21 billion permanently reinvested offshore, according to its 2013 Annual Report (downloadable here), p. 93. “Full market value,” indeed.

Finally, a note on Johnston’s and Worstall’s main dispute. Worstall argued that an inversion does not reduce the tax that a U.S. subsidiary would owe to the United States, noting that you can drain profits (except, as we saw, he doesn’t really believe you can drain profits) from the American subsidiary as long as you have a tax haven subsidiary, i.e., you don’t need inversion for that.

From a very narrow point of view, this is correct. But what Worstall overlooks is that, for the U.S., worldwide taxation substitutes for a general anti-avoidance rule making avoidance itself illegal, which is the approach most other industrialized countries take. Inversions make it impossible to police avoidance, so they indeed threaten tax collections from U.S. subsidiaries. But one might argue that deferral has almost completely neutered the benefit from worldwide taxation already. The bottom line is that the United States needs an end to deferrals at least until it adopts strong anti-avoidance rules, at which point it would only then be possible to discuss ending worldwide taxation.

But all of that will be for naught if we allow ourselves to be seduced by silly claims about how transfer prices have to be the same as “full market value.”

Cross-posted from Middle Class Political Economist.

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