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

Thinking about the idea of a consumption tax, I can’t help tying this into the somewhat infamous “Lucky Duckies” editorial in the WSJ (“The Non-Taxpaying Class. Those lucky duckies!“). Who are lucky duckies? The working poor who do not have to pay income taxes (though they do of course pay payroll taxes). See also the WSJ follow up editorial, “Lucky Duckies Again“. Slate’s Tim Noah is on top of this and the “tax the poor” implications of various other proposed tax changes. See “Meme Watch: Return of the Lucky Duckies” and the links therein.

AB

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Static and Dynamic Analysis of Consumption Taxes

This and one more post on Chapter 5 of the Economic Report of the president. The author(s) of this chapter clearly anticipated a “consumption taxes are regressive” line of attack and attempt to construct a defense, coming up short in my opinion. Here are two phrasings of their defense:

Conventional distributional analysis typically considers a snapshot of a taxpayers’ economic well-being at a particular point in time. Research has shown that [What research? How? Who?] when a longer view is taken, differences in well-being, whether measured by income or by consumption, tend to be not as great, because of the fluidity of household incomes over time.” [ERP, p. 177]

and

The substantial movement of taxpayers across rate brackets suggests that the tax burdens in a given year may tell a very different story of the distribution of the tax burden than do measures of tax burdens over longer horizons…Analyses that rely on annual snapshots of taxpayer incomes are likely to suggest that a small fraction of taxpayers benefit from rate cuts, when in fact a larger fraction of taxpayers are likely to benefit because of the substantial movement of taxpayers up and down the tax rate schedule over time.”[Box 5.4, p. 201]

Get it? It’s ok if the proposed consumption tax is regressive because later on you might make more money and be on the side of the income distribution that benefits from regressivity! Let’s just say it: relying on this argument is a tacit but telling stipulation that in a static sense (i.e., looking only at one year), consumption taxes are regressive. But is the argument right, even so? There are a number of things wrong with the line of reasoning in this chapter:

  1. Their own stats (see Box 5.4) indicate that a large part of the population will continue to be subject to the regressive tax. They take families in 1987 and examine what tax brackets those same families are in circa 1996, finding “about 53 percent of taxpayers were in a different [not necessarily higher] tax bracket at the end of the period [1996] than at the beginning.” Of course 47% are still in the same bracket–regressively taxed in both 1987 and 1996 and presumably the intervining years as well. So it’s not at all clear clear that the mobility factor averages out in a way that makes lifetime taxes non-regressive, much less progressive.
  2. Also comparing 87 to 96, they find that “about 28% of taxpayers had moved to a higher tax bracket at the end of the 10 years. About 66% of the taxpayers in the bottom (zero tax rate) bracket in year 1 had moved to a higher bracket after 10 years, the vast majority moving to either the 10 percent or the 15 percent bracket.” Fine. But being in the 10% or 15 % bracket does not make a family wealthy. In 2002, the 15% bracket topped out at $27,950 for single filers and $46,700 for joint filers. Remember, a consumption tax is less of a burden as less of your income is devoted to consumption. A married couple with children making a combined $46,700 is still going to spend nearly early all of their income on consumption. Sure, at that level, they likely do save via a 401(k) or similar vehicle, but the remainder after that is spent on consumption, not savings. So these families may move up from the “extremely regressive” bracket to the “somewhat regressive” bracket, but would still pay more of their income in taxes than would wealthier familes!
  3. Nowhere do the authors deny that in a static snapshot, the consumption tax is in fact regressive. Instead they rely on the Panglossian notion that it’s fine because you’ll move up, devote a smaller portion of your income to consumption, and then benefit by paying less in taxes. Whether the movements in brackets are truly “substantial” is subjective, but let’s assume it is. The authors fail to note that implementing a regressive tax will reduce the very mobility they use to defend the proposed consumption tax. An old truism is that it takes money to make money. If we take more money from poor people now (via consumption taxes), it will be more difficult for them to become not poor later.
  4. The economy goes up and down; it’s a fact of economic life. But the size of the swings in the post-war era pale in comparison to those of the late nineteenth and early twentieth centuries. Why have the swings become smaller? A variety of counter-cyclical mechanisms implemented since World War II, such as unemployment insurance. And the progressive income tax is innately counter-cyclical: when a recession moves families into a lower tax bracket, their after-tax income falls by less than does their pre-tax income (because they move into a lower bracket). Consumption taxes are intrinsically less counter-cyclical. A family’s spending can be divided into subsistence (food, clothing, shelter) and discretionary (new car instead of used, vacations, …). By definition, subsistence spending can’t be varied in concert with the business cycle, though discretionary can. The point: families whose income is devoted mostly to subsistence will not have an off-setting tax benefit in recessions. Here’s the shocker: which families devote the most to subsistence and the least to discretionary spending? Poor families.

AB

Next up: Social Security and why this may all be much ado about nothing.

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The Economic Report of the President is authored by the Council of Economic Advisors (CEA), currently chaired by noted economist Glenn Hubbard. Noam Scheiber gives essential background analysis of both the politicization of the CEA, and Hubbard drifting from analyst to advocate. See Bush’s war on honest economics. Scheiber may slightly overstate the historical lack of bias on behalf of the CEA economists, but he makes a strong case that the level of bias (whether it previously was zero or small and positive) is now at an all time high.

“Hubbard seems to have responded to [assistant to the president for economic policy Lawrence] Lindsey’s influence not by digging in his heels, like many of his predecessors, but by making CEA more political itself.”

More generally, as I read chapter 5, I’m struck by the number of passive phrasings such as “it has been estimated…”, “research has shown that…”, “some have argued…”. This is generally considered (sic) to be a weak way of couching an argument. Scratch that. This is a weak way to couch an argument. What research? Who has argued? Who estimated and how? Without active statements of the theory in question and how it was tested, these statements are not falsifiable, nor can they be replicated by other researchers, and thus are barely more than opinions and speculation.

Here’s a nice excerpt from a randomly googled site on usage of the passive voice:


The agent (the original subject) is often left out of a passive verb phrase. Do not use passives just to hide the fact that you do not know the source of something. Sentences which begin like these should be avoided:

It is widely known that …

It has been claimed that ..

It is universally acknowledged that …

It cannot be denied that …

A critical reader will immediately want to know “who knows?”, “who has claimed?”, “who acknowledges?”, or will say “Oh yes, I can deny it ..”

But what about the substance of the chapter?

Stay tuned.

AB

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So this is a bit off topic, but last night I saw an infomercial on the benefits of “Coral Calcium”. While generally not much better or worse than the average infomercial, I feel compelled to share this phrase from the informecial:

“DNA can’t work unless it’s smothered in calcium”.

I’m now anxiously awaiting my shipment, the old DNA has been feeling a bit lethargic of late.

AB

P.S. Next up: more on Chapter 5 of the Economic Report of the President, “Tax Policy for a Growing Economy”.

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Corner Solutions and Backwards-Bending Labor Supply Curves

If taxing an activity makes people do less of something, why might replacing the income tax with a consumption tax not lead to a large increase in industriousness? The first two factors, related to corner solutions, will mostly apply to wage workers. The third applies to upper income workers.

Reason 1: Corner Solutions: For firms that pay on an hourly basis, there is a natural tendency not to exceed 40 hours. Each week, many employees ask to work overtime and are denied. Certainly, if their take home pay were to increase as a result of an income tax cut, they might ask more often, or more workers might ask for overtime, but that does not mean that employers would grant that overtime. It’s cheaper for firms to use more workers at the base wage than it is to use fewer workers and pay time and a half. (Now, if we could combine an extension in the base work week with a shift to consumption taxes, then we might be on to something! Ari? Karl?).

Another Corner Solution: Many workers pay no income taxes (though they do pay payroll taxes). Reducing the income tax will not affect these employees’ incentives to work.

One caveat to both of these is that, because employers also pay taxes on the labor that they hire, reducing those taxes would in fact increase the incentive to hire more workers (whether this would be sufficient to offset the employment-depressing effects of the distortions described in the previous post is unclear).

Reason 2: The Backward-Bending Labor Supply Curve. Suppose you are currently making an after-tax wage of $60.00 an hour, netting roughly $125,000 per year based on a 40 hour work week. What would you do if you were to get a raise to $80.00 an hour (or elimination of the tax cut raised your take-home wage to $80/hour)? As it turns out, if you study workers’ behavior, different people do different things. For some, they will work harder (think of an hour off work as now costing $80.00 instead of $60.00—people generally do less of something, in this case leisure, when its price increases). But for many, they will actually work less. What explains this contradiction? When people make more money, they consume more of almost everything. “Almost everything” in this case includes leisure. So, paradoxically, the incentive to work can actually fall as the returns to work increase! Another way to think of this is to imagine the increase in your effective wage from $60 to $80 (due, say to eliminating the income tax). At $80 per hour, you could work only 35 hours a week and make $145,000 per year–$20,000 more to buy stuff with and 5 more hours of leisure and family time per week. The punchline of the story is that cutting the income taxes of those who make a lot of money will not necessarily induce those people to work more.

Ignoring this effect when setting the consumption tax rate could also lead to a shortfall in revenue. If revenue targets are premised upon people working the same or more hours and then spending the additional income on consumption (which will then be taxed), then there will be shortfalls due to people spending the additional income on leisure (that is, not working). (Now if we could combine eliminating the income tax with a tax on leisure, this might not be a problem—Ari? Karl?).

AB

P.S. I don’t anticipate every post being as wonky as this one and the previous one.

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Income and Consumption

So here’s the exciting bit of information that lead me to finally decide to put my two cents on the web. Dave Neiwert reports that the 2003 Economic Report of the President contains language referring to plans to eliminate or reduce the income tax and replace it with a consumption (i.e., sales) tax. This is an astounding plan.

A general principle of Economics is that when the government wants the citizenry to do less of something, then the government should levy a tax on that activity. In this case, the ramifications seem twofold: (1) less taxes on income means more working (the principle acting in reverse) and (2) more taxes on consumption, which implies

less consumption for any given level of income. Of course the latter effect is confounded by the fact that if people work more, then they will have more income and thus tend to consume more. So the a priori effect of this policy proposal is ambiguous.

Here’s the frightening language from Chapter Five of the Economic Report of the President:

“The major objectives of tax reform are to reduce complexity, improve economic incentives, and address fairness. The central theme that brings these objectives together is that household and business decisions should depend on the tax code as little as possible. Taxing all income, but taxing it only once, is a key ingredient of many reform plans. This would involve broadening the tax base while lowering tax rates. Some efforts have also focused on a shift from taxing income to taxing consumption or consumed income [emphasis mine].”

First, much like the upper-income tax cuts disguised as an expanded savings plan in the current proposed budget, plans like these are never explicitly discussed by the current administration. In particular, they certainly did not make it into the State of the Union Speech. And with good reason: it’s a terrible idea, unless you consume a relatively small portion of your income.

Second, this abandons all pretense of progressivity in the tax code. If you are living paycheck to paycheck, as many do, then virtually all of your income is spent on consumption, and therefore will be subject to a “consumption tax”. Conversely, as your income reaches the top levels, a very small portion is devoted to consumption, with the balance going to savings and investment (admittedly, good things for the economy). Let’s hypothesize that the consumption tax is 25%. A family of four making $50,000 likely spends 90% of its income on consumption (food, shelter, leisure), making the tax burden $50000*.9*.25=$11,250, a tax rate of $1,250/50,000 = 22.5%. If the same family makes $200,000 per year, they would spend perhaps $150,000 of that on consumption, which would correspond to taxes of .25*$150,000 = $37,500, which is a tax rate of $37,500/200,000=18.75%. It’s regressive: as you make more, you pay a lower percentage of your income in taxes. (Extra credit: suppose your income is $1m and you spend $400,000 on consumption, what is your effective tax rate under a 25% consumption tax?)

There are a number of reasons, including social justice, why a regressive tax is not a good idea, but that’s a topic for a later post. Instead, the question is why a consumption tax is worse than an income tax. First, it will surely cost more than it is expected to. Why? Because naively setting the target consumption tax in a revenue-neutral fashion will actually lead to a decline in revenue. A consumption tax increases the cost of the final good to the consumer, meaning that for any price that stores charge, consumers buy less after the tax is imposed than before. Most states have sales taxes around 8%. To replace all income taxes with consumption taxes would require a federal consumption tax of at least 15% on top of the states’ 8%. So things will change from the scenario in which, when a store sells a DVD player for $100, the consumer pays $108 to a situation in which the consumer pays $123. Consumers care about price after tax, not before (question: can you buy a $100 DVD player with only a $100 bill?)! So what happens when the effective price to consumers goes up? They buy less DVD players! But the government can not collect sales (consumption) taxes on unsold DVD players. As an economic aside, some, but not all, of the impact of the tax would be borne by sellers. In the current example, the retail price might fall to $95 ($5 less for stores) and the after tax price to consumers would be $95*1.23=$116.85 (an $8.85 increase). Stores get less and consumers pay more, as a result the total volume of goods traded will fall. More generally, any move to a consumption tax that proposes a neutral tax rate, one such that

“(the value of all goods sold * proposed rate) = Income Tax Revenue”

will not generate the same revenue as under the income tax because it fails to account for the fact that the volume of commerce will fall (economists call this “dead weight loss”). If this tax is actually pursued, look for this factor to be ignored by Fleischer, Rove, et al.

But aren’t income taxes distortionary too? Yes they are, but two factors make them less so. First, corner solutions: at prevailing wages, many people are willing and able to work more hours, but employers do not hire them to work those additional hours. Second, a phenomenon that economists call the “backward bending supply curve”.

Stay tuned! AB

P.S. No, consumption taxes are not necessarily regressive–exemptions could make them progressive, but that invalidates the “simplicity” argument for such taxes.

P.P.S. Are there legitimate reasons for elimnating the dividend tax? Yes, there are. Dividend taxes are in fact distortionary, but all taxes are distortionary (no one is yet proposing a lump sum tax), so why choose to eliminate the one that is only paid by the wealthy? …”But over 1/2 of the population now has savings invested to some degree in stocks”….yes, but for most of those people, those investments are made through 401k’s or other tax-protected accounts, meaning that a dividend tax cut does almost nothing for them.

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I’ve thought about it for a while and now I’ve decided that a few people, somewhere in the vast spaces of the internet, may care what I think. See the next post for the trigger issue. In the meantime, you might want to know whose views you are reading. For the time being, I’m staying anonymous (I think–it’s the Internet), but here’s a brief bio:

Ph.D. in Economics, now researching and teaching at a top business school.

AB

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