Preparing to pivot

The tricky move the Obama Administration faces in budget policy is to go lax in the short run, given the need for stimulus to fight off recession, but then to steer back towards fiscal sustainability, with the drop-dead date possibly having been moved up from, say, the early 2020s to the late 2010s. 

According to today's Times, they are already thinking about this, with Jason Furman consulting with Congressional "Blue Dogs" about budget rules, "including a potential law requiring balanced budgets to formalize the pay-as-you-go approach favored by the coalition."

I'm increasingly convinced that balanced budgets and annual pay-as-you-go aren't really the right way to go about this.   The focus should instead be on a combination of short-term (five or ten year) plus long-term (infinite horizon) balance, or at least constraints on making things worse, given the distinct political pathologies that can lead to violation of either.  There are also tricky design questions involving the choice between super-majority rules and automatic changes (such as sequesters) if targets are missed.

More on this as things develop if it gets anywhere.  But the basic underlying task of designing constructive budget rules is tricky to say the least, and more art than science given the political economy aspects.

There's got to be a metaphor in here somewhere

But even if not, an amusing photo.

Yes, those are baby skunks that she has evidently adopted.

Confession of a deficit hawk

Before the financial crisis hit, the U.S. appeared to be headed towards a fiscal calamity, probably no later than the early 2020s. The likely doomsday date has surely moved several years closer, perhaps to some point in the late 2010s.

I nonetheless accept the need for something like Obama's Economic Recovery Plan, and also agree that this is the time to do healthcare. But even if all this goes well, the really tricky part will be navigating back towards fiscal responsibility, after having opened the federal wallet wide and benefited from doing so.

In a really optimistic scenario, the political credibility rightfully gained in 2009 will create genuine political capital, not Bush 2004-style fool's gold, that can actually be used to do unpopular things that are unlikely to have any Republican support.

Which do you want first, the bad news or the good news?

Bad news, you say? The Dow fell 445 points today.

The good news is that it can only happen 17 more times, then we'll be done.

If I were a billionaire

Certainly, under those circumstances, I'd be tempted to consider paying $50,000 to have our 18-year-old cat Shadow cloned, although I gather the cat cloning business isn't going so well. People raise ethical questions about cat cloning, rightly enough given all the unwanted strays, but Shadow, with his astonishingly good temperament (if we could recreate it), surely is a special case.

Today I found another use for that mythical money, upon reading that a mere $10 million could bring to life a reconstituted woolly mammoth. That would be an easy call for me if I had a billion. And sign me up as well for the reconstituted Neanderthal that (whom?) the article discusses - ethical questions be damned when you think of how astonishing this would be.

Before getting too excited, I should note that, while I haven't yet checked today's stock prices, as of yesterday they didn't appear to be heading me in the direction of a billion dollars. Indeed, these days zero is starting to look a lot more likely.

Rangel corporate rate cut proposal

From Bloomberg, courtesy of Tax Prof:

"New York Representative Charles Rangel said he's revising his tax overhaul proposal to reduce U.S. corporate tax rates to 28 percent, down from the current rate of 35 percent .... [to be financed] by targeting special-interest provisions that favor some industries and companies over others.

"Only Japan has a higher marginal corporate tax rate among developed nations, the Treasury Department said last year. When state taxes are factored in, U.S. corporations pay about 39 percent on their last dollar of profit.

"Obama has said that the effective tax rate paid by U.S. companies is much lower once they claim deductions, credits, and other adjustments to taxable income. In 2006, for example, American companies paid an average effective tax rate of about 23.7 percent, according to a study by Ernst & Young LLP."

Tax preferences that Rangel says are on the chopping block include the domestic production incentive, LIFO accounting, some stuff for multinationals, and something in the carried interest realm.

A few points to keep in mind here: First, cutting the corporate rate and broadening the base is generally an unambiguously good idea (keeping in mind, however, that for outbound investment this depends on whether a worldwide tax is optimal, as seems unlikely given its resting on the weak reed of corporate residence).

Second, a fully financed domestic corporate rate cut (i.e., not necessarily financed by corporate base-broadening) is also highly likely to be a good idea in the setting of worldwide tax competition.

Third, even if the effective tax rate paid by U.S. companies on domestic investment is low, a high marginal rate is still a problem - not just for the general reasons why base-broadening plus rate-cutting is desirable, but also because in various cases it will be the marginal rate, not the effective rate, that drives particular decisions in the realm of worldwide tax competition. (An example is transfer pricing incentives to treat marginal dollars as foreign source rather than U.S. source.)

Here's hoping Rangel gets somewhere on this, although it is more out of his playbook than Obama's.

Act now while supplies last

My latest article, The Long-Term U.S. Fiscal Gap: Is the Main Problem Generational Inequity?, is now available on SSRN here.

Abstract is as follows:

Current U.S. budget policy is unsustainable because it violates the intertemporal budget constraint. While the resulting fiscal gap will eventually be eliminated whether we like it or not, the big issue in current budget debate is whether the ultimately unavoidable course corrections should start now or be left for later. This paper argues that concerns of generational equity, which often are relied on by those demanding a prompt course correction, do not convincingly settle the issue, given empirical uncertainties about future generations' circumstances. However, efficiency issues create powerful grounds for urging a course correction sooner rather than later, on three main grounds: to eliminate the risk of a catastrophic fiscal collapse, achieve the advantages of tax smoothing, and smooth adjustments to the consumption made possible by various government outlays. Political economy considerations suggest that the risk of a catastrophic fiscal collapse may be significant even though in principle it could easily be avoided.

Colloquium presentation at Loyola LA

Yesterday I presented my forthcoming budget policy paper, The Long-Term U.S. Fiscal Gap: Is the Main Problem Generational Inequity? [to be posted on SSRN & linked here shortly], at Loyola Los Angeles.

Ted Seto offered excellent comments in which he showed, to my surprise, that I am not at the most pessimistic end of the spectrum concerning where U.S. budget policy is headed over the next 10+ years. He suggests that I add to my "doomsday scenario" (the ugly mess if the U.S. tiptoes too close to outright default) both (a) the collapse/replacement of the dollar as the worldwide reserve currency, clearly to our detriment and to that of other countries as well if a good replacement currency (such as the Euro) doesn't seamlessly emerge, and (b) the geopolitical consequences of economic troubles that might lead to the rise of extremist political regimes in hard-hit countries around the world, a la what happened in the Great Depression, only now with widespread nuclear weapons.

JCT Tax Expenditure estimates

I've commented in the past on the great work that's been going on at the Joint Committee on Taxation seeking to improve the usefulness of the tax expenditure concept by wresting it free of the irrelevant side-debate with which it was long intertwined concerning efforts to define a "normal" tax base.

The JCT has now issued what I believe are its first new set of annual five-year estimates using their revised methodology.

This advance deserves attention, and over time I hope will get it.

Stanford Law School conference on the tax gap

This past Saturday I was a commentator, at the Stanford Law School's tax gap conference, on a paper by Joe Bankman, Stuart Karlinsky, and Susan Morse concerning why cash businesses cheat (based on field interviews with people who spoke freely because it was confidential).

In my comments, I described the paper's chief finding as quite similar to that of a recent scientific study that addressed the question: Why do the female spiders in some species eat their mates?

As a news article on the study explains:

"[Previous s]tudies have suggested various complex evolutionary reasons involving costs and benefits to the species, sperm competition and esoteric sexual selection schemes.

"But it turns out that the motivation for this creepy cannibalism is much simpler. It's all about size. The males are much smaller. Big females eat their puny mates simply because a) they're hungry and b) they can."

That, in a nutshell, is the Bankman-Karlinsky-Morse finding. Cash businesses often cheat because (a) they're hungry (that is, they'd rather have more money than less) and (b) they can. It's not about deep feelings concerning the government, social reciprocity norms, etcetera.

Empirical evidence cited in the paper suggests that cash businesses, on average, pay tax on only half their income, versus 99% for employees. This is clearly a big efficiency problem as well as a revenue problem, amounting to a huge tax preference for one set of activities over another. Talk about excessive incentives for entrepeneurship. And while part of the under-reporting comes from hand-to-mouth small operators, it also extends well up the income scale.

Why hasn't enforcement been better? It's inherently hard to observe cash businesses' transactions, but not impossible, especially in the modern computer age. Political will and under-powered government incentives to find the revenue are important as well. Aggressive data mining operations, perhaps involving private firms that will be compensated by the Treasury based on how much their suggested approaches end up yielding, could do a lot to address the problem, and perhaps in the next few years we will see movement in this direction. Even if the reported income percentage from cash businesses were raised just a bit - say, from 50% to 60% to 70% - that would raise revenue while actually reducing economic distortion.

Once again, an economic downturn isn't the absolute best time to start doing this, but it might be an ideal time to lay the groundwork to start doing it in the next phase of the business cycle.

Audacious stunt by the Treasury Department

Today's Washington Post reveals a truly audacious stunt that the Treasury Department pulled in late September, essentially repealing on its own motion Code section 382 as applied to banks. The ruling through which it did this is available here, and it appears to be aptly described as flat-out repeal of the provision so far as banks are concerned.

Background for non-tax geeks (or tax non-geeks): companies can't deduct their net losses (you pay zero tax, but don't get a refund, whether your income for the year is zero or minus $10 billion). But losses thus rendered unusable can be carried over to other taxable years and used to offset taxable income in those other years. Loss companies therefore stagger around carrying "net operating losses" (NOLs) that they can use whenever they have offsetting positive taxable income, but in some cases they are unlikely to have such income any time soon or perhaps ever.

The NOLs are a tax asset, however, potentially making the companies (even if otherwise they are dogs) attractive to companies that have profits they would like to shelter. Section 382 greatly limits this little game by sharply reducing the ability to use the losses when you (i.e., another company) acquire a loss company.

The policy merits of this provision are decidedly mixed. For starters, why should losses be nonrefundable? An alternative approach to existing law would say that, if $10 billion of taxable income generates $3.5 billion of tax liability, then a $10 billion loss should generate a $3.5 billion negative tax, i.e., payment by the Treasury to the unfortunate taxpayer. Absent such a rule, the tax law discourages risk-taking and increases effective tax rates via a "heads we win, tails you lose" approach to tax liability. This is unambiguously bad policy (ignoring a complicating consideration that I'll add in a moment), and recent research by economist Alan Auerbach suggests that it has increasing adverse effects on corporate tax burdens because of greater dispersion in economic outcomes that makes losses more common.

There is, however, one decent rationale for loss nonrefundability. It serves as a backstop on the extent to which companies can derive tax benefit from generating fake tax shelter losses. Consider Enron. They were losing tons of money, but creating tons of positive taxable income through sham transactions that they used to generate bogus financial accounting income. They then offset the fake income with fake losses from preposterous tax shelters. But they could only use the shelters to drive their taxable income to zero. Absent nonrefundability, they could have kept on going and forced the government to pay them huge sums annually through the tax system.

Nonrefundability is thus defensible, which is not to say that it is clearly correct or unproblematic, so long as we remain unconfident that claimed tax losses are true economic losses. Section 382 then serves as a backstop by preventing the use of mergers as an endrun around the loss limit (create fake losses, then sell them to someone who can use them). It is a bad provision insofar as it tightens the constraint on using real losses that ought to be refundable, a good one insofar as it limits the abuse scenario, and a bit of a good one insofar as it prevents otherwise inefficient and socially undesirable mergers from being done simply for tax reasons (as the price of getting to buy the losses).

What's the balance of merits overall? Hard to say. But it is troubling to see the Treasury unilaterally repealing it as to banks, really beyond its proper authority (at least in normal circumstances) even if they can get away with it.

Even given the financial crisis, I don't think they should have flat out repealed section 382 as to banks. More limited relief, directed to the current financial situation and the next few years, would have made more sense and been less fundamentally improper. Perhaps policy enthusiasm for the broader repeal played a role.

Then again, given the change in Administration, it's plausible to me that the overreach will be allowed to stand just for now (again, perhaps justifiably given the financial crisis) and then reversed. And/or Congress can reverse it with deferred implementation of the rule restoring the provision's applicability to banks.

It will be interesting to see, in the years ahead, whether the Treasury reverses other Bush-era regulatory giveaways to corporate taxpayers, as there were indeed a lot of them and some at least were dubious (though often also defensible) on policy grounds. A recession might not be the right time to do any of this, but the new Administration should be around for a while, and the current Treasury has certainly left us here with a precedent for sharply reversing course, just because one wants to, when the time seems right.

Go West, young (?) man

Later today I'm headed to California, where I will first, on Saturday, comment at a Tax Gap conference on a paper by Joe Bankman, Stu Karlinsky, and Susan Morse concerning cash businesses. Then, on Monday, I will go to Loyola Los Angeles and present my paper (from the GWU conference that I blogged recently here) concerning the long-term U.S. fiscal gap. The forum is Loyola's tax colloquium, hosted by Ted Seto. That paper will also shortly be posted on SSRN, whereupon I will offer the link to it here.

I'm also planning to say something here, at some point soon, concerning U.S. tax and budget policy under the Obama Administration, given the fiscal gap on the one hand, the still-cratering economy on the other, and some of the tax policy issues that the Administration either may or must be taking on soon (e.g., outbound investment by US multinationals, expiring Bush-era tax cuts, etc.). But that will take a bit more time (though I write these entries super-fast) than I will have available for the next few days.

Obama wins

Eight years of unrelieved ugliness are almost over.

Perhaps the most important thing, in the long run, is that the Republicans return to sanity so that we have two reasonably responsible parties, as any well-functioning democracy needs. They have been stark raving mad for 14 years now, relentlessly undermining civil society and seeking to destroy honest public discourse along with the rule of law. I am very pessimistic about this in the short run, but more hopeful as one looks past, say, 2012.

Some important things, perhaps healthcare reform, arguably can be accomplished by just one party. Likewise, rejecting endless war, to the utter exclusion of moral suasion and "soft power," as our primary foreign policy tool. Other important goals, such as addressing the fiscal gap, clearly do require both parties. And still others, such as fundamental tax reform, ain't gonna happen nohow anyway.

In any event, however, kicking them out tonight was a start.

Election Day

I got to the polling place at 6:25 AM - lines around the block, hundreds of people, I've never seen anything close on Election Day even more towards prime time. But the line moved well, and in 35 minutes I was done.

The guy behind me on line was saying he hadn't voted since Perot. The woman he was talking with said she tries to vote each time, but in the past didn't always see a clear choice. "But with all the corruption, it seems like every day there's a new scandal ..."

Seven and a half long years of lies, corruption, incompetence, malevolence, and endless insults hurled at New Yorkers and others like us - indeed, at anyone around the world who isn't a small town white religious conservative Republican - are evidently more than enough to bring out the fighting spirit in this town, and elsewhere, I am sure, as well. I think people around the country who are sick to death of it all will brave long lines if they have to, even in places like New York where the statewide outcome is a given.

Nate, don't fail me now

On Election Eve, Silver at fivethirtyeight.com has it up to 98.1 percent.

This will make it easier to sleep tonight.

I'm planning to vote by 6:30 a.m., but just the once.

EARLY AFTERNOON ELECTION DAY UPDATE: If Silver's estimates are treated as reliable (and they assume lack of overall systematic bias in the polling data), Obama gets 264 electoral votes from states that the model treats him as having a 100 percent chance of winning. (Pennsylvania, with 21 electoral votes, is among those states.) He would go over 270 if he got Colorado's 9 EVs (98%), Virginia's 13 (97%), Ohio's 20 (88%), or Florida's 27 (73%). Nevada's 5 (95%) would get him to 269, presumably good enough for the win given (a) Democratic control in Congress plus (b) the persuasive significance of his popular vote edge, assuming it holds.

Obviously, these various probabilities, even if we take them at face value, are unlikely to be entirely uncorrelated.

While some might take comfort from these numbers, they also provide a panic guide if Virginia doesn't fall briskly into place in the hour after 7 pm (as this might undermine confidence in the entire projection).

The flat tax isn't flat

Freddie, a thoughtful conservative blogger not previously known to me but linked by Andrew Sullivan, says the following about McCain's "socialism" attack:

"I think we could have an election that involves a major debate about the progressive income tax, but in order to have it, we'd have to have a candidate who is actually opposed to progressive taxation. The alternative to progressive taxation is a flat tax, and John McCain is not a flat tax supporter. If this 'spread the wealth around' argument is an argument with actual substance, instead of pure political opportunism, it has to be waged by people who are actually opposed to progressive taxation, in favor of a flat tax. John McCain, as much as he may want to limit the slope of the tax line, isn't in favor of a flat tax; it's not in his policy proposals at all. Could you have a simple 'let's have a more regressive tax scheme than we currently do' argument? Sure. But that can't be this scorched-earth, progressive taxation equals socialism argument the McCain campaign is making. It just doesn't make sense to have this extremist argument when the candidate making it isn't on one of the extremes."

Freddie has a point, but he doesn't go far enough. First of all, if you are truly anti-redistributive, a uniform head tax is as good a candidate as the flat tax, and perhaps better, for your preferred tax norm. Hard to choose between them on anti-redistributionist grounds when (absent a meaningful non-government baseline) we don't really have a way to measure the relationship between benefit and rising income.

But in any case the flat tax isn't actually flat. It has a zero bracket, which means that it has a progressively graduated marginal rate structure. Historical tidbit: when the Supreme Court struck down the income tax (pre-Sixteenth Amendment) in the infamous 1896 Pollock v. Farmer's Land case, it held that a flat tax with a huge zero bracket and one very low rate (maybe 2.5% or so?) was unduly progressive, violating equal protection and indeed being, in the Court's view, socialistic.

To believe in flat rate taxation as a matter of principle - leaving aside the formalism and incoherence of a principle that's based only on the revenue side of the budget without regard to the outlay side - you just cannot believe in a zero bracket. Otherwise, as the old joke goes, we have already established what you are (i.e., a "socialist" under the inane and intellectually bankrupt pretend view of the McCain campaign) and are merely haggling over the price.

Economist Christine Romer on fiscal policy

From an interview (along with her husband David Romer) in a Federal Reserve Bank of Minneapolis publication, the Region:

"What's very striking is that we had a pretty sensible long-run fiscal view in the 1950s - the budget should be balanced over the medium run, but not each and every year and not in exceptional circumstances ....

"But views took an unfortunate turn in the 1960s and 70s. Policymakers started to believe that budget balance was not important even over an extended horizon, and that tax cuts would pay for themselves. And views took another wrong turn in the 1980s, when policymakers added notions such as the starve-the-beast hypothesis that tax cuts would force spending cuts. I think these are wrong turns that we haven't corrected yet - as evidenced by our ever-worsening long-term fiscal outlook."

The Romers' empirical work has refuted the starve-the-beast hypothesis as applied to the last few decades, and showed instead that what tax cuts lead to is subsequent tax increases. (I've also seen empirical work suggesting that tax cuts tend to be accompanied by spending increases, since fiscal discipline is either tight or slack - although here the theory is correlation with an underlying common cause, not necessarily direct causation).

Astonishing historical factoid from the Romer interview: taxes were apparently raised at the beginning of the Korean War BEFORE significant money was actually being spent on it, simply because they knew that the high expenditure levels were coming. That is like hearing tidings from another planet, inhabited by a farsighted species entirely unlike our own.