"I really like Emma, and I was glad to see her again. I don't blame her for what happened. I think she just got confused."
Emma is a moray eel, and the show is called "When Fish Attack."
Saturday, February 26, 2011
Friday, February 25, 2011
NYU Tax Policy Colloquia - Kenneth Scheve, Allison Christians
Last week (Feb. 17) our colloquium guest was Yale political scientist Kenneth Scheve, with his paper Envy and Altruism in Hard Times. The paper reports U.S. survey evidence (the next draft will also have French survey evidence that for the moment remains "in the field") showing that respondents' views about hypothetical policy changes, such as protectionism for a particular industry, a tax on bankers, or raising income tax rates to reduce the deficit, depends on the income ascribed in the question to the group that would be hit by the tax. Thus, it confirms that people not only care about the own-consumption consequences of policy changes, but also are swayed by "envy" (desire to lower the incomes of those above them) and "altruism" (desire to raise the incomes of those below them).
In keeping with the paper's title, the survey was done during "hard times" (2009), but since there's no control from, say, 2006, we don't learn anything about preferences during such times as compared to those that are seemingly non-hard.
My reactions to the paper included questioning the use of "envy" upwards as part of the explanatory framework. The term sounds as if ripped from the op-ed pages of the Wall Street Journal, though in fact Scheve takes it from a specific model in the prior poli sci literature. The evidence in the paper does nothing to support "envy" as the explanation as compared to, say, a behind-the-veil utilitarian ethos in which it's altruism up as well as down, based on the view that all people's welfare counts equally and that people generally have similar utility functions characterized by declining marginal utility.
Yesterday our speaker was Allison Christians of Wisconsin Law School (home of the current U.S. political ground zero). Her paper, Hard Law, Soft Law, and No Law: The World of International Tax Dispute Resolution, provides what one might argue is too balanced an account of the issues posed by the extreme paucity of publicly available information regarding how treaty disputes (e.g., concerning transfer pricing) involving two countries and a multinational that is active in both end up being resolved. What I mean by "too balanced" is the following. It's certainly desirable, and indeed highly preferable, to give a fair and full account of the issues presented by various tradeoffs (e.g., how public to make the terms of a dispute resolution when all the parties are averse to publication and they have some defensible as well as socially dubious grounds for preferring confidentiality). And the paper does express Christians' view that there is way too much confidentiality, permitting huge swathes of public policymaking to be done in secret, with no one but the insiders knowing what's happening). It also hints at her skepticism, which I believe she has discussed more fully elsewhere, regarding the OECD's role in developing non-binding legal norms (i.e., "soft law"). But insofar as she appears to want to make these very points very strongly, arguably the paper could push them harder (and make her point of view clearer) without either degenerating into a rant or being "unfair and unbalanced."
I am persuaded that the secrecy issue is a significant one. My main disagreement goes to the paper's characterization of the main issues likely to be raised by what is effectively extensive secret and nonprecedential lawmaking (or at least case resolution). It emphasizes concerns that OECD-type countries are being greedy and grabby of tax base at the expense of non-OECD countries, whom they want to keep in the dark regarding the extent to which all this is going on. It seems to me, however, that the non-OECD countries are doing just fine so far as transfer pricing, the use of debt, etc., are concerned to place taxable income in locations where it is lower-taxed. Thus, I would surmise that the main issue raised by the secrecy of treaty-related administrative decisions in the U.S. and other countries goes to internal politics and agency costs - what are these guys deciding on whose behalf, why, are cozy insider relationships distorting outcomes, etcetera.
In keeping with the paper's title, the survey was done during "hard times" (2009), but since there's no control from, say, 2006, we don't learn anything about preferences during such times as compared to those that are seemingly non-hard.
My reactions to the paper included questioning the use of "envy" upwards as part of the explanatory framework. The term sounds as if ripped from the op-ed pages of the Wall Street Journal, though in fact Scheve takes it from a specific model in the prior poli sci literature. The evidence in the paper does nothing to support "envy" as the explanation as compared to, say, a behind-the-veil utilitarian ethos in which it's altruism up as well as down, based on the view that all people's welfare counts equally and that people generally have similar utility functions characterized by declining marginal utility.
Yesterday our speaker was Allison Christians of Wisconsin Law School (home of the current U.S. political ground zero). Her paper, Hard Law, Soft Law, and No Law: The World of International Tax Dispute Resolution, provides what one might argue is too balanced an account of the issues posed by the extreme paucity of publicly available information regarding how treaty disputes (e.g., concerning transfer pricing) involving two countries and a multinational that is active in both end up being resolved. What I mean by "too balanced" is the following. It's certainly desirable, and indeed highly preferable, to give a fair and full account of the issues presented by various tradeoffs (e.g., how public to make the terms of a dispute resolution when all the parties are averse to publication and they have some defensible as well as socially dubious grounds for preferring confidentiality). And the paper does express Christians' view that there is way too much confidentiality, permitting huge swathes of public policymaking to be done in secret, with no one but the insiders knowing what's happening). It also hints at her skepticism, which I believe she has discussed more fully elsewhere, regarding the OECD's role in developing non-binding legal norms (i.e., "soft law"). But insofar as she appears to want to make these very points very strongly, arguably the paper could push them harder (and make her point of view clearer) without either degenerating into a rant or being "unfair and unbalanced."
I am persuaded that the secrecy issue is a significant one. My main disagreement goes to the paper's characterization of the main issues likely to be raised by what is effectively extensive secret and nonprecedential lawmaking (or at least case resolution). It emphasizes concerns that OECD-type countries are being greedy and grabby of tax base at the expense of non-OECD countries, whom they want to keep in the dark regarding the extent to which all this is going on. It seems to me, however, that the non-OECD countries are doing just fine so far as transfer pricing, the use of debt, etc., are concerned to place taxable income in locations where it is lower-taxed. Thus, I would surmise that the main issue raised by the secrecy of treaty-related administrative decisions in the U.S. and other countries goes to internal politics and agency costs - what are these guys deciding on whose behalf, why, are cozy insider relationships distorting outcomes, etcetera.
Tuesday, February 22, 2011
Rocket J. Squirrel
Teasing though affectionately meant new nicknames are OK, I figure, when you give them to a cat. A person's feelings might be hurt, but the cat doesn't know.In this spirit, we've long, for obscure historical reasons relating to my first-ever cat, the fondly remembered Puddin', referred to all of our cats as "bunnies." Part of the idea is that one imagines they'd be insulted by, or even indignant about, the label if they were still cats but also had human cognitive attributes including language capacity. It doesn't quite match what one imagines is their self-image as apex predators in the world of creatures half or less their size.
In this spirit, it recently occurred to me to accuse Seymour of actually being a squirrel. He's certainly gray enough (in the fur and flesh, perhaps a bit lighter than he looks in this photo), and arguably also un-fierce enough, albeit not active or frenzied enough (he's generally quite serene).
The next step was to dub him Rocket J. Squirrel, this being the full name of Bullwinkle's smallish flying superhero companion. As you can see from this look at Seymour pursuing his favorite activity, rockets are not exactly the first thing he brings to mind once he's had his morning meal.
Timeout for a quick basketball comment
As a Knick fan (albeit one who loathes both Dolan and Isiah), I'm skeptical about the Melo trade. Perhaps the most interesting feature was Melo's deliberately playing his hand so the Knicks would have to pay more. To me, this signals that he is either not bold enough (to risk free agency), not shrewd enough, or (most likely) not sufficiently interested in winning to be the player the Knicks need.
Thursday, February 17, 2011
Be careful what I wish for?
The Michigan Law Review, which publishes an Annual Survey of Books "related to the law," (i.e., a special issue that is book reviews only), is welcoming unsolicited submissions. Reviews must be 8,500 words or less, and the proposal guidelines are available here.
Just thinking aloud here ... I suppose Getting It is "related to the law" and might be fun for someone to review ...
Just thinking aloud here ... I suppose Getting It is "related to the law" and might be fun for someone to review ...
Wednesday, February 16, 2011
Video appearance
In honor of tax filing season, I discuss the marriage penalty in a video for Smart Money Magazine here.
Monday, February 14, 2011
Yale Law School talk on "Tax Cuts and the Impending Budget Crisis"
St. Augustine famously remarked: “Give me chastity & continence, but not yet.”
Our current U.S. budget problems verge on being exactly the same. We need “laxity” now to address an ongoing down economy & almost 10% unemployment as Americans go through painful deleveraging.
But we need budgetary “chastity & continence” – that is, a massive retrenchment to head off an unsustainable public debt explosion – in the future.
Instead, however, we often get St. Augustine in reverse – calls for austerity now, alongside little willingness to face hard long-term choices.
This is especially true on the spending side, where President Obama and the Republicans are trumpeting dueling packages of large discretionary spending cuts at a time when this could do a lot of harm to the fragile economic recovery. Yet, if you try to restrain long-term Medicare growth, you’re accused of imposing “death panels.”
On the tax side, things at least superficially look better. The Bush tax cuts were extended for two years, but not as yet permanently.
But the problem is, the Bush tax cuts are poorly designed as stimulus, and no one is confident that they’ll actually expire in two years. Indeed, their possible continuation is a big contributor to the “Alternative Fiscal Scenario” on the handout [showing an exploding relationship of public debt to GDP by 2030 or so].
The long-term forecasts imply a disastrous credit market event. Let me quote economist Len Burman on the worst case scenario:
There’s “an immediate freezing of the U.S. Treasury market altogether & an inability of the U.S. government to roll over debt that is coming due … or to fund current activities…. No one is willing to lend to the U.S. government at any interest rate. Essentially, the Treasury holds a debt auction and no one shows up.”
The upshot might be that the Federal Reserve Bank decides or is told to print money, and uses it to buy the Treasury bonds, giving the government money to spend but via Weimar Germany-style finance.
All this would come with worldwide rejection of the dollar as a valuable currency, hyper-inflation, and massive waves of financial failure by firms and individuals holding U.S. debt that has now lost value. It would make the 2008 financial crisis look like a Sunday school picnic.
Plus, the U.S. government would be unable to provide fiscal backup as it did in 2008, if it had itself effectively become a governmental version of Lehman Brothers. And the shock to the entire world economy would be far greater than when a smaller country like Greece runs into such problems. The feedback effects of this would only increase the economic carnage in the U.S., while also potentially undermining global political stability.
But how worried should we be that this will happen?
Hypothetical projections like the one on the handout are just what I call “statements about statements.” They compute expected future cash flows under someone’s interpretation of current policy. If that’s easy to change, no sweat. Indeed, if current policy isn’t sticky at all, then the fact that it’s currently leading us off a cliff would be just as trivial as a car’s GPS system currently directing you due east towards the Long Island Sound, when you know that at some point you will need to head due south.
But when you look at the causes of the long-term problem, and the factors that make current policy sticky, you start to worry a bit more. I see 3 problems, one nestled inside the next like Russian Matryoshka dolls.
The main apparent cause of the problem is demographic and technological change. People are living longer, there’s been somewhat of a baby bust, and healthcare costs are growing faster than the economy although yielding genuine improvements in healthcare outcomes.
But these trends are well-known. In principle they’d be easy to adjust for, even if Congress hasn’t gotten around to it yet. Just slow the spending growth a bit and raise the revenue path a bit, and you can avoid a budget catastrophe, no matter what the forecasts look like now.
The problem is, it’s hard to believe our political system can handle this. I believe it’s grown seriously dysfunctional and will be radically unable to respond rationally. So we get to the second doll. In a sense, it’s not really a demographics and technology problem, but a political economy problem.
This is a big change. 30 years ago, when things were far less dire, Congress made bipartisan budget deals that either reduced the deficit or addressed other important and controversial issues, in 1982, 1983, 1984, 1985, 1986, 1988, and 1990.
Mainly the Republicans have changed since then. This is an important sociological story that remains poorly understood, and with likely implications for how Democrats play the game. (They don’t want to repeat the scenario of a Clinton-era surplus feeding subsequent Republican tax cuts.)
The problem is not just “partisanship” but that social and intellectual discord are so high now, undermining cooperative norms & yielding pervasive chicken games at the political party, interest group, & individual voter levels.
But shouldn’t financial markets respond to this? You’d think the bond markets would get nervous and that U.S. borrowing rates would gradually rise.
While this wouldn’t be good news as such, as least it would offer a signal, helping to encourage a course adjustment before the debt-to-GDP ratio reaches the stratosphere.
But the “bond vigilantes” have been silent about the long-term problem. This is partly from the short-term flight to quality – for example, would you rather hold Euros than dollars?
But is a wise and farsighted optimism also at work? Who’s to say the political system won’t solve things in time?
“The markets know best” might have been a more credible position before the 2008 crisis. But we’ve had repeated bubbles lately – e.g., Internet stocks before the great real estate crash.
It’s plausible that bubbles are a fundamental structural feature of today’s financial markets. They may be powerfully reinforced by key market players’ incentives, not just by myopia. (The issues here might include agency cost problems in public companies, reduced financial transparency in an age of derivatives, maldesigned incentive compensation schemes, and the fact that the players need not count on staying around for very long if they are getting rich so fast.) All this raises the prospects for a very bumpy hard landing, as the financial markets respond to the U.S. debt situation only belatedly and extremely discontinuously.
So arguably the third and innermost Matryoshka doll is a financial markets problem.
What are the tax policy implications?
At some point, taxes must and will go up. So in a sense the Bush tax cuts are toast, no matter what Congress does just before or after the 2012 elections.
Now, it’s true that we could get a long way by repealing tax expenditures. And if those rules are actually “spending through the tax code,” which we can discuss in the Q&A if people are interested, then repealing them wouldn’t really be a tax increase in substance – although people would certainly experience it as one. But repealing tax expenditures is very hard to do politically even in more harmonious times than these.
What else could happen on the tax side as the fiscal crisis approaches? Let me quickly mention some implications both for new tax instruments and for existing ones.
New taxes – there are plenty of ideas out there. They include value-added taxes (VATs), carbon taxes, and Tobin or turnover taxes on financial transactions. I’m personally a fan of the first two but not the third, and could discuss why in the Q&A. But clearly our revenue needs push in favor of all these ideas, whether they’re good or bad, so we’re likely to hear more about them at some point.
Existing taxes – I’m very skeptical about the current desirability of 1986-style tax reform, in which you broaden the base but then give away most or all of the budgetary gain by cutting tax rates. The repeal of tax expenditures should mainly finance narrowing the budget gap – not sharply cutting tax rates for individuals when we really can’t afford it.
[I here mentioned possibly disagreeing with my co-panelist Michael Graetz on his plan to use VAT revenues to greatly scale back the income tax. Though I can’t quote him or definitely confirm this, I interpret his view on this issue as being that revenue neutrality might merely be step 1, at the tax reform stage, with revenue-raising perhaps to come later on.]
On the business side, unfortunately, there are some good ideas that cost money. In particular, lowering the U.S. corporate rate because of global tax competition pressures, and eliminating most of the existing U.S. tax burden on U.S. companies’ foreign source income. For that matter, if we could, it would be nice to move closer to corporate integration, with corporate income being taxed only once, rather than duplicatively at the entity and shareholder levels. This might involve an “allowance for corporate equity,” so that equity as well as debt generates entity-level deductions.
But when your wallet is bare, it’s a lot harder to do these things – especially if we can’t or won’t make other, harder choices.
[I then declined to spread any more doom and gloom on Valentine’s Day, at least before the Q&A.]
Our current U.S. budget problems verge on being exactly the same. We need “laxity” now to address an ongoing down economy & almost 10% unemployment as Americans go through painful deleveraging.
But we need budgetary “chastity & continence” – that is, a massive retrenchment to head off an unsustainable public debt explosion – in the future.
Instead, however, we often get St. Augustine in reverse – calls for austerity now, alongside little willingness to face hard long-term choices.
This is especially true on the spending side, where President Obama and the Republicans are trumpeting dueling packages of large discretionary spending cuts at a time when this could do a lot of harm to the fragile economic recovery. Yet, if you try to restrain long-term Medicare growth, you’re accused of imposing “death panels.”
On the tax side, things at least superficially look better. The Bush tax cuts were extended for two years, but not as yet permanently.
But the problem is, the Bush tax cuts are poorly designed as stimulus, and no one is confident that they’ll actually expire in two years. Indeed, their possible continuation is a big contributor to the “Alternative Fiscal Scenario” on the handout [showing an exploding relationship of public debt to GDP by 2030 or so].
The long-term forecasts imply a disastrous credit market event. Let me quote economist Len Burman on the worst case scenario:
There’s “an immediate freezing of the U.S. Treasury market altogether & an inability of the U.S. government to roll over debt that is coming due … or to fund current activities…. No one is willing to lend to the U.S. government at any interest rate. Essentially, the Treasury holds a debt auction and no one shows up.”
The upshot might be that the Federal Reserve Bank decides or is told to print money, and uses it to buy the Treasury bonds, giving the government money to spend but via Weimar Germany-style finance.
All this would come with worldwide rejection of the dollar as a valuable currency, hyper-inflation, and massive waves of financial failure by firms and individuals holding U.S. debt that has now lost value. It would make the 2008 financial crisis look like a Sunday school picnic.
Plus, the U.S. government would be unable to provide fiscal backup as it did in 2008, if it had itself effectively become a governmental version of Lehman Brothers. And the shock to the entire world economy would be far greater than when a smaller country like Greece runs into such problems. The feedback effects of this would only increase the economic carnage in the U.S., while also potentially undermining global political stability.
But how worried should we be that this will happen?
Hypothetical projections like the one on the handout are just what I call “statements about statements.” They compute expected future cash flows under someone’s interpretation of current policy. If that’s easy to change, no sweat. Indeed, if current policy isn’t sticky at all, then the fact that it’s currently leading us off a cliff would be just as trivial as a car’s GPS system currently directing you due east towards the Long Island Sound, when you know that at some point you will need to head due south.
But when you look at the causes of the long-term problem, and the factors that make current policy sticky, you start to worry a bit more. I see 3 problems, one nestled inside the next like Russian Matryoshka dolls.
The main apparent cause of the problem is demographic and technological change. People are living longer, there’s been somewhat of a baby bust, and healthcare costs are growing faster than the economy although yielding genuine improvements in healthcare outcomes.
But these trends are well-known. In principle they’d be easy to adjust for, even if Congress hasn’t gotten around to it yet. Just slow the spending growth a bit and raise the revenue path a bit, and you can avoid a budget catastrophe, no matter what the forecasts look like now.
The problem is, it’s hard to believe our political system can handle this. I believe it’s grown seriously dysfunctional and will be radically unable to respond rationally. So we get to the second doll. In a sense, it’s not really a demographics and technology problem, but a political economy problem.
This is a big change. 30 years ago, when things were far less dire, Congress made bipartisan budget deals that either reduced the deficit or addressed other important and controversial issues, in 1982, 1983, 1984, 1985, 1986, 1988, and 1990.
Mainly the Republicans have changed since then. This is an important sociological story that remains poorly understood, and with likely implications for how Democrats play the game. (They don’t want to repeat the scenario of a Clinton-era surplus feeding subsequent Republican tax cuts.)
The problem is not just “partisanship” but that social and intellectual discord are so high now, undermining cooperative norms & yielding pervasive chicken games at the political party, interest group, & individual voter levels.
But shouldn’t financial markets respond to this? You’d think the bond markets would get nervous and that U.S. borrowing rates would gradually rise.
While this wouldn’t be good news as such, as least it would offer a signal, helping to encourage a course adjustment before the debt-to-GDP ratio reaches the stratosphere.
But the “bond vigilantes” have been silent about the long-term problem. This is partly from the short-term flight to quality – for example, would you rather hold Euros than dollars?
But is a wise and farsighted optimism also at work? Who’s to say the political system won’t solve things in time?
“The markets know best” might have been a more credible position before the 2008 crisis. But we’ve had repeated bubbles lately – e.g., Internet stocks before the great real estate crash.
It’s plausible that bubbles are a fundamental structural feature of today’s financial markets. They may be powerfully reinforced by key market players’ incentives, not just by myopia. (The issues here might include agency cost problems in public companies, reduced financial transparency in an age of derivatives, maldesigned incentive compensation schemes, and the fact that the players need not count on staying around for very long if they are getting rich so fast.) All this raises the prospects for a very bumpy hard landing, as the financial markets respond to the U.S. debt situation only belatedly and extremely discontinuously.
So arguably the third and innermost Matryoshka doll is a financial markets problem.
What are the tax policy implications?
At some point, taxes must and will go up. So in a sense the Bush tax cuts are toast, no matter what Congress does just before or after the 2012 elections.
Now, it’s true that we could get a long way by repealing tax expenditures. And if those rules are actually “spending through the tax code,” which we can discuss in the Q&A if people are interested, then repealing them wouldn’t really be a tax increase in substance – although people would certainly experience it as one. But repealing tax expenditures is very hard to do politically even in more harmonious times than these.
What else could happen on the tax side as the fiscal crisis approaches? Let me quickly mention some implications both for new tax instruments and for existing ones.
New taxes – there are plenty of ideas out there. They include value-added taxes (VATs), carbon taxes, and Tobin or turnover taxes on financial transactions. I’m personally a fan of the first two but not the third, and could discuss why in the Q&A. But clearly our revenue needs push in favor of all these ideas, whether they’re good or bad, so we’re likely to hear more about them at some point.
Existing taxes – I’m very skeptical about the current desirability of 1986-style tax reform, in which you broaden the base but then give away most or all of the budgetary gain by cutting tax rates. The repeal of tax expenditures should mainly finance narrowing the budget gap – not sharply cutting tax rates for individuals when we really can’t afford it.
[I here mentioned possibly disagreeing with my co-panelist Michael Graetz on his plan to use VAT revenues to greatly scale back the income tax. Though I can’t quote him or definitely confirm this, I interpret his view on this issue as being that revenue neutrality might merely be step 1, at the tax reform stage, with revenue-raising perhaps to come later on.]
On the business side, unfortunately, there are some good ideas that cost money. In particular, lowering the U.S. corporate rate because of global tax competition pressures, and eliminating most of the existing U.S. tax burden on U.S. companies’ foreign source income. For that matter, if we could, it would be nice to move closer to corporate integration, with corporate income being taxed only once, rather than duplicatively at the entity and shareholder levels. This might involve an “allowance for corporate equity,” so that equity as well as debt generates entity-level deductions.
But when your wallet is bare, it’s a lot harder to do these things – especially if we can’t or won’t make other, harder choices.
[I then declined to spread any more doom and gloom on Valentine’s Day, at least before the Q&A.]
Returning to old haunts
Today I went to Yale Law School (a simple day trip from NYC) for a lunch talk on tax cuts and the impending budget crisis. It was sponsored by a student organization, the American Constitution Society, and I'm pretty sure was my first-ever appearance at another law school by invitation of a student group, rather than someone on the faculty. I suppose no Federalist Society fave would be able to say this (though I have spoken at a Federalist Society event in Washington).
To my surprise verging on shock, the head count for this talk (where Michael Graetz also appeared) was 55, which looked all the bigger in the event's small room. It was good to see so many interested people. But I don't know for sure how strong a data point this is in support of the claim that a scarcity of tenured, in-house, full-time tax faculty tends to raise turnout by leaving unmet demand, rather than - as I would have posited before seeing the head count - to lower it through lack of encouragement.
It was nice to see old haunts again - I have not often made it to New Haven since graduating in 1981 - though sad in a way to learn that the courtyard where I spent much of my last two spring semesters playing whiffle ball has been converted from dorm rooms to offices.
I'll shortly post an approximate version of my remarks (which resembled the comments I meant to give in Boca Raton a couple of weeks ago before the weather intervened). But for now, why not enter more fully into the auld lang syne spirit of things by reproducing the lyrics of a song that I performed (!! - albeit with guitarist and backup vocalist) at the YLS student talent show, when I was either a 2nd year or 3rd year law student:
NERD NERD NERD (TO THE TUNE OF THE BEACH BOYS' "FUN FUN FUN")
I've got this real good friend who's going through law school on loan, yeah
He's always working in his room but he doesn't like to answer the phone, yeah
You try to start a conversation and he says "Hey, leave me alone," yeah
He'll be a NERD NERD NERD till Dean Dauer takes the money away.
In Calabresi's class, his hand it always goes up, yeah
In policy discussions he doesn't know how to shut up, yeah
You can see him in the library busily reading F. Supp., yeah
He'll be a NERD NERD NERD till Dean Dauer takes the money away.
Well, the money ran out and Dean Dauer said to hit the road, now
'Cause they found out that he lied about the money that he said that he owed, now
So now he just parties and at night he hangs out at Toad's, now
He was a NERD NERD NERD till Dean Dauer took the money away.
[Ooh-ooh, etc.]
I think my attitude was different in those days.
To my surprise verging on shock, the head count for this talk (where Michael Graetz also appeared) was 55, which looked all the bigger in the event's small room. It was good to see so many interested people. But I don't know for sure how strong a data point this is in support of the claim that a scarcity of tenured, in-house, full-time tax faculty tends to raise turnout by leaving unmet demand, rather than - as I would have posited before seeing the head count - to lower it through lack of encouragement.
It was nice to see old haunts again - I have not often made it to New Haven since graduating in 1981 - though sad in a way to learn that the courtyard where I spent much of my last two spring semesters playing whiffle ball has been converted from dorm rooms to offices.
I'll shortly post an approximate version of my remarks (which resembled the comments I meant to give in Boca Raton a couple of weeks ago before the weather intervened). But for now, why not enter more fully into the auld lang syne spirit of things by reproducing the lyrics of a song that I performed (!! - albeit with guitarist and backup vocalist) at the YLS student talent show, when I was either a 2nd year or 3rd year law student:
NERD NERD NERD (TO THE TUNE OF THE BEACH BOYS' "FUN FUN FUN")
I've got this real good friend who's going through law school on loan, yeah
He's always working in his room but he doesn't like to answer the phone, yeah
You try to start a conversation and he says "Hey, leave me alone," yeah
He'll be a NERD NERD NERD till Dean Dauer takes the money away.
In Calabresi's class, his hand it always goes up, yeah
In policy discussions he doesn't know how to shut up, yeah
You can see him in the library busily reading F. Supp., yeah
He'll be a NERD NERD NERD till Dean Dauer takes the money away.
Well, the money ran out and Dean Dauer said to hit the road, now
'Cause they found out that he lied about the money that he said that he owed, now
So now he just parties and at night he hangs out at Toad's, now
He was a NERD NERD NERD till Dean Dauer took the money away.
[Ooh-ooh, etc.]
I think my attitude was different in those days.
Friday, February 11, 2011
February 10 NYU Tax Policy Colloquium (with Mick Keen), part 3
Before reading this, you may want to check out Part 1 and Part 2 of this multi-part post.
Okay, I've described some settings where the taxes versus regulation choice may arise for addressing the problems with financial institutions that triggered the 2008 financial collapse. Mick Keen's paper offers a very interesting, if somewhat tersely described, initial analysis of how to think about the issue. (A more technical companion paper with a formal model makes the underlying analysis clearer, but may not be available on-line.) It addresses what I call the "cash in the strongbox" issue, but potentially could be deployed on the other regulatory issues as well.
If you check out Figure 1 on p. 18 of the paper, you will see something that looks a bit like supply and demand curves. But the horizontal axis is the amount of regulatory capital that a bank maintains (in my rendition, the percentage of its cash that remains in the strongbox). The vertical axis is the marginal cost or benefit - as the case may be - that would be derived from the next dollar of increased cash in the strong box. The Figure has two lines. The downward sloping one is marginal external benefit (MEB) - the marginal benefit to everyone else, as cash in the strongbox increases, of having yet another dollar in there. It slopes downward because each dollar helps a bit less than the one before, as the amount of cash hand (and thus the demand from one's depositors that can readily be satisfied) increases. The upward sloping one is private marginal cost (PMC) - the marginal cost to the banker for each additional dollar in the strongbox.
A bit more on the determinants of PMC: though not stated in the paper, I think of it as equaling r - b, where r is the expected return the banker could have earned by investing that dollar instead of keeping it in the strongbox, and b is the benefit to the banker of making a disastrous bank run less likely by having something in there. Since bankers, in the model (and in reality) don't want bank runs (even if they don't dislike them enough), r - b is negative where cash in the strongbox stands at zero. Thus, even absent regulation, they'd keep something there (although only the amount shown by the point where PMC crosses the horizontal axis).
PMC is downward sloping for two possible reasons. First, as noted in the paper, each dollar does less at the margin to reduce the prospects of a bank run than the dollar before it. Thus, PMC is downward-sloping for exactly the same reason that MEB is upward sloping (and opposite in direction because we are drawing it as a negative cost, rather than as a positive benefit). Second, perhaps the banker has a range of investment opportunities that he ranks from best to worst. Leaving aside the risk issue for the moment, he ranks them from the opportunity with the highest r to that with the lowest r. So the first dollar in the strongbox only deprives him of his least-favorite investment opportunity, among those for which he otherwise potentially had enough cash. But as additional dollars are taken out of his sweaty hands and placed in the strongbox, increasingly appealing investment opportunities, with ever-higher r's, start evaporating. So PMC is upward because, as the amount of cash in the strongbox increases, r gets higher and b gets lower for each additional dollar. So the marginal cost to the banker of keeping more cash in the strongbox turns positive and then keeps rising.
The socially optimal amount of cash required to stay in the strongbox is shown by the point where PMC and MEB cross. Require less, and the banker is investing dollars that yield less expected benefit to him than the expected cost that is being imposed on everyone else. Require more, and he is losing the use of cash that would have benefited him more than the cost being imposed on others. The optimal risk of a bank run, of course, is not zero, given that this would require effectively shutting down the financial sector (by banning all bank loans) and with it most of the economy.
With perfect information, you can get to this point (as Figure 1 shows) either by simply mandating the right amount of cash in the strongbox, or by relatively subsidizing such cash, such as by taxing everything that comes out of the strongbox. If the strongbox subsidy (i.e., the avoided tax) is set just right, you get the right amount of regulatory capital.
So this is a lot like, say, the carbon tax versus permits question, where you can get the same result, which with perfect information is right in either case, either by setting the carbon tax exactly right or by issuing exactly the right amount of permits. Obviously, the point of greater interest is what to do once you realize that you don't have perfect information - a point that may hold even more strongly in the bank regulatory than the carbon tax setting. (This is not to minimize the extreme difficulties presented both by alternative climate models and by the difficulty of evaluating the human welfare cost of a given set of climate changes - but at least the carbon tax setting is conceptually a bit clearer.)
One important difference that I put in my notes for the session is that PMC and MEB will tend to shift together with certain changes in information. For example, if a bank run is starting to become more likely, PMC shifts downward (as shown in Figure 1), because the bankers now want to keep a bit more capital on hand. (Again, PMC = r - b, and here we've increased b.) But this should also cause MEB to shift upward, since if a bank run is more likely the expected benefit to the public of each expected dollar in the strongbox goes up. Nothing similar would be likely to hold in a pollution version of the same chart, which would be comparing the private cost to the business of carbon abatement versus the external benefit to the public of reduced global warming. The polluter is effectively entirely indifferent to contributing global warming (since his marginal effect on it will be so small), and thus would do zero abatement absent regulation or taxes.
On the other hand, PMC might also shift downward because r declines. That is, the set of available investment opportunities grows less appealing. This may not imply any change in MEB.
OK, at last on to the Weitszman analysis that the paper deploys. Weitzman shows, to put it as unintuitively as possible, that the right answer depends on the relative slope of the two lines, here MEB and PMC, in the region where we are uncertain about getting it right. But let's make that more intuitive by giving an example from an early footnote in the Weitzman paper describing a case where we may prefer quantity to price regulation. "Suppose that fulfillment of an important emergency rescue operation demands a certain number of airlplane flights. It would be inefficient to just order airline companies or branches of the military to supply a certain number of the needed aircraft, because marginal (opportunity) costs would almost certainly vary all over the place. Nevertheless, such an approach would undoubtedly be preferable to the efficient procedure of naming a price for plane services. Under profit maximization, overall output would be uncertain, with too few planes spelling disaster and too many being superfluous."
Weitzman's point is that falling just short of having enough planes would be enormously costly - it would doom the rescue operation - whereas having too many planes is simply garden-variety wasteful. Another way of putting this would be that MEB is extremely steep as we move towards having just enough planes. Plus, presumably we know enough about this point that quantity regulation would not be done entirely in the dark. So in a case like this, you may want to require at least a sufficient quantity to get past the point where you are confident that MEB is still very steep.
(By the way, we can do better still in the Weitzman example by using the equivalent of cap and trade - that is, by assigning the obligation to deploy rescue planes just as above, but permitting the obligors to pay others to perform the same services instead. In a well-functioning market, the resulting transactions would ensure that those for whom the cost of sending rescue flights was cheapest would end up being the ones who were deployed.)
Back to regulatory capital or required cash in the strongbox. This analysis arguably rationalizes using command regulation to require some minimum capital, up to the point where it is no longer clear that one is quite significantly reducing the risk of a bank run. One doesn't want to take the risk of ending up with less regulatory capital than one believes is the minimum necessary to reduce bank run risk to acceptable levels. But beyond that point, one is in the realm where taxes and regulation are both plausible players.
Keen's paper also notes the possibility that we might consider trying to create a situation where high-quality firms can buy out of some of their capital requirements, by paying an otherwise avoidable tax. This would be good sorting if the firms that elected to pay the tax were those for whom b is especially low because they are well-managed, or for whom r is especially high and hence the opportunity cost of keeping cash in the strongbox is greater. One can convert this into a tradable permits-style scenario by positing that one bank is permitted to keep less capital on hand if it pays a second bank to agree to keep more on hand (although it is unclear how much this helps, if MEB depends on per-firm rather than sector-wide capital inadequacy).
While clearly worth thinking about, the problem is that we might not end up with the right sorting. For example, suppose that the firms that opt out of having more regulatory capital are those with a fake high r - that is, one that reflects their ability to make risky "heads I win, tails you lose" bets that don't actually have a higher social return.
Still, requiring regulatory capital PLUS a tax on the stuff that leaves the strongbox is an interesting regulatory approach to consider, if it can reasonably be operationalized. Likewise, for the arguably bigger problem of financial firms making unduly risk bets, one could combine an FAT approach with Glass-Steagall style regulatory bans (although, for the latter, keep in mind that in today's world we need to worry about a wide range of "non-bank banks" that perform important financial intermediary and transaction services). And likewise as well, perhaps, for "too big to fail" issues.
All this falls depressingly short of being anywhere near a constructive and practical approach to taxing and regulating the financial sector. Not to mention that, at least in the U.S. it's pretty hard to do anything that financial firms don't like, especially if it's called a tax. It's their country, the rest of us just live in it. So we may have to wait for the next horrendous crisis, leaving aside the possibility that we'll get a U.S. government fiscal implosion first.
Still, perhaps Keen's paper offers a bit of intellectual progress, regarding how to think about these very complicated, important, and yet in a sense distressingly amorphous, issues.
Okay, I've described some settings where the taxes versus regulation choice may arise for addressing the problems with financial institutions that triggered the 2008 financial collapse. Mick Keen's paper offers a very interesting, if somewhat tersely described, initial analysis of how to think about the issue. (A more technical companion paper with a formal model makes the underlying analysis clearer, but may not be available on-line.) It addresses what I call the "cash in the strongbox" issue, but potentially could be deployed on the other regulatory issues as well.
If you check out Figure 1 on p. 18 of the paper, you will see something that looks a bit like supply and demand curves. But the horizontal axis is the amount of regulatory capital that a bank maintains (in my rendition, the percentage of its cash that remains in the strongbox). The vertical axis is the marginal cost or benefit - as the case may be - that would be derived from the next dollar of increased cash in the strong box. The Figure has two lines. The downward sloping one is marginal external benefit (MEB) - the marginal benefit to everyone else, as cash in the strongbox increases, of having yet another dollar in there. It slopes downward because each dollar helps a bit less than the one before, as the amount of cash hand (and thus the demand from one's depositors that can readily be satisfied) increases. The upward sloping one is private marginal cost (PMC) - the marginal cost to the banker for each additional dollar in the strongbox.
A bit more on the determinants of PMC: though not stated in the paper, I think of it as equaling r - b, where r is the expected return the banker could have earned by investing that dollar instead of keeping it in the strongbox, and b is the benefit to the banker of making a disastrous bank run less likely by having something in there. Since bankers, in the model (and in reality) don't want bank runs (even if they don't dislike them enough), r - b is negative where cash in the strongbox stands at zero. Thus, even absent regulation, they'd keep something there (although only the amount shown by the point where PMC crosses the horizontal axis).
PMC is downward sloping for two possible reasons. First, as noted in the paper, each dollar does less at the margin to reduce the prospects of a bank run than the dollar before it. Thus, PMC is downward-sloping for exactly the same reason that MEB is upward sloping (and opposite in direction because we are drawing it as a negative cost, rather than as a positive benefit). Second, perhaps the banker has a range of investment opportunities that he ranks from best to worst. Leaving aside the risk issue for the moment, he ranks them from the opportunity with the highest r to that with the lowest r. So the first dollar in the strongbox only deprives him of his least-favorite investment opportunity, among those for which he otherwise potentially had enough cash. But as additional dollars are taken out of his sweaty hands and placed in the strongbox, increasingly appealing investment opportunities, with ever-higher r's, start evaporating. So PMC is upward because, as the amount of cash in the strongbox increases, r gets higher and b gets lower for each additional dollar. So the marginal cost to the banker of keeping more cash in the strongbox turns positive and then keeps rising.
The socially optimal amount of cash required to stay in the strongbox is shown by the point where PMC and MEB cross. Require less, and the banker is investing dollars that yield less expected benefit to him than the expected cost that is being imposed on everyone else. Require more, and he is losing the use of cash that would have benefited him more than the cost being imposed on others. The optimal risk of a bank run, of course, is not zero, given that this would require effectively shutting down the financial sector (by banning all bank loans) and with it most of the economy.
With perfect information, you can get to this point (as Figure 1 shows) either by simply mandating the right amount of cash in the strongbox, or by relatively subsidizing such cash, such as by taxing everything that comes out of the strongbox. If the strongbox subsidy (i.e., the avoided tax) is set just right, you get the right amount of regulatory capital.
So this is a lot like, say, the carbon tax versus permits question, where you can get the same result, which with perfect information is right in either case, either by setting the carbon tax exactly right or by issuing exactly the right amount of permits. Obviously, the point of greater interest is what to do once you realize that you don't have perfect information - a point that may hold even more strongly in the bank regulatory than the carbon tax setting. (This is not to minimize the extreme difficulties presented both by alternative climate models and by the difficulty of evaluating the human welfare cost of a given set of climate changes - but at least the carbon tax setting is conceptually a bit clearer.)
One important difference that I put in my notes for the session is that PMC and MEB will tend to shift together with certain changes in information. For example, if a bank run is starting to become more likely, PMC shifts downward (as shown in Figure 1), because the bankers now want to keep a bit more capital on hand. (Again, PMC = r - b, and here we've increased b.) But this should also cause MEB to shift upward, since if a bank run is more likely the expected benefit to the public of each expected dollar in the strongbox goes up. Nothing similar would be likely to hold in a pollution version of the same chart, which would be comparing the private cost to the business of carbon abatement versus the external benefit to the public of reduced global warming. The polluter is effectively entirely indifferent to contributing global warming (since his marginal effect on it will be so small), and thus would do zero abatement absent regulation or taxes.
On the other hand, PMC might also shift downward because r declines. That is, the set of available investment opportunities grows less appealing. This may not imply any change in MEB.
OK, at last on to the Weitszman analysis that the paper deploys. Weitzman shows, to put it as unintuitively as possible, that the right answer depends on the relative slope of the two lines, here MEB and PMC, in the region where we are uncertain about getting it right. But let's make that more intuitive by giving an example from an early footnote in the Weitzman paper describing a case where we may prefer quantity to price regulation. "Suppose that fulfillment of an important emergency rescue operation demands a certain number of airlplane flights. It would be inefficient to just order airline companies or branches of the military to supply a certain number of the needed aircraft, because marginal (opportunity) costs would almost certainly vary all over the place. Nevertheless, such an approach would undoubtedly be preferable to the efficient procedure of naming a price for plane services. Under profit maximization, overall output would be uncertain, with too few planes spelling disaster and too many being superfluous."
Weitzman's point is that falling just short of having enough planes would be enormously costly - it would doom the rescue operation - whereas having too many planes is simply garden-variety wasteful. Another way of putting this would be that MEB is extremely steep as we move towards having just enough planes. Plus, presumably we know enough about this point that quantity regulation would not be done entirely in the dark. So in a case like this, you may want to require at least a sufficient quantity to get past the point where you are confident that MEB is still very steep.
(By the way, we can do better still in the Weitzman example by using the equivalent of cap and trade - that is, by assigning the obligation to deploy rescue planes just as above, but permitting the obligors to pay others to perform the same services instead. In a well-functioning market, the resulting transactions would ensure that those for whom the cost of sending rescue flights was cheapest would end up being the ones who were deployed.)
Back to regulatory capital or required cash in the strongbox. This analysis arguably rationalizes using command regulation to require some minimum capital, up to the point where it is no longer clear that one is quite significantly reducing the risk of a bank run. One doesn't want to take the risk of ending up with less regulatory capital than one believes is the minimum necessary to reduce bank run risk to acceptable levels. But beyond that point, one is in the realm where taxes and regulation are both plausible players.
Keen's paper also notes the possibility that we might consider trying to create a situation where high-quality firms can buy out of some of their capital requirements, by paying an otherwise avoidable tax. This would be good sorting if the firms that elected to pay the tax were those for whom b is especially low because they are well-managed, or for whom r is especially high and hence the opportunity cost of keeping cash in the strongbox is greater. One can convert this into a tradable permits-style scenario by positing that one bank is permitted to keep less capital on hand if it pays a second bank to agree to keep more on hand (although it is unclear how much this helps, if MEB depends on per-firm rather than sector-wide capital inadequacy).
While clearly worth thinking about, the problem is that we might not end up with the right sorting. For example, suppose that the firms that opt out of having more regulatory capital are those with a fake high r - that is, one that reflects their ability to make risky "heads I win, tails you lose" bets that don't actually have a higher social return.
Still, requiring regulatory capital PLUS a tax on the stuff that leaves the strongbox is an interesting regulatory approach to consider, if it can reasonably be operationalized. Likewise, for the arguably bigger problem of financial firms making unduly risk bets, one could combine an FAT approach with Glass-Steagall style regulatory bans (although, for the latter, keep in mind that in today's world we need to worry about a wide range of "non-bank banks" that perform important financial intermediary and transaction services). And likewise as well, perhaps, for "too big to fail" issues.
All this falls depressingly short of being anywhere near a constructive and practical approach to taxing and regulating the financial sector. Not to mention that, at least in the U.S. it's pretty hard to do anything that financial firms don't like, especially if it's called a tax. It's their country, the rest of us just live in it. So we may have to wait for the next horrendous crisis, leaving aside the possibility that we'll get a U.S. government fiscal implosion first.
Still, perhaps Keen's paper offers a bit of intellectual progress, regarding how to think about these very complicated, important, and yet in a sense distressingly amorphous, issues.
February 10 NYU Tax Policy Colloquium (with Mick Keen), part 2
Before reading this, you may want to check out Part 1 of this multi-part post.
Part 1 left the damsel on the railroad tracks (so to speak) in the sense that I had mentioned Weitzman's "prices versus quantities" framework as giving us a potential handle on how to address the problems with financial institutions that led to their unleashing devastating harm on the world economy in 2008.
Before going further, however, I should note a certain Rashomon quality to discussions of what wrong. In these discussions (whether or not in Rashomon), often all the interpretations appear to be correct. E.g., should we think the banks were mispricing risky assets because they had bad incentives ("heads I win, tails you lose") that led them to embrace investments with an above-normal return in most circumstances but a hideous downside from "tail risk" that was bound to manifest sooner or later? I'm inclined to say yes. But wait a second, wasn't there a bubble going on, such that everyone was mispricing the bubble assets, and the key thing about a bubble is that it's hard to be sure one really exists until it in fact pops. Not a bad theory either.
But moving right along: what are some of the tax versus regulatory choices that we face with regard financial institutions? (From now on, I'll call them "banks" although I mean financial institutions more generally.) Here are a few:
--How much regulatory capital should banks be required to keep on hand? In the notes I prepared for the colloquium discussion, I dramatized this as the little bank in It's a Wonderful Life deciding how much cash to keep in the strongbox so they could satisfy any demand depositors who came in. In a more realistic modern setting, it has to do with "regulatory capital" that is effectively equity rather than debt, hence generating no right to demand either one's principal back or periodic payments. A banker who was utterly indifferent to the risk of a bank run would want to keep zero in the strongbox so that he could invest every penny he had at an expected positive rate of return. More realistically, while he might want to keep something in the strongbox so that the bank doesn't collapse the moment the first depositor shows up, the amount he decided to keep there might be socially too low, as he would give weight only to his aversion, if any, to having the bank collapse, as opposed to a full measure of the social harm this would cause. And even if the depositors can monitor what he does, everyone else who would be affected presumably can't.
--How riskily should banks be allowed to invest? My notes analogized this to the question of whether they should be restricted to making safe but boring loans, or instead allowed to go to Vegas and bet everything on red (apart from the cash in the strongbox). Here we face a familiar incentive problem, since bankers may have an incentive to make "heads I win, tails you lose" bets that are only appealing because they don't face the downside. (The incentive may arise either from their owning shares in the banks they operate, or from incentive compensation packages.) The same moral hazard issues arises, for example, whenever a borrower has limited liability (whether literally, as in the case of a corporation, or effectively, as in the case of an individual who might end up declaring bankruptcy). But for banks the issue may be especially dire given both (a) the externality problem, extending beyond depositors, and (b) the fact that derivatives permit bankers to make huge bets, even with very limited capital, that are very opaque so far as any potential monitor is concerned.
--What about other decisions that may increase systemic risk, such as becoming "too big to fail" and thereby increasing the failure externality, with the possible consequence that the government will have to become an implicit guarantor (thus substituting an increased bailout externality for some or all of the added failure externality).
Each of these three margins can be addressed through "quantity" regulation (using that term very broadly) and/or by a "pricing" approach that uses taxes or subsidies.
Thus, in addition to or instead of requiring a given level of "cash in the strongbox" via capital adequacy regulations such as those that have existed for decades and are being revised, one could address bankers' incentives by treating such cash more favorably than that which the bank takes out of the strongbox and invests (i.e., by issuing debt rather than equity, if we can define these terms meaningfully enough, in relation to the underlying objective).
Likewise, one can reenact Glass-Steagall-style restrictions on permitted investments by relevant financial institutions, or alternatively one can tax-penalize risky relative to safe investment. (Note, BTW, that various institutions that never would have been subject to Glass-Steagall have nonetheless proved to create failure externalities given their role in the financial system.) The tax approach does not require identifying which investments are in fact the unduly risky ones. Instead, one can get at the problem through unfavorable treatment for what are observed ex post as unusually high returns. An arguable example of this approach is the "Financial Activities Tax" or FAT that a recent IMF Staff Report outlined. The FAT would tax above-normal returns, such as by the mechanism of allowing a deduction for the ordinary rate of return (or equivalently, applying expensing to all cash flows) and also disallowing for this purpose the high-end executive compensation that reflects bankers' paying out these above-normal returns to themselves. The rationale offered for the FAT is that the extra-normal returns may be rents, which in theory can be taxed away without creating inefficiency. But an alternative or additional rationale would be that observed above-normal returns ex post may actually not have been rents, but simply bets with nasty tail risk that simply didn't eventuate in the observed period.
Finally, firms that appear to be "too big to fail" can be broken up under a regulatory approach, or alternatively simply tax-discouraged. Indeed, if the pricing problem were easier than it is, one could simply tax them for the value of the implicit guarantee that they force on us (via the potential magnitude of the failure externality), thus in effect pricing it into their decisions.
Okay, one last word on all this before I turn to how one might think about the taxes versus regulation choice given the analysis in Mick Keen's paper along with that in the Weitzman paper on taxes versus subsidies. A whole lot of regulatory effort, and I gather indeed the main effort, has focused on capital adequacy. But is this a misdirection of effort - not in the sense that one shouldn't do this, but rather that it may be inadequate unless a lot of other things are done as well? I am inclined to say yes, though admittedly not an expert on financial institutions.
Consider AIG. My crude rendering of what it did is as follows. By holding so much of the downside risk that credit default swaps faced from the prospect of a nationwide decline in real estate prices, AIG exacted very much like the hypothetical individual who shows up in New Orleans in 2004 and issues hurricane insurance to everyone in town. By the way, that fictional New Orleans guy, like AIG, has a fabulous business model. He gets people to pay him all these hurricane insurance fees. If no hurricane hits, it's free money. If Katrina comes, the party is over but at least he doesn't have to pay on the policies (because he can't). So this is equivalent to betting everything on red because heads he wins, tails other people lose.
Would capital adequacy rules help enough with such an individual? As stated, not unless (a) each person's insurance premium covered 100% of the expected harm that a big hurricane the next year would cause (which seems unlikely) and (b) the capital adequacy requirement was 100% - none of the premiums can be reinvested.
Again, the point isn't that capital adequacy regulations aren't important and valuable, but that by themselves they're inadequate and arguably have received relative over-emphasis - not because they should be done less, but because other and additional things should be done more.
But this post has also gotten long enough, so I'll finish my observations in Part Three, which is available here.
Part 1 left the damsel on the railroad tracks (so to speak) in the sense that I had mentioned Weitzman's "prices versus quantities" framework as giving us a potential handle on how to address the problems with financial institutions that led to their unleashing devastating harm on the world economy in 2008.
Before going further, however, I should note a certain Rashomon quality to discussions of what wrong. In these discussions (whether or not in Rashomon), often all the interpretations appear to be correct. E.g., should we think the banks were mispricing risky assets because they had bad incentives ("heads I win, tails you lose") that led them to embrace investments with an above-normal return in most circumstances but a hideous downside from "tail risk" that was bound to manifest sooner or later? I'm inclined to say yes. But wait a second, wasn't there a bubble going on, such that everyone was mispricing the bubble assets, and the key thing about a bubble is that it's hard to be sure one really exists until it in fact pops. Not a bad theory either.
But moving right along: what are some of the tax versus regulatory choices that we face with regard financial institutions? (From now on, I'll call them "banks" although I mean financial institutions more generally.) Here are a few:
--How much regulatory capital should banks be required to keep on hand? In the notes I prepared for the colloquium discussion, I dramatized this as the little bank in It's a Wonderful Life deciding how much cash to keep in the strongbox so they could satisfy any demand depositors who came in. In a more realistic modern setting, it has to do with "regulatory capital" that is effectively equity rather than debt, hence generating no right to demand either one's principal back or periodic payments. A banker who was utterly indifferent to the risk of a bank run would want to keep zero in the strongbox so that he could invest every penny he had at an expected positive rate of return. More realistically, while he might want to keep something in the strongbox so that the bank doesn't collapse the moment the first depositor shows up, the amount he decided to keep there might be socially too low, as he would give weight only to his aversion, if any, to having the bank collapse, as opposed to a full measure of the social harm this would cause. And even if the depositors can monitor what he does, everyone else who would be affected presumably can't.
--How riskily should banks be allowed to invest? My notes analogized this to the question of whether they should be restricted to making safe but boring loans, or instead allowed to go to Vegas and bet everything on red (apart from the cash in the strongbox). Here we face a familiar incentive problem, since bankers may have an incentive to make "heads I win, tails you lose" bets that are only appealing because they don't face the downside. (The incentive may arise either from their owning shares in the banks they operate, or from incentive compensation packages.) The same moral hazard issues arises, for example, whenever a borrower has limited liability (whether literally, as in the case of a corporation, or effectively, as in the case of an individual who might end up declaring bankruptcy). But for banks the issue may be especially dire given both (a) the externality problem, extending beyond depositors, and (b) the fact that derivatives permit bankers to make huge bets, even with very limited capital, that are very opaque so far as any potential monitor is concerned.
--What about other decisions that may increase systemic risk, such as becoming "too big to fail" and thereby increasing the failure externality, with the possible consequence that the government will have to become an implicit guarantor (thus substituting an increased bailout externality for some or all of the added failure externality).
Each of these three margins can be addressed through "quantity" regulation (using that term very broadly) and/or by a "pricing" approach that uses taxes or subsidies.
Thus, in addition to or instead of requiring a given level of "cash in the strongbox" via capital adequacy regulations such as those that have existed for decades and are being revised, one could address bankers' incentives by treating such cash more favorably than that which the bank takes out of the strongbox and invests (i.e., by issuing debt rather than equity, if we can define these terms meaningfully enough, in relation to the underlying objective).
Likewise, one can reenact Glass-Steagall-style restrictions on permitted investments by relevant financial institutions, or alternatively one can tax-penalize risky relative to safe investment. (Note, BTW, that various institutions that never would have been subject to Glass-Steagall have nonetheless proved to create failure externalities given their role in the financial system.) The tax approach does not require identifying which investments are in fact the unduly risky ones. Instead, one can get at the problem through unfavorable treatment for what are observed ex post as unusually high returns. An arguable example of this approach is the "Financial Activities Tax" or FAT that a recent IMF Staff Report outlined. The FAT would tax above-normal returns, such as by the mechanism of allowing a deduction for the ordinary rate of return (or equivalently, applying expensing to all cash flows) and also disallowing for this purpose the high-end executive compensation that reflects bankers' paying out these above-normal returns to themselves. The rationale offered for the FAT is that the extra-normal returns may be rents, which in theory can be taxed away without creating inefficiency. But an alternative or additional rationale would be that observed above-normal returns ex post may actually not have been rents, but simply bets with nasty tail risk that simply didn't eventuate in the observed period.
Finally, firms that appear to be "too big to fail" can be broken up under a regulatory approach, or alternatively simply tax-discouraged. Indeed, if the pricing problem were easier than it is, one could simply tax them for the value of the implicit guarantee that they force on us (via the potential magnitude of the failure externality), thus in effect pricing it into their decisions.
Okay, one last word on all this before I turn to how one might think about the taxes versus regulation choice given the analysis in Mick Keen's paper along with that in the Weitzman paper on taxes versus subsidies. A whole lot of regulatory effort, and I gather indeed the main effort, has focused on capital adequacy. But is this a misdirection of effort - not in the sense that one shouldn't do this, but rather that it may be inadequate unless a lot of other things are done as well? I am inclined to say yes, though admittedly not an expert on financial institutions.
Consider AIG. My crude rendering of what it did is as follows. By holding so much of the downside risk that credit default swaps faced from the prospect of a nationwide decline in real estate prices, AIG exacted very much like the hypothetical individual who shows up in New Orleans in 2004 and issues hurricane insurance to everyone in town. By the way, that fictional New Orleans guy, like AIG, has a fabulous business model. He gets people to pay him all these hurricane insurance fees. If no hurricane hits, it's free money. If Katrina comes, the party is over but at least he doesn't have to pay on the policies (because he can't). So this is equivalent to betting everything on red because heads he wins, tails other people lose.
Would capital adequacy rules help enough with such an individual? As stated, not unless (a) each person's insurance premium covered 100% of the expected harm that a big hurricane the next year would cause (which seems unlikely) and (b) the capital adequacy requirement was 100% - none of the premiums can be reinvested.
Again, the point isn't that capital adequacy regulations aren't important and valuable, but that by themselves they're inadequate and arguably have received relative over-emphasis - not because they should be done less, but because other and additional things should be done more.
But this post has also gotten long enough, so I'll finish my observations in Part Three, which is available here.
February 10 NYU Tax Policy Colloquium (with Mick Keen), part 1
Yesterday, Michael (Mick) Keen of the International Monetary Fund appeared at our colloquium to present his paper, The Taxation and Regulation of Financial Institutions.
An initial word about my blogging about these sessions may be in order. IMF staff and officials, along with others who sometimes appear at the colloquium either as speakers or in the audience, sometimes have to be mindful of what they are quoted publicly as having said. Our colloquium discussions are private and off the record, a point that attendees from the press know and have honored. But it occurred to me a couple of years ago that my blogging these sessions was potentially inconsistent with this. Accordingly, for the last couple of years, I've had a consistent rule of commenting, not on what was said at a given session, but instead exclusively on my thoughts (both going in and once it was all over) concerning the paper and/or the topic.
The paper is a very interesting one, on an important and very difficult topic. The 2008 financial crisis highlighted huge problems in the financial sector. At a minimum, we were brutally reminded of two important negative externalities that may arise when financial firms fail. The first is the "failure externality." The collapse of institutions such as Lehman, AIG, etcetera can trigger severe and lasting recessions, initially because they trigger a collapse of the liquidity based on the transaction services they offer that a modern economy needs to function. The second is the "bailout externality." Because the consequences of banks' and quasi-banks' collapse can be so dire, the government (and hence taxpayers) often lay out substantial cash to restore their solvency, whether via FDIC-style advance guarantees or the implicit ones that triggered government action in 2008.
Since these are externalities from the standpoint of the managers and employees at a financial institution who are making business choices, it would be analytically useful to deploy the modern economic understanding of externalities as it has been developed in more straightforward settings - for example, with respect to pollution, which can be handled through Pigovian taxes, among other means. The idea would be to give these people more socially appropriate incentives or behavioral constraints.
Once one analogizes the harm banks can do to others to more familiar problems, such as pollution, one runs into the classic choice between Pigovian taxes and regulation. A tax sets a price, e.g., you can pollute as much as you like, but you have to pay $X per unitn of carbon or smoke or gunk. If the price is set correctly, economic production that generates gunk should only take place in cases where the benefit exceeds the cost, as now correctly measured by prices.
Or alternatively, you can regulate how much gunk can be produced and in what circumstances. While this may sound like the more big-government, anti-market approach (and in a sense it is), business often actually prefers it. The reason being that they get to earn rents by cutting the quantity produced, which is better for them (though worse for everyone else) than their having to pay a tax equal to the harm caused.
An intermediate approach is to use permits, as in cap and trade. Where the amount issued is fixed (as distinct from the case where the government will issue more if the price goes up), they resemble regulation by fixing the quantity of permitted pollution, but they resemble pollution taxes in letting the market decide (presumably based on cost differences) who will end up doing the polluting production.
In today's intellectual environment, market-based approaches have much more prestige than they did decades ago, reflecting their advantages, when private incentives are properly aligned, in handling asymmetric information issues along with the problem of what incentives government actors will have. But of course even a Pigovian tax is non-market-based in one sense: the government determines the price. (Hence it might be better still, as Coase argued, simply to assign property rights to one side or the other where transaction costs are low enough for this approach to work.)
This point notwithstanding, setting the price may nonetheless sound more appealing than fixing the quantity from a generally pro-market perspective. But Martin Weitzman, in his famous 1974 paper, Prices vs. Quantities, demonstrated that this is not generally true. With perfect information, the government can set either prices or quantities and get the same answer either way. And in the more realistic setting of limited information, which one is better depends on the broader circumstances.
Okay, enough very general background, as the question raised by Keen's paper is how one should deploy Weitzman's insights (and other relevant aspects of current knowledge) to think about the taxes versus regulation choice with respect to banks and other financial institutions. But as this post is already quite long, I'll post it as is and continue the discussion in a follow-up post.
(Link to part two is here, and link to part 3 is here.)
An initial word about my blogging about these sessions may be in order. IMF staff and officials, along with others who sometimes appear at the colloquium either as speakers or in the audience, sometimes have to be mindful of what they are quoted publicly as having said. Our colloquium discussions are private and off the record, a point that attendees from the press know and have honored. But it occurred to me a couple of years ago that my blogging these sessions was potentially inconsistent with this. Accordingly, for the last couple of years, I've had a consistent rule of commenting, not on what was said at a given session, but instead exclusively on my thoughts (both going in and once it was all over) concerning the paper and/or the topic.
The paper is a very interesting one, on an important and very difficult topic. The 2008 financial crisis highlighted huge problems in the financial sector. At a minimum, we were brutally reminded of two important negative externalities that may arise when financial firms fail. The first is the "failure externality." The collapse of institutions such as Lehman, AIG, etcetera can trigger severe and lasting recessions, initially because they trigger a collapse of the liquidity based on the transaction services they offer that a modern economy needs to function. The second is the "bailout externality." Because the consequences of banks' and quasi-banks' collapse can be so dire, the government (and hence taxpayers) often lay out substantial cash to restore their solvency, whether via FDIC-style advance guarantees or the implicit ones that triggered government action in 2008.
Since these are externalities from the standpoint of the managers and employees at a financial institution who are making business choices, it would be analytically useful to deploy the modern economic understanding of externalities as it has been developed in more straightforward settings - for example, with respect to pollution, which can be handled through Pigovian taxes, among other means. The idea would be to give these people more socially appropriate incentives or behavioral constraints.
Once one analogizes the harm banks can do to others to more familiar problems, such as pollution, one runs into the classic choice between Pigovian taxes and regulation. A tax sets a price, e.g., you can pollute as much as you like, but you have to pay $X per unitn of carbon or smoke or gunk. If the price is set correctly, economic production that generates gunk should only take place in cases where the benefit exceeds the cost, as now correctly measured by prices.
Or alternatively, you can regulate how much gunk can be produced and in what circumstances. While this may sound like the more big-government, anti-market approach (and in a sense it is), business often actually prefers it. The reason being that they get to earn rents by cutting the quantity produced, which is better for them (though worse for everyone else) than their having to pay a tax equal to the harm caused.
An intermediate approach is to use permits, as in cap and trade. Where the amount issued is fixed (as distinct from the case where the government will issue more if the price goes up), they resemble regulation by fixing the quantity of permitted pollution, but they resemble pollution taxes in letting the market decide (presumably based on cost differences) who will end up doing the polluting production.
In today's intellectual environment, market-based approaches have much more prestige than they did decades ago, reflecting their advantages, when private incentives are properly aligned, in handling asymmetric information issues along with the problem of what incentives government actors will have. But of course even a Pigovian tax is non-market-based in one sense: the government determines the price. (Hence it might be better still, as Coase argued, simply to assign property rights to one side or the other where transaction costs are low enough for this approach to work.)
This point notwithstanding, setting the price may nonetheless sound more appealing than fixing the quantity from a generally pro-market perspective. But Martin Weitzman, in his famous 1974 paper, Prices vs. Quantities, demonstrated that this is not generally true. With perfect information, the government can set either prices or quantities and get the same answer either way. And in the more realistic setting of limited information, which one is better depends on the broader circumstances.
Okay, enough very general background, as the question raised by Keen's paper is how one should deploy Weitzman's insights (and other relevant aspects of current knowledge) to think about the taxes versus regulation choice with respect to banks and other financial institutions. But as this post is already quite long, I'll post it as is and continue the discussion in a follow-up post.
(Link to part two is here, and link to part 3 is here.)
February 3 NYU Tax Policy Colloquium (with David Miller)
Just over a week ago, David Miller of Cadwalader, Wickersham & Taft LLP appeared at our colloquium to present his paper, Unintended Consequences: How U.S. Tax Law Encourages Investment in Offshore Tax Havens. I didn't post on it earlier because I was off at the crack of dawn the next morning to give an international tax policy talk in Washington, and then this week was pretty full.
I would argue that one word in the title should be changed so that it more accurately reflects the paper's content. It should say, after the colon, "How U.S. Tax Law Encourages INCORPORATION in Offshore Tax Havens." That's what the paper is about - not moving actual resources to tax havens, but using foreign incorporation, in a country with very limited if any income taxes, to advance assorted types of fun and games in reducing one's U.S. income tax liability.
A central underlying point of the paper is that an act that may have essentially zero economic substance or significance - establishing a legal entity abroad and then running income and/or deduction items throughout - can have large tax consequences. This might be bad for either of two reasons: (a) people are using foreign incorporation to achieve tax results that we dislike, or (b) even if we don't mind their avoiding a particular result, e.g., because it reflects a bad rule, the avoidance should not be conditioned on pointless paper-shuffling, either because that's wasteful or because not everyone can do it. Rationale (b), of course, is a bit less robust, since it's unclear how hard we should want to fight to curb legal avoidance (even if based on trivial and wasteful paper-shuffling) or bad rules.
A broader underlying point is that U.S. tax law (and that of everyone else) relies, presumably for administrative reasons, on two awkward fictions: that legal entities should be treated (and taxed) as distinct from their owners, and that the notion of corporate residence makes sense (and that where a company is incorporated has any normative interest from a tax policy perspective).
The early part of the paper discusses deferral by U.S. companies with foreign subsidiaries abroad. It cites information that tellingly makes the case about how oddly profitable U.S. multinationals' subsidiaries in tax havens, as distinct from anywhere else, turn out to be, according to the companies' tax accounting. However, while basing deferral on the use of a foreign subsidiary rather than a branch is nonsensical (as proponents of both worldwide and territorial taxation mutually recognize), this does not tell us anything about whether subs should be treated like branches (as under a worldwide system), or branches like subs (which would be step 1 towards establishing a territorial system, although step 2 would be dividend exemption). But David recognizes this, and arguing for a worldwide system was not the paper's agenda.
The main part of the paper describes a huge range of situations in which individuals can change their tax treatment for the better by running things through a tax haven company that is bordering on fictional. But some of the rules that people can avoid have greater merit than others. For example, suppose recent proposals to convert particular itemized deductions into 28 percent credits were enacted. (The aim is to reverse the current approach under which high-bracket individuals get a larger subsidy per dollar deducted, and low-income individuals a smaller one, than those in the 28 percent bracket.) High-income taxpayers might be able to avoid this rule by creating shell entities in the Caymans that would nominally deduct the items, reducing their earnings and profits, and thus eventually the true taxpayer's income at a 35 percent rate. This is a bad result if one believes, as I do, that the 28 percent credit rule might be a good policy change.
But then again, consider high-income individuals' use of the very same trick to avoid the rule denying miscellaneous itemized deductions except to the extent that they exceed 2 percent of the taxpayer's adjusted gross income. This is pretty much a stupid rule that denies deductions for true costs of earning income (e.g., an investment advisor's fee that resulted in the taxpayer's earning includable income). While what's going on is exactly the same, in this case one might be less eager to crack down given the problems with the underlying rule.
I would argue that one word in the title should be changed so that it more accurately reflects the paper's content. It should say, after the colon, "How U.S. Tax Law Encourages INCORPORATION in Offshore Tax Havens." That's what the paper is about - not moving actual resources to tax havens, but using foreign incorporation, in a country with very limited if any income taxes, to advance assorted types of fun and games in reducing one's U.S. income tax liability.
A central underlying point of the paper is that an act that may have essentially zero economic substance or significance - establishing a legal entity abroad and then running income and/or deduction items throughout - can have large tax consequences. This might be bad for either of two reasons: (a) people are using foreign incorporation to achieve tax results that we dislike, or (b) even if we don't mind their avoiding a particular result, e.g., because it reflects a bad rule, the avoidance should not be conditioned on pointless paper-shuffling, either because that's wasteful or because not everyone can do it. Rationale (b), of course, is a bit less robust, since it's unclear how hard we should want to fight to curb legal avoidance (even if based on trivial and wasteful paper-shuffling) or bad rules.
A broader underlying point is that U.S. tax law (and that of everyone else) relies, presumably for administrative reasons, on two awkward fictions: that legal entities should be treated (and taxed) as distinct from their owners, and that the notion of corporate residence makes sense (and that where a company is incorporated has any normative interest from a tax policy perspective).
The early part of the paper discusses deferral by U.S. companies with foreign subsidiaries abroad. It cites information that tellingly makes the case about how oddly profitable U.S. multinationals' subsidiaries in tax havens, as distinct from anywhere else, turn out to be, according to the companies' tax accounting. However, while basing deferral on the use of a foreign subsidiary rather than a branch is nonsensical (as proponents of both worldwide and territorial taxation mutually recognize), this does not tell us anything about whether subs should be treated like branches (as under a worldwide system), or branches like subs (which would be step 1 towards establishing a territorial system, although step 2 would be dividend exemption). But David recognizes this, and arguing for a worldwide system was not the paper's agenda.
The main part of the paper describes a huge range of situations in which individuals can change their tax treatment for the better by running things through a tax haven company that is bordering on fictional. But some of the rules that people can avoid have greater merit than others. For example, suppose recent proposals to convert particular itemized deductions into 28 percent credits were enacted. (The aim is to reverse the current approach under which high-bracket individuals get a larger subsidy per dollar deducted, and low-income individuals a smaller one, than those in the 28 percent bracket.) High-income taxpayers might be able to avoid this rule by creating shell entities in the Caymans that would nominally deduct the items, reducing their earnings and profits, and thus eventually the true taxpayer's income at a 35 percent rate. This is a bad result if one believes, as I do, that the 28 percent credit rule might be a good policy change.
But then again, consider high-income individuals' use of the very same trick to avoid the rule denying miscellaneous itemized deductions except to the extent that they exceed 2 percent of the taxpayer's adjusted gross income. This is pretty much a stupid rule that denies deductions for true costs of earning income (e.g., an investment advisor's fee that resulted in the taxpayer's earning includable income). While what's going on is exactly the same, in this case one might be less eager to crack down given the problems with the underlying rule.
On the road again
This coming Monday, on Valentine's Day, I'll be heading to New Haven for a few hours in order to speak at a lunchtime session sponsored by a Yale Law School student organization, the American Constitution Society, entitled "Tax Cuts and the Impending Budget Crisis." I'll give a short talk not dissimilar to the one I had planned to give on this subject in Boca Raton (but missed due to weather), though without the PowerPoint slides I had planned for there. Michael Graetz will then offer his own comments, followed by general discussion.
More on this (including the text I'll use to organize my comments) in due course.
UPDATE: Link for the event is here.
More on this (including the text I'll use to organize my comments) in due course.
UPDATE: Link for the event is here.
Wednesday, February 09, 2011
Metaphorical truth that will soon become literal truth
According to this Bloomberg article, about 27 percent of U.S. homeowners are currently "underwater" - that is, their mortgage debt exceeds their home value.
That's a bad choice of word for me, as I have just started reading a scary book that ought to be in the horror section, Peter Ward's The Flooded Earth: Our Future in a World Without Icecaps.
Ward, a NASA astrobiologist, describes what we might expect over the next few hundred years if current levels of carbon dioxide buildup continue, with the expected climate effects on storms and sea levels, among other things. So far I've just read the Introduction, which features Miami in 2120 as a lawless island (without even a functioning airport or bridges, due to hurricanes plus the rising sea level), abandoned by the federal government as it desperately tries to help less doomed cities hang on elsewhere. In the rest of the book, it apparently gets worse. For example, 10 million Bangladeshis could be made homeless by an 8-inch sea level rise that could hit by 2050, making this "the most likely spot for one of the greatest catastrophes in human history," basically Katrina to the nth power.
Ward is a cockeyed optimist, in the sense that he hopes some such disaster might actually prompt a change in our willingness to address these issues, though I suppose one could say, don't bet on it.
That's a bad choice of word for me, as I have just started reading a scary book that ought to be in the horror section, Peter Ward's The Flooded Earth: Our Future in a World Without Icecaps.
Ward, a NASA astrobiologist, describes what we might expect over the next few hundred years if current levels of carbon dioxide buildup continue, with the expected climate effects on storms and sea levels, among other things. So far I've just read the Introduction, which features Miami in 2120 as a lawless island (without even a functioning airport or bridges, due to hurricanes plus the rising sea level), abandoned by the federal government as it desperately tries to help less doomed cities hang on elsewhere. In the rest of the book, it apparently gets worse. For example, 10 million Bangladeshis could be made homeless by an 8-inch sea level rise that could hit by 2050, making this "the most likely spot for one of the greatest catastrophes in human history," basically Katrina to the nth power.
Ward is a cockeyed optimist, in the sense that he hopes some such disaster might actually prompt a change in our willingness to address these issues, though I suppose one could say, don't bet on it.
Saturday, February 05, 2011
Traveling road show
Yesterday I spent 6-1/2 hours on the Acela (including one hour of train delay) in order to round-trip to Washington and spend 2 hours at a conference, including a 40 minute stretch when I was the speaker. (Rising corporate residence electivity paper on international tax, which also rethinks the broader basic issues a bit; paper is available here and the slides for the talk are here.)
The ratio between the travel time and the payoff certainly makes one wonder a bit. And this is one reason for my moving the colloquium to Tuesdays for next year - at least I can spread the travel over 2 days and attend more sessions at the conferences where I give talks.
But nonetheless, no regrets. I get a lot of work done on the train; the opportunity to discuss and get exposure for one's ideas is a big part of the biz (especially since everyone is too busy to read anything not immediately germane to their current projects); you get feedback and hear about other people's intellectual interests and concerns, which can be very broadening; and you keep running into old friends who are also doing the Grand Tour or who made it to a particular stop.
UPDATE: Next stop on the tour is Monday, but just a train ride away in midtown. I'll be doing a short video interview on marriage penalty-type issues that the Wall Street journal website will post on-line as part of a set of videos honoring (if that's the word) the rapid approach of April 15.
The ratio between the travel time and the payoff certainly makes one wonder a bit. And this is one reason for my moving the colloquium to Tuesdays for next year - at least I can spread the travel over 2 days and attend more sessions at the conferences where I give talks.
But nonetheless, no regrets. I get a lot of work done on the train; the opportunity to discuss and get exposure for one's ideas is a big part of the biz (especially since everyone is too busy to read anything not immediately germane to their current projects); you get feedback and hear about other people's intellectual interests and concerns, which can be very broadening; and you keep running into old friends who are also doing the Grand Tour or who made it to a particular stop.
UPDATE: Next stop on the tour is Monday, but just a train ride away in midtown. I'll be doing a short video interview on marriage penalty-type issues that the Wall Street journal website will post on-line as part of a set of videos honoring (if that's the word) the rapid approach of April 15.
Wednesday, February 02, 2011
Corporate tax distortions
Today's New York Times had an article by David Leonhardt on corporate tax reform, of interest even though the chance that such reform will be seriously addressed in the next two years strikes me as close to zero. (The one thing that I could see happening is an unfinanced corporate rate cut and/or shift to exempting foreign source income, which would happen immediately if President Obama agreed to it and Congressional Democrats were willing to go along.)
Key sentence in the Leonhardt piece:
"Arguably, the United States now has a corporate tax code that’s the worst of all worlds. The official rate is higher than in almost any other country, which forces companies to devote enormous time and effort to finding loopholes. Yet the government raises less money in corporate taxes than it once did, because of all the loopholes that have been added in recent decades."
The obvious question of interest is: What are these loopholes?
The number one item the article mentions is "maximizing the amount of profit that is officially earned in countries with low tax rates." This mainly reflects, not so much newly enacted loopholes as the forward march of tax planning technologies to exploit income-shifting opportunities.
Secondarily, it mentions "spending large sums on new equipment or buildings. Such spending can often be deducted." Under a pure income tax, capital outlays could not be expensed (i.e., written off in full right away), but instead would be capitalized and only deductible more slowly under cost recovery rules. But, under currently applicable law, much of it can be expensed - for example, equipment and R&D outlays (which also are partly creditable).
A third item, the allowance of net operating loss carryovers from prior taxable years is, as Leonhardt notes, much less of a policy concern. A company that makes no money over time generally shouldn't pay net taxes even if it has income in some years and losses in others.
What should we think about the first two items? Income-shifting by U.S. and other multinationals to low-tax foreign jurisdictions is not listed as a tax expenditure, because the whole point is that we don't know how to source the income accurately. (Indeed, to some extent this question has no clear theoretical answer even with perfect information.)
But we know that the results companies can and do report under existing law lowball the U.S. while putting economically implausible amounts of taxable income in tax havens where nothing actually happens, plus a few low-tax countries where there actually is some economic activity (e.g., Ireland) but the claimed profit shares are implausibly high.
As I noted in an earlier post, repealing deferral for the foreign source income that U.S. companies earn through their foreign subsidiaries is not really the answer, given that by definition this can only address income-shifting by U.S. multinationals, as opposed to those whose corporate parents are incorporated abroad. Plus, they also tax the "true" foreign source income, which is not necessarily optimal especially at the domestic U.S. rate, subject to allowing foreign tax credits, which definitely are not optimal.
So what we really need is better rules for determining the source of income. These rules would have to treat a multinational corporate group, whether the overall parent was a U.S. company or not, as effectively a single entity for purposes of determining what income is U.S. source. So intra-company debt would be ignored, and it wouldn't matter which group member borrowed from third-party lenders. Existing transfer pricing rules, based on the myth of comparable arm's length prices, would be thrown in the trash where they belong, reflecting universal recognition that they are unworkable. In their place, one might use some set of objective factors that the companies would find costly to move for tax reasons. There have also been other suggestions, however, aimed at teasing out "true" inter-company pricing by alternative methods.
What about expensing? This is a consumption tax feature that we have plunked into the income tax at various points. The odd thing about it is that, in a consistent consumption tax environment where (among other distinctions from present law) everything is expensed, it actually creates neutral investment incentives, based purely on pre-tax expected profit, and without the income tax's discouragement of investment and saving.
But shoving it into an income tax causes a couple of problems. First, items that are expensed are tax-preferred relative to those that are not. Second, combining it with income tax treatment of debt financing can have peculiar results.
Perhaps the following simple hypothetical can help to demonstrate. For arithmetic simplicity, suppose the tax rate is 50%, the normal rate of return on investment (including loans) is 10%, and the government always provides an immediate refund (at the 50% tax rate) when you claim a deduction.
I make a $100 investment that I am allowed to expense (even though we otherwise have an income tax). So it costs me only $50 after applying the instantaneous tax refund. I borrow this $50, and thus get to make a $100 investment at zero out-of-pocket cost.
In a year, given the normal 10% return, I get to cash in my investment for $110. But I have to pay back the bank, which gets $55, as it has earned 10% interest on its $50 loan. So I have $55 left in my pocket before considering the income tax consequences.
As it happens, my taxable income is $105 (i.e., $110, given that the $100 outlay has already been expensed, minus $5 interest). At a 50 percent rate, I pay tax of $52.50 and have $2.50 left. So I generate a profit on a zero cash outlay even though I merely earned the normal rate of return.
Even if I had earned only 8%, I would still have come out ahead. This would have left me with $108 before repaying the loan, $53 afterwards, taxable income of $103, a tax liability of $51.50, and $1.50 left in my pocket even though I invested both the bank loan and my tax refund in something offering a below-normal return.
The underlying point is that expensing of investments plus debt financing that gets income tax rather than consumption tax treatment is affirmatively subsidized, not merely exempted (as under a consumption tax that exempts the "normal" rate of return), potentially creating bad incentives.
Admittedly there may be more to the example, permitting one to challenge the diagnosis. In particular, if the lender is taxable on its $5 of interest income, the government gets its money back and breaks even, rather than handing out a net subsidy. Suppose, however, that the lender is effectively tax-exempt. This brings back the problem, but arguably changes the diagnosis to one of how tax rate differences can be exploited (especially, it turns out, when debt and equity are treated differently).
For me the bottom line is that the discussion of how to finance lowering the corporate rate (leaving aside the political reality point that it will either be unfinanced or remain undone) should focus on (1) the source rules for all (i.e., U.S. and non-U.S.) multinationals, (2) income tax preferences that we are willing to address, and (3) interest deductibility, given both its interaction with expensing and the debt versus equity problem.
The unfortunate thing about #2 on this list is that moving closer to a true income tax is not necessarily the right way to go. But shifting to consistent consumption tax treatment of business (and also of individuals) is probably not on the agenda.
Key sentence in the Leonhardt piece:
"Arguably, the United States now has a corporate tax code that’s the worst of all worlds. The official rate is higher than in almost any other country, which forces companies to devote enormous time and effort to finding loopholes. Yet the government raises less money in corporate taxes than it once did, because of all the loopholes that have been added in recent decades."
The obvious question of interest is: What are these loopholes?
The number one item the article mentions is "maximizing the amount of profit that is officially earned in countries with low tax rates." This mainly reflects, not so much newly enacted loopholes as the forward march of tax planning technologies to exploit income-shifting opportunities.
Secondarily, it mentions "spending large sums on new equipment or buildings. Such spending can often be deducted." Under a pure income tax, capital outlays could not be expensed (i.e., written off in full right away), but instead would be capitalized and only deductible more slowly under cost recovery rules. But, under currently applicable law, much of it can be expensed - for example, equipment and R&D outlays (which also are partly creditable).
A third item, the allowance of net operating loss carryovers from prior taxable years is, as Leonhardt notes, much less of a policy concern. A company that makes no money over time generally shouldn't pay net taxes even if it has income in some years and losses in others.
What should we think about the first two items? Income-shifting by U.S. and other multinationals to low-tax foreign jurisdictions is not listed as a tax expenditure, because the whole point is that we don't know how to source the income accurately. (Indeed, to some extent this question has no clear theoretical answer even with perfect information.)
But we know that the results companies can and do report under existing law lowball the U.S. while putting economically implausible amounts of taxable income in tax havens where nothing actually happens, plus a few low-tax countries where there actually is some economic activity (e.g., Ireland) but the claimed profit shares are implausibly high.
As I noted in an earlier post, repealing deferral for the foreign source income that U.S. companies earn through their foreign subsidiaries is not really the answer, given that by definition this can only address income-shifting by U.S. multinationals, as opposed to those whose corporate parents are incorporated abroad. Plus, they also tax the "true" foreign source income, which is not necessarily optimal especially at the domestic U.S. rate, subject to allowing foreign tax credits, which definitely are not optimal.
So what we really need is better rules for determining the source of income. These rules would have to treat a multinational corporate group, whether the overall parent was a U.S. company or not, as effectively a single entity for purposes of determining what income is U.S. source. So intra-company debt would be ignored, and it wouldn't matter which group member borrowed from third-party lenders. Existing transfer pricing rules, based on the myth of comparable arm's length prices, would be thrown in the trash where they belong, reflecting universal recognition that they are unworkable. In their place, one might use some set of objective factors that the companies would find costly to move for tax reasons. There have also been other suggestions, however, aimed at teasing out "true" inter-company pricing by alternative methods.
What about expensing? This is a consumption tax feature that we have plunked into the income tax at various points. The odd thing about it is that, in a consistent consumption tax environment where (among other distinctions from present law) everything is expensed, it actually creates neutral investment incentives, based purely on pre-tax expected profit, and without the income tax's discouragement of investment and saving.
But shoving it into an income tax causes a couple of problems. First, items that are expensed are tax-preferred relative to those that are not. Second, combining it with income tax treatment of debt financing can have peculiar results.
Perhaps the following simple hypothetical can help to demonstrate. For arithmetic simplicity, suppose the tax rate is 50%, the normal rate of return on investment (including loans) is 10%, and the government always provides an immediate refund (at the 50% tax rate) when you claim a deduction.
I make a $100 investment that I am allowed to expense (even though we otherwise have an income tax). So it costs me only $50 after applying the instantaneous tax refund. I borrow this $50, and thus get to make a $100 investment at zero out-of-pocket cost.
In a year, given the normal 10% return, I get to cash in my investment for $110. But I have to pay back the bank, which gets $55, as it has earned 10% interest on its $50 loan. So I have $55 left in my pocket before considering the income tax consequences.
As it happens, my taxable income is $105 (i.e., $110, given that the $100 outlay has already been expensed, minus $5 interest). At a 50 percent rate, I pay tax of $52.50 and have $2.50 left. So I generate a profit on a zero cash outlay even though I merely earned the normal rate of return.
Even if I had earned only 8%, I would still have come out ahead. This would have left me with $108 before repaying the loan, $53 afterwards, taxable income of $103, a tax liability of $51.50, and $1.50 left in my pocket even though I invested both the bank loan and my tax refund in something offering a below-normal return.
The underlying point is that expensing of investments plus debt financing that gets income tax rather than consumption tax treatment is affirmatively subsidized, not merely exempted (as under a consumption tax that exempts the "normal" rate of return), potentially creating bad incentives.
Admittedly there may be more to the example, permitting one to challenge the diagnosis. In particular, if the lender is taxable on its $5 of interest income, the government gets its money back and breaks even, rather than handing out a net subsidy. Suppose, however, that the lender is effectively tax-exempt. This brings back the problem, but arguably changes the diagnosis to one of how tax rate differences can be exploited (especially, it turns out, when debt and equity are treated differently).
For me the bottom line is that the discussion of how to finance lowering the corporate rate (leaving aside the political reality point that it will either be unfinanced or remain undone) should focus on (1) the source rules for all (i.e., U.S. and non-U.S.) multinationals, (2) income tax preferences that we are willing to address, and (3) interest deductibility, given both its interaction with expensing and the debt versus equity problem.
The unfortunate thing about #2 on this list is that moving closer to a true income tax is not necessarily the right way to go. But shifting to consistent consumption tax treatment of business (and also of individuals) is probably not on the agenda.
Tuesday, February 01, 2011
NYU Tax Policy Colloquium: 2012 heads-up for those who are interested
After 16 years of doing the NYU Tax Policy Colloquium on Thursdays, we've switched for next year (2012) to Tuesdays. Those who come from outside NYU to attend our little sessions should take note and, if motivated, can rely and plan accordingly. The public sessions will still run from 4 to 6 pm, as they always have, albeit now earlier in the week.
I'll also be informing our e-mail distribution list of this change, probably more than once, as there are actually are some people who plan their schedules (such as for teaching) with the colloquium in mind.
"Change can be good" was part of the thinking. The rest of it was that I, my co-convener, and prospective speakers may all prefer going earlier in the week, because so many conferences are held on Fridays. Travel early Friday morning can be a nightmare, especially with winter weather, if you are committed to staying home through late Thursday night (as we hold post-colloquium dinners that the author and conveners attend).
I polled my e-mail distribution list about the possible change, and basically came up with a tie between Tuesday and Thursday (although with "either's fine" in the majority). Sorry to anyone who's interested but will less able to attend this way, but at least it's 50-50.
I'll also be informing our e-mail distribution list of this change, probably more than once, as there are actually are some people who plan their schedules (such as for teaching) with the colloquium in mind.
"Change can be good" was part of the thinking. The rest of it was that I, my co-convener, and prospective speakers may all prefer going earlier in the week, because so many conferences are held on Fridays. Travel early Friday morning can be a nightmare, especially with winter weather, if you are committed to staying home through late Thursday night (as we hold post-colloquium dinners that the author and conveners attend).
I polled my e-mail distribution list about the possible change, and basically came up with a tie between Tuesday and Thursday (although with "either's fine" in the majority). Sorry to anyone who's interested but will less able to attend this way, but at least it's 50-50.
Upcoming international tax policy talk in Washington
This Friday, I'll be presenting my paper on rising corporate residence electivity at a meeting of the International Tax Policy Forum in Washington.
The slides, greatly shortened from when I presented the same paper (per these slides) as the 2010 NYU Tillinghast Lecture because my time slot is much shorter, are available here.
This paper has not been all that extensively downloaded, although I believe it contains important ideas, not all of which are hinted at by the title.
Among other things, I offer an admittedly sketchy preview (my international tax book, and perhaps a separate article, will offer the full-dress version) of what I think is a better analysis of the territorial versus worldwide issue than any I have previously seen.
So long as the U.S. has any market power over the use of U.S. corporate residence in investing abroad, I argue, a zero rate for foreign source income is unlikely to be a first-best even relative to the otherwise already thousandth-best character of the setting (with entity-level corporate income taxation and residence determinations, etcetera). But if one could choose an intermediate rate between zero and the full domestic rate (currently 35%), a first step would be to repeal deferral and foreign tax credits (in favor of mere foreign tax deductibility), and a second step would be to decide what tax rate for foreign source income is best, all else equal.
Exemption (with a zero rate for foreign source income) is an example of such an approach, as it has implicit deductibility for foreign taxes plus no deferral. But it differs only moderately from, say, a 1% foreign rate with no deferral and no credits.
In this setting, while I suspect that the optimal U.S. rate for foreign source income would be closer to zero than to 35 percent, I doubt it would actually be zero (for reasons I very briefly discuss, or at least advert to, in the slides). But if one rules out intermediate rates, on such grounds as treaty adherence and political economy, then exemption may be preferable to current law as the only feasible way of getting rid of foreign tax credits and deferral (which result in a system that raises too little revenue relative to its U.S. efficiency costs). At least, the case for this view strikes me as powerful if we (a) improve the source rules (such as by treating all multinationals, whether headed by a U.S. company or not, as a single unitary worldwide group) - a change that would be desirable in any event, but all the more so if income-shifting abroad would no longer carry the implicit price of creating a potential future "foreign trapped earnings" problem - and (b) address the transition issue that I also delicately advert to in the shortened slides.
Be all that as it may, however, let me segue into one more associated topic that recently came to mind, in connection with the vanishingly slim (if not indeed zero) prospect of a serious push in the next couple of years for significant corporate rate reductions that are financed by corporate base-broadening.
Eric Toder has an excellent post at the Tax Policy Center's Tax Vox blog in which he runs through the main corporate "tax expenditures," as per the prevailing official lists, that could be curtailed in order to finance a corporate rate cut. He notes that # 1 on the list, in terms of current revenue cost, is repealing deferral and going to a pure worldwide system (foreign tax credits aside) for U.S. companies' foreign source income. The continuation of deferral is estimated to cost $169 billion over the next few years, although Eric notes that the revenue actually raised from repealing it might be significantly lower - among other reasons, due to the tax planning responses one would expect in the case of repeal.
Once we agree that deferral is a tax expenditure, meaning that the baseline is a worldwide tax, it becomes hard to disagree with going to a pure worldwide system - other than on the ground that one happens to favor more "preferential" treatment of U.S. taxpayers in this respect, which opens the door for others to say "Me, too!" about their own favored preferences. But it is difficult to make a compelling case for the bedrock principle that legal entities - as distinct from individuals - should be taxed on a worldwide basis if and only if they are U.S. residents. Corporate residence means so little normatively. Is it a bedrock principle of a theoretically pure income tax system that the foreign investments I hold through a corporate entity should be taxable in the U.S. if I incorporate in Delaware but not if I incorporate abroad?
As I explain here in my article on tax expenditures (albeit just in general terms, as I dodged international issues in the piece), this type of use of the tax expenditure concept is neither intellectually persuasive nor likely to prove very helpful. I would put deferral, as well as foreign tax credits, in my category of "disputed" items in which there are mutiple alternative baselines (here, worldwide with credits, worldwide with deductions, and exemption of foreign source income).
The slides, greatly shortened from when I presented the same paper (per these slides) as the 2010 NYU Tillinghast Lecture because my time slot is much shorter, are available here.
This paper has not been all that extensively downloaded, although I believe it contains important ideas, not all of which are hinted at by the title.
Among other things, I offer an admittedly sketchy preview (my international tax book, and perhaps a separate article, will offer the full-dress version) of what I think is a better analysis of the territorial versus worldwide issue than any I have previously seen.
So long as the U.S. has any market power over the use of U.S. corporate residence in investing abroad, I argue, a zero rate for foreign source income is unlikely to be a first-best even relative to the otherwise already thousandth-best character of the setting (with entity-level corporate income taxation and residence determinations, etcetera). But if one could choose an intermediate rate between zero and the full domestic rate (currently 35%), a first step would be to repeal deferral and foreign tax credits (in favor of mere foreign tax deductibility), and a second step would be to decide what tax rate for foreign source income is best, all else equal.
Exemption (with a zero rate for foreign source income) is an example of such an approach, as it has implicit deductibility for foreign taxes plus no deferral. But it differs only moderately from, say, a 1% foreign rate with no deferral and no credits.
In this setting, while I suspect that the optimal U.S. rate for foreign source income would be closer to zero than to 35 percent, I doubt it would actually be zero (for reasons I very briefly discuss, or at least advert to, in the slides). But if one rules out intermediate rates, on such grounds as treaty adherence and political economy, then exemption may be preferable to current law as the only feasible way of getting rid of foreign tax credits and deferral (which result in a system that raises too little revenue relative to its U.S. efficiency costs). At least, the case for this view strikes me as powerful if we (a) improve the source rules (such as by treating all multinationals, whether headed by a U.S. company or not, as a single unitary worldwide group) - a change that would be desirable in any event, but all the more so if income-shifting abroad would no longer carry the implicit price of creating a potential future "foreign trapped earnings" problem - and (b) address the transition issue that I also delicately advert to in the shortened slides.
Be all that as it may, however, let me segue into one more associated topic that recently came to mind, in connection with the vanishingly slim (if not indeed zero) prospect of a serious push in the next couple of years for significant corporate rate reductions that are financed by corporate base-broadening.
Eric Toder has an excellent post at the Tax Policy Center's Tax Vox blog in which he runs through the main corporate "tax expenditures," as per the prevailing official lists, that could be curtailed in order to finance a corporate rate cut. He notes that # 1 on the list, in terms of current revenue cost, is repealing deferral and going to a pure worldwide system (foreign tax credits aside) for U.S. companies' foreign source income. The continuation of deferral is estimated to cost $169 billion over the next few years, although Eric notes that the revenue actually raised from repealing it might be significantly lower - among other reasons, due to the tax planning responses one would expect in the case of repeal.
Once we agree that deferral is a tax expenditure, meaning that the baseline is a worldwide tax, it becomes hard to disagree with going to a pure worldwide system - other than on the ground that one happens to favor more "preferential" treatment of U.S. taxpayers in this respect, which opens the door for others to say "Me, too!" about their own favored preferences. But it is difficult to make a compelling case for the bedrock principle that legal entities - as distinct from individuals - should be taxed on a worldwide basis if and only if they are U.S. residents. Corporate residence means so little normatively. Is it a bedrock principle of a theoretically pure income tax system that the foreign investments I hold through a corporate entity should be taxable in the U.S. if I incorporate in Delaware but not if I incorporate abroad?
As I explain here in my article on tax expenditures (albeit just in general terms, as I dodged international issues in the piece), this type of use of the tax expenditure concept is neither intellectually persuasive nor likely to prove very helpful. I would put deferral, as well as foreign tax credits, in my category of "disputed" items in which there are mutiple alternative baselines (here, worldwide with credits, worldwide with deductions, and exemption of foreign source income).