Talk at University of Louisville Law Review Symposium on Deficit Reduction

This past Saturday (Oct. 22), during a lightning appearance in Louisville to participate in a conference on federal deficit reduction that was sponsored by the University of Louisville Law Review, I presented my paper, previously linked and available here, entitled "Tax Reform Implications of the Risk of a U.S. Budget Catastrophe." This is a kind of short interplanetary grand tour through previous work I've written that has a bearing on how concern about the long-term fiscal gap might affect our thinking about tax reform. It also briefly addresses why we face a long-term default risk. I use the analogy (also in several previous talks that I have linked here, but not previously in any of my published work) to the nesting Russian "Matryoshka" dolls, one inside another. I posit that, while the outermost doll is the fiscal impact of rising life expectancy plus the baby bust plus the current path of healthcare technology, the fact that this could in principle easily be addressed means one has to look to the next doll inside (U.S. political economy problems), and then to the doll inside that (potentially malfunctioning and discontinuously responding financial markets).

For a pithy overview of the already somewhat pithy paper, a pdf version of the PowerPoint slides that I used for my talk is available here.

Among the things I'm sorry to have missed at the conference, which I had to leave early, were the afternoon talks by Daniel L. Thornton, who is Vice President and Economic Advisor at the Federal Reserve Bank of St. Louis, and UNC law prof Greg Polsky. Although I suspect I would have disagreed with a lot in Thornton's talk (addressing how we have arrived at the current fiscal situation), I am sure it was interesting and provocative. And Polsky's talk on cutting tax expenditures is certainly a topic of interest to me (and I suspect I would have agreed with a lot of his analysis).

Another interesting talk that I missed was by GW law prof Neil Buchanan, arguing against ever fully paying off the U.S. national debt. Once again I suspect I would have agreed a lot, although I'm not convinced we'll be dealing with this problem any time soon. Buchanan and I appear to agree more than we used to about budgetary issues. He might argue that I've moved a bit towards him, and maybe he'd have a point. But I might respond that current events have pushed me towards a terrain where we always agreed to a considerable extent. I probably remain more favorably inclined than he is to adopting (under appropriate circumstances) policy changes that curtail the rate of growth of existing entitlement programs, with these changes to be announced ASAP and to begin being implemented as soon as the macroeconomic climate permits. I believe in "smoothing" expected long-term changes to the entitlement programs, based on the best available fiscal estimates of what will be necessary, and I am quite willing to reduce expected benefits to the better-off members of current retirees - again, subject to the macroeconomic climate and to this being part of a good overall package that includes, e.g., needed tax increases.

I did get to hear Penn State law prof Sam Thompson's interesting paper, arguing that Social Security and Medicare benefits should be phased out fairly rapidly for high income retirees, whose capital income might suggest that they have substantial wealth. Thompson had a powerful rhetorical point to the effect that, if you give retirement benefits to an individual who will be leaving a bequest, and if this means that the bequest ends up being larger than it would have been otherwise, one could view this as something not far from a federal match or supplement to the bequest. I could imagine this point being politically significant, and it is also reasonably intellectually defensible.

One concern I had with Thompson's proposal was that, by rapidly phasing out retirees' Social Security and Medicare benefits as their income increases, it operates as a powerful work disincentive. Even people who have retired from their prior full-time jobs and begun claiming retirement benefits often do some work on the side, and the empirical evidence suggests that they are quite tax-responsive. Such individuals do not necessarily have the wealth and expected bequest profile that Thompson assumes when arguing for his proposal, and I see no good reason, even with high unemployment, to discourage work by seniors. But in the limited time we had, we didn't get to discuss this issue more fully.

In response to my paper and talk, Berkeley law prof David Gamage argued that what he called my "let's preserve revenues" model for evaluating how concern about the fiscal gap should affect tax reform thinking - a fair enough label, I'll concede - doesn't take the next step that one ought to take in thinking about these issues. He proposes analyzing much more fully than I as yet have the question of how a given change (even a small one) that is adopted today might influence the likely long-term political equilibrium, assuming that the political chicken games do indeed eventually give away to a negotiated solution. Two examples he noted: (a) 1986-style tax reform, with base-broadening plus rate reduction, might grease the skids for raising the rates again in the future, (b) once a VAT is enacted, Congress's ability to raise revenue easily by boosting the rate becomes much enhanced, compared to when one doesn't have a VAT in place. I suppose there might be analogues for entitlements changes as well.

This may be a good next-stage framework for thinking about tax reform in relation to the long-term fiscal situation, albeit going beyond the relatively modest tasks I set for myself in recent writing about the issue, but certainly worth consideration. (Whether or not by me depends on where my interests take me over the next few years.)

Unauthorized activity

I would assume that Seymour is eyeing the chicken, not the lettuce.

From 9-9-9 to 9-0-9?

In response to criticism of 9-9-9's low-end regressivity, Herman Cain has apparently partially dropped one of the 9's. He is quoted by CNN as saying the following:

"If you are at or below the poverty level, your plan isn't 9-9-9 it is 9-0-9. Say amen y'all. 9-0-9."

This appears to refer to putting a zero bracket into the personal income tax (or wage tax?) portion of the 9-9-9 plan. However, three thoughts about this are the following:

(1) Poor people who are unemployed will get no benefit, since they already are earning zero. An 18 percent federal tax rate is a huge hike for them, compared to present law.

(2) Once you agree to a zero bracket, haven't you surrendered the entire supposed logic (whatever it is) of having a flat tax? This, of course, is also an issue for the so-called flat tax that Rick Perry is expected to endorse shortly. That proposal has historically had two brackets, one of them at zero percent, and I gather that the Perry proposal is expected to share this feature. So it isn't actually a flat tax.

Once you agree to a zero bracket, in a certain sense the flat tax game is over. As the old saying goes, from there on in we're just haggling over the price. Is there some natural law holding that having exactly two brackets is best? That strikes me as even more peculiar than insisting that there must only be one.

(3) Once Cain has agreed to put a zero rate in one of his three taxes, why not in the other two? Obviously, as an administrative matter one can't have a retail sales tax, or a quasi-VAT that has been mislabeled as a "business income tax," apply multiple brackets based on the income level of the individuals who purchase consumer goods. But doesn't the zero-rate feature that has now been added to Cain's personal tax imply that this is a defect one might want to address?

The so-called FAIR tax does so through what is effectively a demogrant, rather than a rate bracket. I've seen indications that Cain would like to have something of that nature in his 9-9-9 plan as well, but he hasn't made this entirely clear, and it would have significant budgetary / revenue implications unless its scope was trivial.

Cain also claims to add progressivity to his plan through an "opportunity zone" proposal. The idea, as described by CNN, is that "in cities facing high unemployment ... businesses could also deduct a certain amount of payroll expenses from their corporate taxes."

Enterprise zone features of income taxes generally have not received a hugely favorable write-up in the literature. In addition, if we can imagine Cain's proposals being adopted by Congress - and I certainly can't imagine this, even if he were to become president - it's hard to see why this special feature would be adopted and no others. Mightn't it open the floodgates? It's also fun to think about how the set of qualifying cities at any given time would be compiled, and whether businesses would be able to use this as a ground for deducting, say, high-end Wall Street salaries if New York qualified as an opportunity zone. Sure, one could start writing rules to address these problems, but by then (if not sooner) the 9-9-9 tax would be starting to look like a very different and more complicated animal.

They're calling the wrong tax the "Robin Hood tax"

A report on the web suggests that Occupy Wall Street protestors may coalesce on a specific policy demand: the enactment of the so-called "Robin Hood tax" on financial transactions.

Although I have considerable sympathy for what I deem to be the OWS political economy critique of U.S. policy and institutions, I fear that they are being misled by labels into supporting the wrong tax. It's understandable. After all, how could they resist something that proponents call the "Robin Hood tax" and that would be collected from banks and other such financial institutions, given what the OWS protestors (and we) know about the U.S. financial sector and its grip on the U.S. economy and government, as well as that sector's responsibility for the last few years' disasters and the evident possibility that they will soon be doing it to us again?

The problem is, the wrong instrument has been labeled the "Robin Hood tax," apparently because some enterprising policy entrepeneurs, undoubtedly acting in good faith, took the initiative thus to label what those of us in the biz call the "financial transactions tax" or FTT.

The so-called Robin Hood tax - which I will now switch to calling the FTT - would be levied at a very low rate (say. 0.05%) on a wide range of financial asset transactions - for example, the sale of stocks, bonds, commodities, unit trusts, mutual funds, and derivatives such as futures and options. Thus, if you buy Microsoft stock for $10,000, the tax at 0.05% would be $5. Despite the low rate, enough financial assets in face value are sold that it could add up to a lot of money. For the thing to work, it obviously would have to address the problem of people, say, using swap transactions to replicate the economics of a debt-financed purchase of stock without actually doing the literal sale. That's a big problem, but let's put it to one side for present purposes.

Presumably your broker will actually remit the $5 sale proceeds to the tax authorities. I would guess that he'd list it as a separate charge that you had to pay, and would simply add it on to the other fees he was charging you. In principle, this could exert a mite of downward pressure on broker fees, raising the economic incidence question of who bears the tax, along with the possibility that, with sales being costlier, there'll be a small bit of exit from the broker industry. But it might be a good first approximation to say that you are likely to bear the tax, whether the broker separately states it or simply charges you $5 more than he would have otherwise.

Now let's consider Goldman Sachs, which presumably would be remitting a whole lot of fees to the government from the deals it does. (Leaving aside the fact that they would no doubt be at the forefront of figuring out, at least for their large customers, how to structure deals so as to avoid the tax.) Is this a tax "on" Goldman Sachs - or more specifically, on the firm's owners and highly compensated employees? I am a bit skeptical, as a matter of economic incidence. Come to think of it, if they do figure out how big players can avoid the tax they will be well-compensated for that, but even in other cases I suspect the incidence issue might play out a bit like the retail sales tax that the guy in the candy store collects from you and then remits to the local authorities.

The broader academic debate about the FTT - on which I will be presenting a short piece at a conference in Amsterdam in early December - emphasizes the efficiency question. Will the FTT have desirable economic effects? With perfectly functioning financial markets, the answer would obviously be no. Why burden trades that conventional economic reasoning suggests make the transactors better off while hurting no one else. But I would agree that we have reason to be very unhappy about a lot of what goes on in financial markets, so the FTT has a fighting chance.

What among the things that might be wrong with financial markets might the FTT address? The main argument is about volatility, which some types of trading may make worse. This is basically an externalities argument. By running computer programs that, say, go SELL-SELL-SELL as soon as the price of Zircon stock falls below $X, one can prompt runaway market panics. But the problem is that the FTT is not well-designed to address a specific externality. Trading can also reduce volatility. And if I want to buy or sell a given stock then it's good for me that someone else is actually willing to do so at a given price. FTT studies suggest that the tax might well make volatility worse rather than better. More generally, a well-designed instrument would have to target the types of trading that were worth discouraging.

A second point is sometimes called "internalities." Suppose people trade too much from the standpoint of their own welfare because they over-rate their ability to out-smart or correctly time the market. Once again, we're only in a subcategory of the overall trading that would be subject to the FTT. I have doubts about how strongly this line of reasoning can support the so-called Robin Hood tax, and it is certainly light years from the rationale and assumed incidence.

Now here's what I not only prefer to the FTT but think is far more entitled to the label of "Robin Hood tax" - a financial activities tax or FAT, such as that recently proposed by the staff of the International Monetary Fund.

The FAT would be a tax on extra-normal returns earned by financial institutions, with the potentially taxable returns including high-end compensation paid out to the big hitters. The FAT has two main rationales, other than the fact that the financial industry may generally be both over-large from a normative standpoint and widely under-taxed under VATs and income taxes.

The first rationale is that extra-normal returns may be rents, or opportunities that they have, in effect, to get free money not available to others. Taxing rents is efficient because it won't discourage activity that still has an extra-normal after-tax return. Plus, a tax on rents is borne by the party that is earning the rents.

The second rationale is that observed extra-normal returns in the financial sector are in a sense fake. They represent risky bets, the expected return from which is merely normal, but where the bettors earn an above-market rate in most states of the world, subject to downside "tail risk" if things go badly wrong. We don't want the financial sector making these bets due to their "heads I win, tails you lose" character, in which first they get extra-normal returns, then we have to bail them out so as to mitigate the degree of global macroeconomic collapse.

Once again, we would expect the financial sector to bear the incidence of this tax, because they'd be pushed back in the direction of a merely normal return by the mechanism of in effect taxing them for the suspected transfer of tail risk to the rest of us.

The FAT truly is a Robin Hood tax that would address the problems with the financial sector and likely be borne by the bankers themselves. Why tax Goldman Sachs' customers under the FTT, with no clear efficiency gain, instead of taxing Goldman Sachs itself under the FAT (leaving aside the most recent quarter, in which they reported losses) and addressing the costs that it may be imposing on the rest of us?

Virtually there

Zocalo Public Square, a website devoted to "connecting people to ideas and each other" that also has actual, in-the-flesh public events, usually in Los Angeles, is having a session today on economist Robert Frank's new book, The Darwin Economy: Liberty, Competition, and the Common Good.

On to the personal plug for a moment, then back to the more substantial topic of Frank and his new book. In connection with this session, Zocalo has posted 4 short sets of comments on the topic "Taxes Hurt So Good: Levies Can Be Painful, But the Right Ones Bring Big Gains." The question for discussion was whether taxes can promote good behavior. Available here. As you may have guessed by now, I am one of the commentators; the others are Daniel Markovits, Timothy Hackenberg, and Annette Nellen.

Bob Frank, in his book, "argues that the man who best understood how economics works was not an economist at all [such as Adam Smith with his theory of the invisible hand], but renowned naturalist Charles Darwin. Darwin's understanding of competition held that favored traits were the ones that best served the individual, whether they benefited the group or not -- a theory Frank says explains the modern system much better than Smith's [invisible hand theory]."

To my mind, it risks being a bit cute to deploy Darwin as actually an economist. But Frank's basic point is quite sound. Smith's invisible hand theory derives a lot of powerful results from the fact that, under certain conditions, the possibility of mutual gain through trade can cause people to have interests in common and to behave cooperatively. But - as Smith certainly recognized but perhaps downplayed a bit - when these conditions don't hold, there is no general reason to expect cooperative rather than socially damaging beggar-your-neighbor behavior.

In this regard, evolution at least provides an analogy, and perhaps can even be described as directly operative in economic behavior (although people's battles over wealth, success, and power play out in arenas not limited to gene transmission). Cooperative group behavior has to pay off at the individual level (which depends on the specific environment and the odds it presents for various things) in order to be sustainable. And there is certainly no reason to assume that compatible incentives and cooperative behavior are the dominant features in a modern economy, any more than it makes sense to assume that "nature red in tooth and claw" is the dominant model in biological evolution. "Cooperation or competition - which prevails?" is a silly question, to which the only good answers are "both," "it depends," and "they're likely to be complexly intertwined."

I am definitely a fan of Bob Frank, who, through his work on positional goods and status competition, has made a very important contribution to modern thinking about GDP, technological progress, tradeoffs between equity and efficiency, and yes, tax policy. As it happens, he was a speaker at the NYU Tax Policy Colloquium many years ago. Our main criticism (I was still doing the colloquium with David Bradford at the time) was that his important insights didn't necessarily translate into thinking about income versus consumption taxation as he thought they did, since the two are arguably the same insofar as the points of interest to him are concerned. (Income and consumption taxation differ in how they treat present versus future consumption, either of which one might want to tax-discourage on the ground that people are competing over positional goods, and thus imposing disutility on others, to a greater extent when they choose work and thus present or future market consumption, than when they choose leisure.)

Frank was also a very pleasant guest and speaker at the colloquium. In person, he turned out (I had worried about this) to have no objection whatsoever to such things as having a nice dinner and accompanying it with a nice bottle of wine.

Does it matter how many separate taxes are in 9-9-9?

Short answer: No, it does not matter at all in substance, although it evidently matters quite a lot optically.

By the way, Grover Norquist, who is no fool when it comes to assessing optics, understands this, and has apparently criticized 9-9-9 for permitting taxes to look lower because they appear to come in separate bundles. There is an ironic jujitsu to all this: so much of Cain's momentum on this issue reflects the fact that, to the conservative base, 9-9-9 looks lower than 27. But holding constant what the taxes actually are, Norquist is right that, if they look lower, this may grease the wheels for letting them go higher than otherwise.

But enough about the optics - why, as a matter of substance, doesn't it matter if there are three 9% taxes, or an 18% tax and a 9% tax, or one 27% tax?

Let's start with the point that Ed Kleinbard and I have been making, and that others such as Ezra Klein have picked up on, which is that 9-9-9's "business tax" and its sales tax are basically the same tax (a few odd details aside), since they are both flat-rate consumption taxes where the tax base is consumer purchases. So we have at a minimum just two taxes, 18% on consumption plus the possibly separate (or not?) 9% personal income (?) tax.

When I made this point in a previous blog post, a commenter made the point that what I called the business-level VAT is in some ways not that far from an income tax. Basically, all you have to do in order to make it an income tax is the following:

(a) allow wages to be deducted by the business. In the standard VAT setting, deducting wages or not is a wash - it doesn't matter in the end - if (i) they are made includable by the worker only if they are made deductible by the business and (ii) the worker and business tax rate are the same. After all, if my business pays me $100 and both its tax rate and mine are 35%, then deduction and inclusion, instead of neither, saves the business $35 of tax and costs me $35 of tax. By the way, even if I don't own the business, then if the net tax on wage payments is zero one would expect wages to adjust, reflecting real market conditions and people's responding to their actual incentives from after-tax returns, so it wouldn't matter (once everything had time to adjust) whether the wages were includable and deductible or neither - apart from in the situation where the worker's marginal tax rate differs from that of the business.

The Cain plan screws this up, of course, by making wages includable by the worker but not deductible by the business. Is this an evil example of that odious crime, "double taxation"? As an optical matter, I suppose you could argue that it is. But in reality, all it does is cause workers who are paid wages to be taxed, in effect once, at 27%. The problem here, as I have noted in prior posts, is that paying observable wages is tax-discouraged, so owner-employees with sufficient liquidity to fund their personal consumption expenses will tend to avoid it and lower their overall tax rates to 18%.

Okay, that more than covers the first important difference between a business VAT and an income tax. On to the next two:

(b) In a business income tax, financial flows such as interest would tend to be deducted by the business that pays them and included by the recipient. (In the present income tax, of course, dividend payments, unlike interest, are not deductible.) In a VAT, all of these financial flows are typically ignored on both sides of the transaction, leading to problems in figuring out how to tax financial institutions (which embed service fees in the spread between the low interest rates they pay and the high interest rates they charge). Once again, however, leaving aside the double taxation of dividends problem in the existing income tax, both including and deducting or doing neither is a wash if the tax rates on both sides of the transaction are the same.

(c) And now for the big difference, applying even when all cash flows are taken into account (or not) reciprocally and when all tax rates are the same. In an income tax, business outlays that create durable assets or lasting value or income expectations beyond the current year are not deducted. Instead, they are capitalized, creating an asset that has a tax "basis," and are only recovered against gross proceeds, such as through depreciation deductions or by only taxing net gain on an asset sale (amount realized minus basis). An income tax, therefore, unlike a consumption tax style VAT, burdens saving and investment.

Suppose Cain altered the business tax in the 9-9-9 plan to be some sort of an income tax version of the VAT, with business outlays potentially being capitalized rather than immediately deducted. This would make the "business tax" component meaningfully different from the sales tax component. At the cost of economic distortion (i.e., discouraging saving and investment), it would burden the business owners and thus presumably increase progressivity.

But to say that there were now two separate 9s, while in a sense optically true, would in a sense be pure semantics. By making the two taxes a bit more different, we would be burdening some people a bit more and others a bit less. But if rates were adjusted to raise the same revenue either way, there would just as much taxation going on from the two taxes that now were somewhat distinct than there would have been if they were the same.

This brings us to the next element of major confusion in the 9-9-9 plan. The campaign website proudly trumpets that dividends will be deductible, so as to avoid present law's double taxation. But what about interest? Is that deductible as well? It is under the current income tax, but again, a VAT generally ignores it. But of course, to understand what would make sense here, we need to consider the last (or first?) of the three 9's, the tax on individuals.

Surely that must include dividends if deducting them at the company level is necessary to avoid double taxation. But surely interest has to be treated symmetrically as well, and the plan says nothing about it.

What is the base for the individual tax? The website says it's "gross income." But what is that? In the existing Internal Revenue Code, "gross income" includes all receipts (except that basis is deducted from the amount realized, so that only the net gain from an asset sale is included) but has no business deductions whatsoever. But everyone seems to agree that the "personal" tax here will not apply to the gross proceeds of, say, a neighborhood candy store, but is only for salary plus apparently some other gross income items - dividends and (despite the hiccup in the business tax) presumably interest, and perhaps all the other stuff that under present law leads you to get a W-2 or 1099. (Though not capital gain, as the plan purports to exempt this.) By the way, if we are including all this gross income, then I don't entirely understand how Cain is repealing the entire existing Internal Revenue Code, since parts of it are surely needed to figure out what income is.

For example, if interest is included by individuals, and is meant to be deducted by the business even though the plan does not say so, then might we need the original issue discount (OID) rules for interest that has accrued economically but not yet been paid? To be sure, if the treatment is symmetric and all the rates are the same, then perhaps this doesn't matter as much.

What the Cain campaign presumably does mean by "gross income" is that there will be none of the deductions that the Internal Revenue Code allows against "adjusted gross income" or AGI. By AGI, it means net rather than gross income, but without itemized deductions such as home mortgage interest, and without personal exemptions or the standard deduction.

Incidentally, I assume that fringe benefits that aren't currently included would be taxed in the Cain plan. Most would agree that the exclusion for employer-provided health insurance is no less a special tax expenditure than the home mortgage interest deduction. So does he mean to make it nondeductible at the business level as part of the wage (although it's currently deductible), AND includable at the individual level on the same rationale? Inquiring minds would like to know.

Okay, suppose we were to conclude that the personal income tax really is an income tax while the other two parts are consumption taxes. This probably isn't right, as it appears to be more of a wage tax plus perhaps a tax on interest and dividends (which of course are includable in "gross income" under present law). But suppose that one of the 9's is an income tax while the other two 9's are consumption taxes. Does this mean we have two taxes of 18 and 9 rather than one at 27?

This question really has no correct answer, or at least none that is meaningful, as it's a matter of optics and semantics. Let's consider instead substance. Suppose we had a single 27% tax but it was one-third income tax and two-thirds consumption tax. (E.g., suppose returns to capital that were income but not current consumption were two-thirds deductible, or alternatively were taxable, in the manner of capital gains today, at a special rate that happened to be 9% instead of 27%.) This would in a sense be the same as 9-9-9 if one of the bits is an income tax and the other two are consumption taxes, yet it would clearly be one instrument.

Bottom line: counting separate tax instruments is a fool's game. What matters is the overall tax being levied. And here, 9 + 9 + 9 = 27. Since this is an equation, the left side equals the right side, and no one should think it matters which side you are looking at.

Busy travel schedule

I appear to have signed myself up for quite a lot. Here's how the next two months are looking for me at the moment:

Saturday, October 22 – At the University of Louisville Symposium on on Federal Budget and Debt Reduction, I will present my paper on the tax reform implications of the risk of a U.S. budget catastrophe.

Friday, October 28 – At the NYU-UCLA Tax Policy Conference on Healthcare Reform, to be held this year at UCLA, I'll be moderating a panel on Healthcare Reform and the Long-Term Fiscal Outlook. The panel will include papers, on which I may briefly comment, by Howard Gleckman, Daniel Kessler, and Mark Pauly.

Thursday, November 3 – At the annual meeting of the American Association of Attorney-Certified Public Accountants (AAA-CPA), to be held in NYC (east midtown), I'll offer a talk entitled "Fundamental Tax Reform: Can, Should, and Will the U.S. Federal Income Tax Be Replaced by a National Consumption Tax?"

Friday, November 11 – In Chicago at the University of Chicago Tax Conference, I will comment on a paper by Phil West concerning foreign tax credits.

Thursday, November 17 through Saturday, Nov. 19 – On to New Orleans for the National Tax Association's 104th (!) Annual Conference on Taxation. Here I will present my paper on corporate residence electivity, moderate a panel on corporate tax reform, and comment on a couple of international tax papers.

December 1-2 – On to Sao Paulo, Brazil, where I will be the keynote speaker (discussing international tax issues) at a conference held by the Center for Fiscal Studies at Sao Paulo Law School.

December 9 – Heading east for a change rather than west or south, I will fly to Amsterdam and present a short paper on the relative merits of financial transaction taxes (FTTs) and financial activities taxes (FATs) at a conference on taxing the financial sector that will be held at the Amsterdam Centre for Tax Law.

While I expect to get the rest of the year off, no doubt for good behavior, on January 6, 2012, I will be presenting work on international taxation at the University of Florida College of Law in Gainesville.

The New York Times is as confused about 9-9-9 as everyone else

From today's front-page NYT article on the 9-9-9 plan:

"From that exchange emerged the plan that Mr. Cain calls 9-9-9: a flat 9 percent individual income tax rate, a 9 percent corporate tax rate and a 9 percent national sales tax."

Again, the "corporate tax" here is in fact a sales tax, no less than the sales tax in the plan is a sales tax. These things matter.

By the way, suppose that we didn't have an income tax - say, because Congress had replaced it with a progressive consumption tax, such as either the David Bradford X-tax or a "consumed income tax" on individuals. BTW, as I've discussed in various places, such as here, I would strongly prefer this to the existing income tax, at least if we could make optimistic assumptions about how Congress would actually implement it. (This is a problem that these plans admittedly would share with 9-9-9.)

If that happened, then we wouldn't need a "corporate tax." The main purpose that the corporate income tax serves today is to backstop the income tax on individuals, which would become a joke if people could avoid it by earning their income through corporate entities. Thus, suppose I could hire myself out to "Shaviro, Incorporated," a newly formed corporation to be entirely owned by myself and close family members, and arranged for it to contract with NYU for my teaching services. It would then pay me (to meet current consumption expenses) only a fraction of my actual salary. Unless we either taxed this company directly or made the income currently taxable at the worker or owner level, we would have shot a huge and pointless whole in the income tax.

Many people nonetheless seem to want a "corporate tax" as an end in itself, not just to backstop the income tax if we have one. This appears to reflect the "pathetic fallacy" of personifying corporate entities. As it happens, concern about this way of thinking was an important reason why David Bradford came to prefer the X-tax to a purely individual-level consumed income tax - he thought it would be more salable politically because corporations would literally be taxpayers (i.e., they would be remitting VAT-like payments to the government).

9-9-9 fails to use its "corporate tax" as a proper backstop to the individual tax, given that nonpayment of owner-employees' salary reduces tax liability at the full 9% individual rate. And it gestures towards the public sentiment for a "corporate tax" by doing something that is entirely misleading - although, again, I see no reason to doubt that the proponents are themselves misled. It would be nice if the New York Times could do more to help public understanding on this front.

Follow-up on Cain's 9-9-9 plan and fiscal self-delusion

The more I think about the level of confusion that appears to underlie the 9-9-9 proposal, and to be shared by proponents and skeptics alike, the more extraordinary I find it. This is really Exhibit 1 for teaching some basic economics ideas in high school.

A key part of 9-9-9's intuitive appeal is the idea that, not only is 9 a low number, but the plans three 9's appear to be spread out. 9 percent on the worker, 9 percent on the business, 9 percent on retail sales.

But as I noted in my prior post, the latter two 9's are effectively THE SAME TAX (a few details aside). Only ignorance and naive folk notions of incidence could make them look like two different taxes that are pointed at different players.

Again, the "business tax" is a VAT, which is basically just another way of collecting sales tax. Most experts would say that you can have either a VAT or an RST (retail sales tax), and that the choice should depend on enforceability and administrability issues, but that it's nuts to have both. And if for some crazy reason you do have both, you still shouldn't fool yourself into thinking that you have two distinct taxes in any meaningful economic sense.

OK, time for a simple illustration to make the point. Say I own some land where I grow timber. I cut down a tree, turn the salvageable parts into a nice log, and sell it for $40 to Rawlings Sporting Goods. They turn it into a baseball bat and sell it for $100 to the parents of little Johny and Janey Smith, who will use the bat in their Little League games. Suppose we have a 9% business tax, Cain-style, and a 9 percent sales tax. How does each treat it?

The sales tax ignores the inter-business sale from me to Rawlings. It hits up the sale from Rawlings to the Smiths for $9.

The business tax generates a net tax of zero on the sale from me to Rawlings. More specifically, I owe tax of $3.60 and Rawlings gets a refund / tax reduction of $3.60. In a fuller account I'd build this in as changing the pre-tax price, but let's ignore that complication here. Net result: no tax on the inter-business sale, and once again a tax of $9 on the sale from Rawlings to the Smiths.

In short, these two taxes are the same, except that in the VAT (i.e., the "business tax") there is a paper trail. I might get in trouble if I don't remit the $3.60, since the tax authorities could cross-check the paperwork and note that Rawlings is claiming a $3.60 credit or refund. And if Rawlings claims the refund, but then pretends that the sale to the Smiths didn't happen so it doesn't have to remit $9 to the government, the tax authorities will say: If you bought timber and claimed a refund and you don't have a bat in your showroom, what exactly happened? Why don't you have inventory on hand from the goods you bought and claim not to have sold?

The underlying problem, again, is naive or folk notions of incidence. We think of the retail sales tax as paid by the Smiths, in part because, under common U.S. practice with sales taxes, it's separately stated. Rawlings could have sold the bat for $109 without ever mentioning the tax. It is going to owe the proper RST to the authorities no matter what. But we think of the tax as paid by the Smiths, in part because Rawlings is likely to flag it as a distinct item.

The business tax only looks different for trivial reasons that have nothing to do with economic incidence. Everyone would understand that this, too, was a tax on the Smiths if it was similarly separately stated, e.g., by having a pre-all-taxes price of $91.74. But presumably Rawlings wouldn't do this. In addition, perhaps everyone would understand that it was really on the Smiths, even without such separate statement if, as is the case with VATs around the world, its character as a consumption tax (and effectively an RST substitute) were better understood. The existence of cross-border VAT rebates may help with this as well. But because the tax part isn't separately stated AND people apparently don't realize that it's a VAT, it ends up getting vulgarly conceptualized as a tax on the business.

So two of the 9's in the Cain plan are simply redundant versions of almost the same thing. But what about the 9 that ostensibly falls on wages? That, as per my prior post, is a tax on being among the poor slobs who can't avoid using an explicit wage payment in order to get the compensation they have earned. So it's a tax on not being self-employed and, among the self-employed, on not having enough cash on hand for personal consumption expenses to simply leave all net cash proceeds in the business.

With all due respect to the late Steve Jobs, recall his famous $1 per year salary. Given his wealth-financed personal consumption, he would be paying 18 percent per year. No need to face the 27 percent rate given that he earned it through his Apple stock, on which 9-9-9 would permit him to earn tax-free capital gain whenever he liked.

But isn't it also true under present law that Jobs was untaxed on salary that effectively was earned but not paid? Yes, but that's not the whole story. By not paying the salary, Apple lost a deduction. So, if both Jobs and Apple faced a 35 percent marginal rate on the next dollar included or deducted, there was no net federal income tax benefit from the under-payment. Thus, current law does not favor the wealthy self-employed to anything approaching the same degree as 9-9-9.

In sum, one could think of 9-9-9 as having 3 tax rate brackets. Poor people without a job are taxed at 18 percent, including on the necessities that they can barely afford. The employed poor and middle class people, along with the non-self-employed rich, pay tax at 27 percent. But the wealthy self-employed get their tax rate back down to 18 percent again.

Herman Cain's 9-9-9 tax plan

When Cain surged to a more prominent place in the Republican field and discussion of his "9-9-9" tax plan began surfacing, I, along with various others in my field, started getting phone calls from the press about it.

To be honest, I found it hard to focus seriously on the plan. With finite time available, a book I am trying to write, etcetera, I am often reluctant to spend a lot of time learning the details of tax proposals - not just by temporarily high-flying candidates, but also by presidential administrations and Congressional leaders - when I suspect, as frequently and with good justification I do, that they are neither well-designed enough to be of any intellectual interest nor likely enough to be enacted to have any real practical interest.

Nonetheless, I suppose a mea culpa is in order on this score, given that those of us in the tax policy biz have professional responsibilities to communicate with the public when issues in our domain reach the front burner. Thus, I am grateful to Ed Kleinbard for thoroughly analyzing the 9-9-9 plan here, and to Bruce Bartlett for doing so here.

One thing I hope I can contribute here, however, is a more succinct version of some of their key conclusions - Kleinbard's in particular, as Bartlett focuses much of his attention on Cain's apparent long-term plan to replace "9-9-9" with a national sales tax, a proposal that Bartlett has done an excellent job critiquing, such as here.

The really comical thing about Cain's 9-9-9 plan is how much it is a product of silly optics. As Kleinbard shows, it essentially amounts to a 27 percent flat tax on wages that is reduced to 18 percent for owner-employees who have enough liquidity not to need to pay themselves an explicit and observable arm's length wage.

There often is debate about whether, if we went the national consumption tax route, a value-added tax (VAT) or retail sales tax (RST) would be better. I regard the two taxes as in principle identical except that a VAT has better enforcement potential. Cain, however, has both in his plan. The business tax, his second "9," is in the main a VAT, apart from a few odd features such as its making dividends deductible. And Cain's third "9" is explicitly an RST.

Why on earth would you have both a VAT and an RST? I think the reason is that 9-9 sounds better than 18. You get the illusion that the taxes are more different than they actually are. Moreover, each, considered in isolation, seems low.

Along these lines, I have a great idea to eliminate the 35 percent individual income tax rate without losing progressivity or revenue. Here's the plan: replace the 35 percent annual income tax with a 3-3-3-3-3-3-3-3-3-3-3-3 monthly tax on annual income. After all, who's counting if the 12 monthly taxes actually add up to 36 percent annually?

Cain's first "9," of course, is the wage tax on individuals. Again, this is only for people who have to take their labor income in the form of wages because they are not owner-employees who can simply omit the step of paying a wage from their left pocket (the business) to their right pocket (the self-employed worker) - an omission that presumably requires sufficient liquidity to pay one's consumer bills with cash already on hand. But since (as Kleinbard shows) a wage tax is in the long run equivalent to a consumption tax apart from the undermeasurement of owner-employees' true economic wages, we end up with what is really a 27 percent / 18 percent consumption or wage tax, with the lower rate going to the self-employed, but, again, only insofar as they have the liquidity not to need to extract from their businesses the full economic wage. And this is not merely deferral, since in the long run you can simply sell the business and derive capital gain that the 9-9-9 plan would exempt.

As Kleinbard notes, Cain would impose a huge tax increase on lower-income and middle-class Americans, who would lose the benefit of lower income tax rate brackets, including the effective zero bracket that results from personal exemptions and the standard deduction. (To be sure, the payroll tax is first-dollar, but its rate is well below 27 percent even if one counts all of the employer / employee and Social Security / Medicare pieces.) So on the bottom end Cain's plan is shockingly regressive. Even his beau ideal the FAIR tax generally has a universal "prebate" in the amount of estimated poverty-level consumption expenditures.

As for imposing a lower tax rate on highly liquid owner-employees than on those whose work situation requires the payment of an observable arm's length wage, this in practice means that we don't even have a flat rate system, but one in which the rich will frequently pay a lower rate than anyone else. Although the high-end lower rate may in part reflect mere confusion and inadvertence, I am reminded of the gabelle - that is, the salt tax in pre-French Revolutionary France from which nobles and the clergy were exempted.

New publication

My co-authored (with Kimberly Clausing) article, A Burden-Neutral Shift from Foreign Tax Creditability to Deductibility?, has now officially appeared in print. It was previously available as an SSRN working paper. The citation is 64 Tax Law Review 431-452 (2011).

The abstract is as follows: "Observers of international tax rules have long conflated two distinct effects of the foreign tax credit on multinational firms: the effect on the incentive to invest abroad and the effect on foreign tax sensitivity. With national welfare as the policy objective, we discuss how a burden neutral shift from foreign tax credits to deductibility could be designed to improve distortions associated with insensitivity to foreign taxation without raising aggregate burdens on outward foreign investment. We also provide new evidence suggesting that the tax sensitivity of outward foreign direct investment is indeed reduced for OECD countries using foreign tax credits, in comparison with other OECD countries. Finally, we discuss policy considerations surrounding a possible burden-neutral shift from foreign tax creditability to deductibility."

It's available for download here.

Corporate integration via dividend deductibility

As promised in my prior post, here is the text of my talk at NYU today regarding Reuven Avi-Yonah's co-authored article, The Case for Dividend Deduction. (See prior post for my link to Reuven's article.)

The text refers to a chart I had distributed to attendees, demonstrating that allowing corporations to deduct dividends paid is potentially identical to the seemingly very different system where they are taxed, but dividend distributions to shareholders get the benefit of "imputation" (i.e., corporate-level tax is in effect treated as an advance payment by the shareholders of their taxes on the corporate income). Imputation is or at least was a very common corporate integration system around the world, whereas dividend deductibility is not. I argue that the paper over-distinguishes between the two and that they can be made identical. Anyway, the chart, which offers a simple illustration of the potential equivalence between the two methods, is available here.

Perhaps the most novel point in my talk is one that I under-developed in the text because it would have taken too long to explain it. So here goes. Reuven argues that dividend deduction would be more effective than imputation in encouraging the managers to pay dividends, on the ground they often don't especially care about shareholder taxes but love to get company-level deductions. Thus, even if the two methods of dividend deduction and imputation are in fact economically equivalent, the former will in fact induce greater payouts.

One could certainly challenge this view on multiple grounds, but the one I emphasized, in particular because I thought it was more of a new point, reflects accepting the basic premise (at least arguendo) but then asking what the managers really care about. A common answer, with considerable real world empirical support, would be that they appear to care more about financial accounting income than about income tax liability. So the entity-level tax benefit of dividend deductibility won't affect their behavior as strongly as Reuven anticipates unless there is an accounting benefit. But would there be?

I am not an accountant, but I've played in or near their waters often enough to realize that this is a trickier question than it may initially seem from a lawyer or economist standpoint.

Presumably the financial accounting rules would NOT be revised to allow dividend deductions against financial accounting income, even if newly made deductible against taxable income. But wouldn't financial accounting income reflect the benefit of reducing federal income tax liability through dividend payouts?

Not necessarily. An initial point to keep in mind is that financial accounting often ignores the mere deferral of federal income tax liability. In principle, under dividend deduction, the ultimate corporate tax is zero as all earnings get paid out (or at least an amount equal to taxable income, which is often less than the tax measure of earnings for dividend purposes). So it would seem that the accounting rules in the dividend deduction scenario should either (a) ignore federal taxes on the ground that they're merely temporary, at least until they escape the possibility of being reversed through net operating losses created by dividend deductions, or at least (b) ignore the difference between paying out deductible dividends this year or next year. I'm not in fact sure how it would all end up playing out, but we should recognize that (a) there would be a tricky issue for the accountants to work out and (b) there wouldn't necessarily be a straight accounting benefit for the tax liability effect.

By analogy, consider the accounting rules for the foreign earnings of U.S. companies' foreign subsidiaries. These get the U.S. tax benefit of deferral - that is, they aren't subject to U.S. tax until they actually are repatriated for tax purposes. But companies get no accounting benefit from deferral - they are treated as if the U.S. repatriation taxes were being fully paid on a current basis - unless they solemnly declare to their accountants that the funds are being "permanently" reinvested abroad. Once this happens, the potential future U.S. repatriation taxes are discounted by 100% (i.e., to zero) rather than by zero percent.

Anyway, if the timing of repatriation is effectively ignored in financial accounting on the view that it doesn't matter exactly WHEN it happens (despite the potential effect on the present value of U.S. tax liability, then the same idea might apply, albeit in a somewhat different and (at least to me) unpredictable fashion, with regard to the effect of current versus future dividend payouts on entity-level, purely domestic U.S. income tax liability.

Any accountants out there, your thoughts on this admittedly esoteric issue (either in the comments page here or by e-mail to me) would be of potential interest.

UPDATE: The following is hoisted from the first comment on this blog entry (by Elijah):

"As you suggest (directionally at least), corporations would presumably book a deferred tax asset for undistributed dividends, much in the same manner as they currently book a deferred tax liability for the (non-permanently reinvested) unrepatriated earnings of their foreign subsidiaries. In this manner, they would "ignore" the actual timing of the (tax) deduction and the tax rate (on U.S. earnings) would move towards zero.

"I say 'move towards' because capital needs will prevent corporations from ever truly distributing everything prior to liquidation, which itself may be too remote a possibility for the corporation to consider for financial accounting purposes. Rather, corporations would undoubtedly get into the usual arguments (with their auditors) about how much of the the deferred tax asset could really be realized, and whether some amount of offsetting valuation allowance would be appropriate. This would ultimately be reflected in the (book) tax rate.

"The more interesting question, I think, is whether any of this would influence managers to pay dividends. My initial thought is that it would not. Managers would, theoretically at least, not be able to influence the book tax rate (year to year) by paying dividends in year 1 versus year 2 (or 3, or 4, etc.)."

Corporate tax reform talk

Today at 12:30 in Greenberg Lounge at NYU Law School, I will be participating in a panel discussion (with Deborah Schenk, Reuven Avi-Yonah, and Deborah Paul), of Reuven's recent co-authored paper, "The Case for Dividend Deduction." Reuven argues here for achieving corporate integration by making corporate dividends deductible at the entity level (and fully taxable to shareholders if they are U.S. taxpayers).

I do not entirely agree with the analysis or conclusions, for reasons that I'll explain. I actually wrote out my remarks in full, including some broader observations about corporate tax reform, so that I would be able to post them here after the session. I'll try to do that this afternoon.

A partially intellectually purist take on the Buffett Rule

President Obama has lately been urging the enactment of tax legislation to implement the "Buffett Rule," which, according to his reelection campaign website, "would require the wealthiest Americans to pay a tax rate at least as high as the middle class."

The basic idea appears to be mathematical, or at least arithmetical. For each individual, you can make an equation where taxes paid are the numerator and some measure of income is the denominator. The Buffett Rule posits that the amount thus computed should be at least as high for the wealthiest Americans as it is for those individuals who are defined as representing the middle class.

Thus, if a middle-class individual earns $50,000 and pays $12,500 in relevant taxes (i.e., one-quarter), then a wealthy individual who earns $100 million should also pay at least 25 percent (i.e., $25 million).

The underlying computation, often called the average tax rate (as compared to the marginal tax rate that applies to your last dollar) is familiar. A number of conceptual problems emerge in trying to use it this way, however.

What's in the numerator? - Presumably not just income taxes, which is the usual Republican ploy to ignore the less progressive levies in our fiscal system. Thus, payroll taxes to finance Social Security and Medicare would presumably be included. But what about the benefits from those programs? Note, for example, that while Social Security taxes, considered in isolation, are extremely regressive, going from 12.4% to zero at around $100,000 of annual earnings, the program as a whole is progressive on a lifetime basis unless high-earners live significantly longer.

Likewise, what about non-federal taxes, which generally are less progressive but may vary significantly? Or the corporate tax, which is indirectly paid by the shareholders? While it has uncertain economic incidence, this issue would exist even if the shareholders paid it directly. What about the expected present value of future taxes on current earnings? This, by the way, is a huge issue in thinking about income tax versus consumption tax progressivity.

What's in the denominator? - Here we presumably don't mean taxable income, or else a system with graduated rates would automatically satisfy the Buffett Rule. But how far are we going towards a measure of economic income? Does all unrealized economic gain count? That would be a huge change, and perhaps a good one, but it would go way beyond anything the Buffet Rule could seriously be thought of as aiming at.

And once you start thinking about items that might be added to the denominator, you may realize that you need to think more about the numerator. Thus, suppose tax-exempt municipal bonds pay 3%, while taxable bonds pay 4%. A high-bracket municipal bondholder is effectively paying an "implicit tax" of 25%. Thus, suppose Warren Buffett holds $100 million in municipal bonds, on which he earns $3 million of tax-exempt income. In performing the computation, rather than adding zero to the numerator and $3 million to the denominator, shouldn't we add $1 million to the numerator and $4 million to the denominator? For a wide range of tax-favored assets, however, these computations will be very difficult to make, and once again far beyond the Buffett Rule's apparently intended scope.

Okay, enough. I understand that this somewhat crude and simplistic idea is in fact a potentially clever marketing device that may serve both (a) to support changes in the direction that I favor, which is increasing the relative tax burdens of the wealthiest Americans in an era when we have massive long-term budgetary shortfalls and they have shot away from the rest of us economically as if propelled by a nuclear rocket launcher, and (b) to dramatize the fact that our current system's progressivity is nothing close to what it may seem if you naively consult the income tax rate tables.

In that sense, the Buffett Rule could have some good effects, relative to the status quo, both on political debate and on the state of the tax law if it leads to some enactment. But it encourages a host of distracting debates about side issues so far as the true points of interest are concerned. And it may discourage focusing more directly on the real issues of tax preferences and after-tax income distribution. And it could lead to the enactment of Rube Goldbergish, alternative minimum tax-style rules, as compared to more straightforwardly broadening the base and increasing high-end marginal rates. Just like the AMT since 1986, moreover, it might be subject to slow-motion unwind, such as legislation removing a particular tax preference from the Buffett tax computation so that the ostensibly wonderful reasons for enacting the item could be fully realized.

So while the Buffett tax may be a clever rhetorical initiative in some respects, I wish they could have come up with something that was substantively more coherent and better. But I suppose that's just one more reason why I'm here (in academics) and they're there (in politics).

Can we forget about the 2007 Mets now?

From Nate Silver:

“The following is not mathematically rigorous, since the events of yesterday evening were contingent upon one another in various ways. But just for fun, let’s put all of them together in sequence:

• The Red Sox had just a 0.3 percent chance of failing to make the playoffs on Sept. 3.

• The Rays had just a 0.3 percent chance of coming back after trailing 7-0 with two innings to play.

• The Red Sox had only about a 2 percent chance of losing their game against Baltimore, when the Orioles were down to their last strike.

• The Rays had about a 2 percent chance of winning in the bottom of the 9th, with Johnson also down to his last strike.

"Multiply those four probabilities together, and you get a combined probability of about one chance in 278 million of all these events coming together in quite this way.”

Nate speculates that the outcomes might have been correlated rather than independent, although this might have to depend on statistically hard-to-support claims about systematically "clutch" and "un-clutch" behavior. But he also offers an amusing stick figure illustration, entitled "All Sports Commentary," in which the first person says: "A weighted random number generator just produced a new batch of numbers."

The second one replies: "Let's use them to build narratives."

Tales from (near) the Vienna Woods

Last Tuesday night I flew to Vienna to teach a 4-day, 3 hours per day International Tax Policy class to students in a new doctoral program at a tax institute among the economics and business programs at Vienna University. The students are mostly lawyers, but also include people with degrees in economics, business administration, and someone with accounting as well as law. We're halfway done now, with a break for the weekend.

One of the best things about teaching this class is that there's no exam. Instead, the students will write papers. And while it's true that writing exams and grading them are the two worst tasks in a law professor's job, that's not even the main reason it's so incredibly refreshing not to have to do it.

I've assigned a bunch of readings (all by me, including unpublished book chapter drafts, except for the Tax Notes versions of Kleinbard's Stateless Income), but I don't feel I have to lecture on them. If on a given day I think it would be more instructive or fun to discuss X, Y, or Z (provided they are pertinent to the class's topic), that's just fine. No one is wondering about whether that's on the test, or whether stuff in the readings that I'm not discussing is on the test.

Obviously, the danger in such a situation is that the students will be unmotivated. But apart from the fact that they have to write papers, they're only in this program (3 years, but they're just starting) because they're interested in international business taxation, and in some cases possibly in academics or government policy jobs. They all have good work experience and would be insane to do this unless they were highly motivated.

When I teach the Tax Policy Colloquium at NYU, I get the same benefit of students who can take an interest without having to worry about the exam. (I of course don't blame students for worrying about exams when given; it just makes the experience much worse both for me and for them, and makes it much less genuinely educational apart from the admittedly important motivation it provides to take a class seriously.)

Of course, the colloquium is 14 weeks long, and the students have lots more going on, including other classes, family life, and job search. Plus, their opportunity cost is much lower, taking as given that they've decided to go to law school (or to add an LLM degree). Thus, the average level of commitment in the colloquium is bound to be less. But this is not to complain - I've been very happy with my colloquium students over the years, and I believe I've had some success, via various measures, in getting enrollees to self-select for being genuinely interested. It's been a true pleasure to get to know all these students (as one does a bit more in the colloquium than the lecture hall setting), and to learn from as well as teach them.

Meanwhile I've been touristing up a storm, so to speak, in Vienna, to the extent that I am feeling run-down and borderline sick. On Wednesday, after arrival, I went to the Schlossburg Palace & its grounds, including the Vienna Zoo, followed by 3 modern art museums in a complex called the Museum Quarter, topped off with dinner at one of the stalls in a place called the Naschmarkt (best translated as Nosh Market).

On Thursday after class, Demel's and Hotel Sacher's pastry shop followed by the delightful Albertina Museum (also with lots of modern stuff). I may go to an obscure American film there tomorrow (George Ray Hill's The Driver).

On Friday after class, the Kunsthistorische Museum (main Vienna art museum for the Renaissance and surrounding periods) followed by the Natural History Museum, then dinner with my host at a very non-touristy and authentic Vienna restaurant right on the edge of the Vienna Woods.

Today I took a train (1 hour each way) to Bratislava, Slovakia for a day trip. Charming town now that it has recovered from the horrid drabness and failure that the Communists imposed on it. Lots of charming and deliberately whimsical town squares, a few museums, a castle, some towers, coffee and a pastry on the town square, etcetera. Bratislava also has the Danube flowing through it, though it looked green rather than blue. At lunch, a very good Slovakian meal that (along with the pastry that followed) will also serve as my dinner.

As it was sunny and nice and everyone around was having a beer, I decided to do so at lunch as well, although that's certainly not my usual practice (too much the puritanical American, I suppose). Pilsener Urquel was prominently listed on the menu, but I was wondering (since I've heard of it in the US) if it is below the top local standard. I asked the waitress if it was good, and she frowned and said "It's Czech." So I got a Slovakian dark beer instead.

Tomorrow, another art museum & park called the Belvedere, then maybe that George Roy Hill movie. This leaves only Monday and Tuesday after class (I leave early on Wednesday).

I've brought work here, and I certainly could use the time doing it, but somehow when one's away from one's usual places and also has touring opportunities (cue the Puritanical sense of duty again, I suppose, although I really do enjoy it & find it interesting), I just can't find the motivation to do any of it.

"Go big" letter on deficit reduction

I am one of the more than 60 signers (or, if you prefer, signatories) of a letter to the Joint Select Committee on Deficit Reduction that urges the Committee to "'go big' and develop a large-scale debt reduction package sufficient to stabilize the debt as a share of the economy."

With the studied generality that was needed to get so many signatures, which range across the ideological spectrum from about the medium left to the medium right, the letter continues:

"We believe that a go big approach that goes well beyond the $1.5 trillion deficit reduction goal that the Committee has been charged with and includes major reforms of entitlement programs and the tax code is necessary to bring the debt down to a manageable and sustainable level, improve the long-term fiscal imbalance, reassure markets, and restore Americans’ faith in the political system.

"While we have differences of opinion about the specific policies that should be included in any plan, we all agree that a large-scale, multi-year debt stabilization package is necessary to deal with the fiscal challenges facing the nation."

I was willing to sign the letter because it doesn't contradict (although it also doesn't endorse) the view I share that in the short run we need to boost consumer demand. Also, I certainly agree about the need for entitlement reform and tax reform, although (as discussed here) I would not include rate reduction in the latter.

And while I am very skeptical that anything good is likely to come out of the current political environment in which the Joint Select Committee on Deficit Reduction is operating - requiring me to swallow some qualms about the "go big" advice in signing the letter - I concluded as follows:

(1) waiting for the political environment to improve is not very promising, as it may just keep on getting worse, and

(2) as I discuss here, the threat of fundamental political dysfunction leading to default is great enough that it wouldn't be prudent (as Bush Sr. might have put it) to favor sitting tight and waiting for a more propitious time.

Tax planning by video game developers

Interesting NY Times article about how video game developers such as Electronic Arts have combined aggressive tax planning with equally aggressive lobbying to pay no U.S. tax on $1.2 billion of global earnings, which I would guess were as a fundamental economic matter nearly all generated by talented employees who were living and working in the U.S.

One supplementary fact, not included in the article (reflecting that the information would be hard to find), but of interest substantively, is what taxes were paid on the owner level, given that one of the main tax provisions employed by Electronic Acts (according to the article) was deductions for employee stock options.

Still, even looking at both levels of tax, I rather suspect that Electronic Arts did pretty well.

The article spends quite a lot of time discussing the "architect" of Electronic Arts' strategies in recent years, "Glen A. Kohl, a tax lawyer colorful enough to publicly compare himself to Bruce Springsteen and to joke in the pages of The Wall Street Journal that his dog, Rubin, shared the name of the Treasury secretary under whom he served (Robert E. Rubin).

"After working in the Treasury Department during the Clinton administration, Mr. Kohl entered the private sector and became head of E.A.’s tax department in 2004, leading the company as it aggressively lobbied for a federal tax break on domestic production and set up a matrix of offshore subsidiaries, many in low-tax countries."

Kohl appears not to have been interviewed on the record for the article, but he is also discussed at length later on. It mentions that, before joining Electronic Arts in 2004, he "co-authored a widely-cited proposal urging the federal government to crack down on corporate tax avoidance, warning that 'the tax shelter problem is simply too detrimental to the tax system not to act.' As head of tax at Electronic Arts, he became a noted expert in using foreign subsidiaries to legally, and sharply, cut a corporation’s United States tax bill. As a co-chairman of the Silicon Valley Tax Directors Group, he also moderated a seminar in 2010 that showed technology companies how to use offshore subsidiaries to reassign the licensing of their intellectual property and, in some cases, reduce their effective federal tax rate substantially from 35 percent."

So it's a classic praise / pan, in some ways making him look great (smart, important, influential, creative, effective) but also no doubt prompting invidious musings from many readers about what might underlie the change in persona that appears to have taken hold around 2004 or so.

I should put my own cards on the table here and note that Glen and I are old law school classmates, and that I consider him a friend (hopefully, notwithstanding my topic choice here). Few if any in my law school class were so charismatic, energetic, or widely known and liked. For that matter, he was (and no doubt remains) far less self-important than Bruce Springsteen. Closer in intellectual outlook to Stephen Malkmus minus the diffidence, and coming from me that's high praise.

But the story of his evolution pre-2004 versus post-2003 certainly reflects the sort of incentives people face in the tax and business world - not just financially, although that's obviously very important, but in other ways as well. There are only so many ways to hit the really big leagues, develop and showcase your professional talents, and express your intellectual creativity, especially if you don't choose (or it isn't quite your thing) to toil in the obscure groves of academe, laboring to develop what you consider insights that maybe 300 people will download and 40 or so truly appreciate. And there may be unfortunate social byproducts to how talent thus ends up being directed.

Call it a cautionary tale, with an individually but not socially happy ending.

New article published on SSRN

I have just published on SSRN an article draft that I prepared over the summer, entitled Tax Reform Implications of the Risk of a U.S. Budget Catastrophe.

The link for downloading the article is here.

The abstract is as follows:

"Despite the demographic causes of the long-term U.S. fiscal gap, only severe dysfunction in our political system, abetted by malfunctioning and discontinuously responsive global financial markets, could lead to a U.S. budget catastrophe. Unfortunately, the risk of disaster appears to be alarmingly high. The rising danger has implications both for income tax reform and for the possible adoption of new tax instruments.

"For income tax reform, the main implication is that base-broadening should be undertaken without accompanying 1986-style tax rate reduction. The threat of a fiscal catastrophe also raises concern about otherwise desirable but potentially revenue-losing reforms, such as to the rules for corporate and international taxation.

"A number of tax instruments not currently used in the U.S. might be appealing even if the reform that included them was revenue-neutral overall. These include a value-added tax (VAT), a carbon tax, and a financial activities tax (FAT), although in my view a financial transactions tax (FTT) would not have comparable merit. All of these instruments potentially gain appeal if they could be used to ease the political prospects for raising overall U.S. tax revenues, and thus for reducing the risk of a budgetary catastrophe."

A few words in further description: I prepared this short article draft pursuant to my obligations as a speaker at the University of Louisville Law Review Symposium on Federal Budget and Debt Reduction, which will be held at the University of Louisville Law School on Saturday, October 22, from 10 am to 4 pm. A link to this conference is available here. The rule for article submissions was 25 pages tops, so my article tries to cover a lot of ground very fast, and inevitably a bit superficially (or at least relying on conclusions from elsewhere that are not substantially defended in the text). That said, it does offer a general perspective on tax reform issues (pertaining to both the existing income tax and possible new instruments) in light of the fiscal dangers that we face.

Is Social Security a Ponzi scheme?

Since Rick Perry keeps calling Social Security a Ponzi scheme, let's examine the accuracy of this characterization.

A true Ponzi scheme has two main elements. First, new investors' contributions are used to pay old investors' benefits. Second, an exploding or unsustainable growth rate is needed to keep the promised or expected benefits coming. (A chain letter where you ask six people to send you a dollar, and they then each ask six people to send them a dollar, is a classic example.)

Social Security has the first of these two elements, reflecting program cash flows and the initial decision, made when the program was started during the Great Depression while millions of seniors faced ineradicable poverty, to start paying benefits to retirees who had not significantly contributed to the program.

This alone, however, is not problematic in the way that the term "Ponzi scheme" inevitably suggests. If you think it is problematic and thus justifies the label, here's another non-exploding and seemingly Ponzi-like scheme for you. My family, like many others, has for countless generations been running this incredibly Ponzi-like scheme called "parenting." As a baby you get these free benefits, paid by your parents via their labor in raising you. Then when you grow up you pay in to the plan (if you have children) by raising your kids.

Surely this is even worse than Social Security. After all, at least in Social Security you pay your taxes before you get your benefits. Here, you get your benefits first! But there's still the key feature that you don't self-finance, i.e., raise yourself from infancy. Instead, each cohort relies on an adjoining one to pay it. Yet somehow this audacious scheme has proved sustainable over time.

So there really is no Ponzi scheme unless an exploding or unsustainable growth rate is needed to keep the promised or expected benefits coming. How does Social Security rank in this regard?

As it happens, the program does not have a well-defined relationship between taxes paid in and benefits that are promised. This depends on how the payroll tax rate and base on the one hand, and the benefit formula on the other hand (each subject to statutory modification at any time), happen to play out given birth rates, life expectancies, wage growth, employment levels, etcetera.

But in Paul Samuelson's famous conceptualization of Social Security in a classic 1958 article, we can think of the program as one in which everyone would get back exactly the amount they paid in if, among other simplifying abstractions, wages and population were constant over time and everyone's life consisted of a fixed "work period" followed by a "retirement period." Throw in population growth and rising real wage levels, and Samuelson foresaw a positive rate of return to Social Security retirees (possibly exceeding the real interest rate, in a Peter Diamond extension of the model) that depended on those two factors. That is, if we imagine payroll taxes being handed over to retirees in a strict pay-as-you-go system, the amount available to be paid over rises if the workforce grows along with wages that are subject to the payroll tax.

There's nothing Ponzi-like about that; it's entirely sustainable. But in actual Social Security, two things went "wrong." One was the baby bust after the baby boom, while the second, more important change was rising post-retirement life expectancies. Having retirees live longer was equivalent to having more of them, and had adverse effects on worker to retiree ratios even if each demographic cohort was larger than the one that came before.

Does this mean that Social Security became a Ponzi scheme after all? Strictly speaking, absolutely not. If we think of Social Security retirement benefits as being adjusted to reflect changing payroll tax revenue levels (even though this is only true, if at all, over the long run), then we'd say that retirees hold an implicit financial instrument, the payoff on which depends on wage and demographic trends. So all that rising life expectancies does in this scenario is cause the payoff to be lower rather than higher than it would otherwise have been. But that's in the nature of the implicit financial instrument - a built-in feature that does not cause Ponzi-like collapse, but merely affects the actual payouts from a program that can keep on running anyway.

This brings us to the point that comes closest to justifying Perry's angry braying about Social Security. The program's retirement benefits do not automatically adjust for these demographic changes. Instead, barring Congressional legislation, they proceed on statutory autopilot (albeit depending in practice on demographic and macroeconomic outcomes). So if adverse demographic changes do not lead to immediate tax or benefit changes, you get a program shortfall that emerges over time, and currently promised benefits become eventually unsustainable without new financing.

That, however, is merely lag in adjusting the actual rules on the books to keep on track with the Samuelson structure that is implied by having a largely pay-as-you-go scheme. And it does not mean that the program will collapse - merely that benefits will need at some point to be adversely adjusted (say, to the tune of 20 or 30 percent) in the absence of increased financing.

Perry is right (words that I must confess I hate typing) insofar as his point is that the current scheme requires adjustment, and that people won't get the full benefits promised by present law unless there is extra financing. But he is very substantially wrong in comparing this to a Ponzi scheme in which, as we well know, the investors (except for the lucky ones who got out fast) end up with nothing.

It would be more accurate to compare Social Security to an investment that has historically produced one rate of return, but which in fact appears likely to offer you a lower rate of return. E.g., suppose stock prices have historically appreciated, over a long period of time, at about 2% annually in real terms. You now hold stocks and are hoping to earn that rate of return. But suppose we can see the future well enough to anticipate that, in fact, you will end up learning less than that (and perhaps even a zero or modestly negative rate of return). That's too bad, but it doesn't make stock market investment a Ponzi scheme.

The negative adjustment to expected returns also obviously does not make mandatory retirement saving (a key feature of Social Security) a bad idea, given that lifetime consumption smoothing is necessary unless you're happy to have two houses and two dinners a day now, followed by none of either when you're old.

In sum, "Ponzi scheme" is really out of place as a description of Social Security, even though the program has financing problems. It's true that there have been some negative shocks to expected returns from the program, and that since it doesn't automatically self-adjust there will be a rising expected long-term program deficit until Congress gets around to adjusting things. But this is way out of Ponzi territory.

What about Medicare? That program is best described as Samuelson-plus. Program participants "bet" not only on economic and demographic trends, but also on the trend in healthcare expenditure relative to GDP. (When that rises, the program becomes costlier under constant benefit design.) What makes Medicare far more fiscally unsustainable than Social Security is the fact that healthcare expenditure levels have been significantly rising relative to GDP - and unsustainably so whether there is a government financing role or not.

Medicare is closer to Ponzi territory if we posit an implicit commitment, not just to the current statutory design, but to covering so large a percentage of seniors' healthcare outlays under a system where they so frequently can get the best procedures that are technologically available at a given moment. The built-in unsustainability comes from purporting to guarantee something that is itself growing at an exploding rate. But that is a piece of the broader healthcare problem that we face, more than an aspect of Medicare as such. So calling Medicare a Ponzi scheme (which even Perry does not seem inclined to do) is less illuminating than saying that healthcare generally is on an unsustainable growth path in our society, that we will need to address in one way or another.

UPDATE: Looking at Perry's statement more closely (although in this post I was more interested in the pervasive "Ponzi scheme" meme than in his murky mental processes), I see that his operating definition appears to be that, if the system is going to go kaput and pay you zero, then from your standpoint it is a Ponzi scheme. That is certainly a reasonable way to define Ponzi schemes. But of course it is wildly inaccurate as applied to Social Security, which is projected to be able (based on expected future Trust Funds) to pay about 75 percent of future retirees' benefits. So he is using what we will charitably call his own facts, rather than the actual ones, in calling Social Security a Ponzi scheme.

Interesting point about Perry: While he obviously feels entitled to his own facts, rather than the actual ones, on global warming, evolution, Keynesian stimulus, Social Security, etcetera, he apparently caused his last two gubernatorial campaigns to run very serious empirical tests regarding how alternative types of campaign expenditures and activities actually contribute to electoral success. See the NY times blog article here. In other words, this would appear to be a guy who (contrary to so much evidence from his cheap talk) actually knows and cares about expertise and empirical proof, in cases where there is something in it for him. But if there is no direct personal benefit to him, then he evidently doesn't care.

What would Nixon do?

The opening of today's New York Times article on President Obama's forthcoming jobs package really turned my stomach:

"The centerpiece of the job creation package that President Obama plans to announce on Thursday — payroll tax relief for workers and perhaps their employers — is neither his first policy choice nor that of many economists. But it is the one that they figure has the best chance of getting Republicans’ support."

So typical of this Administration. They decide up front to advocate what they agree is very far from being the best available, policy - in order to give themselves "the best chance of getting Republicans’ support."

All this notwithstanding that the Administration's actual chance of getting that support is zero. Not 0.00001%. Zero. At least, leaving aside the payment of substantial ransom such as extending the high-end tax cuts. With or without payroll tax relief as a core feature, the Republicans will not agree to pass this legislation. So why would the Administration proceed as if winning their votes was the core design question? (Actually, I'll suggest a rationale below, but it isn't good enough.)

Let's turn our minds back to early 2009 and the big (such as it was) stimulus package. This included lots of tax breaks that the Administration, through its economists, knew would be less effective than alternative programs. They put these in to get Republican support. They got zero Republican support. They kept the tax breaks in anyway, and then of course grossly oversold an inadequately sized package as providing enough to get the economy back on track. Then, when the recovery fell far short of the rhetorical expectations that had been created, the Administration had encouraged the retort that stimulus just doesn't work (as opposed to its having been too small).

Now once again we have a flurry of proposals that are going to be too small in aggregate and deliberately poorly designed, in the hope of getting Republican support, which they have zero chance of getting.

But why did I title this post "What would Nixon do?" OK, I have keen memories of the old Trickster, though I realize that he is ancient history to anyone under the age of 45. But bear with me. One thing we know that Nixon absolutely for sure would have done (because he did it) is use every possible tool he had to push the Fed towards a more stimulative policy. Obama utterly failed to do this, whether through appointments or private sit-downs or public jawboning.

But there is also another standard Nixon trick that, sleazy though it was in context, the Obama Administration ought to think about. Nixon was a big fan of proposing legislation that he knew couldn't be passed, specifically because if it wasn't passed he would get a campaign issue. E.g., supposedly in 1970 he was disappointed by his success in getting the Democratic Congress to pass a tough crime bill that contained provisions that, under the quaint standards of the time, were considered odious by civil libertarians. Nixon had deliberately put these things in the proposed legislation, although they were largely symbolic and expected to have little actual impact on crime, because he wanted the Democrats to refuse to pass the legislation, whereupon he would make it a campaign issue and blame rising crime levels on them. They took the issue away by acceding.

How would such a scenario play out today? If Nixon faced Obama's current political circumstances, he would not be trying actually to enact stimulus legislation. He would know that he had zero chance of getting anything that would make a significant difference. He would want to propose something that the opposition WOULDN'T pass, and that he could then campaign on. (And it is clear this time around, unlike with the 1970 crime legislation, that the Congress won't accede in order to take away the issue.)

We could use a bit of that thinking today. Why not propose something that is actually big, dramatic, and well-designed? And why not make reasonable, economically supportable arguments about why and how much it might actually help? Then Obama could rightly criticize the Republicans and blame the labor market on them when they fail to pass it.

This would not just be Nixon-style maneuvering. It would also help make the correct point that, since at least mid-2009, we have actually been following Republican budget policies and they haven't worked. As things stand, by repeatedly acceding to them, even in what he proposes, he accepts a state of affairs in which they actually set the policy yet he takes the blame.

Meanwhile, Obama is collaborating in basic miseducation of American voters, by adopting all kinds of false or grossly overstated Republican claims about how regulatory burden and budget deficits are responsible for the jobs situation.

If people want Republican policies, they will pick Republicans to implement them. An abler, more courageous, and more farsighted politician than Obama would recognize the importance of laying the intellectual groundwork for good policy over many years.

OK, time is short and it's a bit late for all that now. So admittedly there is one clear political calculation that might explain how Obama is proceeding in his jobs proposal. If he proposed big infrastructure and public spending ideas to hire lots of workers and help get us out of the doldrums, and the Republicans refused to enact it, at least they would have a very strong case that they were acting in good faith. Rather than inviting the campaign charge that they are deliberate economic saboteurs, they would be following their own long-enunciated policy preferences in opposing the legislation. (McConnell has already previewed this by saying they won't enact failed policies, harvesting the legacy of Obama's 2009 overclaiming for the stimulus legislation.)

But even if the Republicans convincingly argued good faith in opposing such a proposal, Obama could still reply that they are wrong, and that they shouldn't be elected in 2012 because they will follow the wrong policies.

Don't call it stimulus, of course - call it creating jobs by hiring lots of people to build things that we need. Don't rely in public rhetoric on Keynesian multipliers that are counter-intuitive. Force the Republicans to argue that there will be no net job creation due to indirect effects - a freshwater economists' claim that is counter-intuitive wholly apart from whether it is right or wrong (and with the collapse of consumer demand I would say that it is clearly wrong).

By instead proposing watered-down, maldesigned, too-small Republican-style jobs legislation, Obama may hope to strengthen the claim that the Republicans are acting in bad faith when they inevitably reject it. But accusations of bad faith, which he will of course make extremely decorously if at all, will only go so far with the voters - especially once he has conceded that in general we need Republican-style policies, which they of course are the better-situated party to keep on providing.

And the reality is even worse. One lesson that voters might very well draw is that, if Republicans engage in bad faith obstructionism whenever a Democrat is president, we'd damn well better put them in charge so that they will have the right incentives. It doesn't make them nice people, but if they will make sure that things go worse when they are not officially in power than when they are, voters could very rationally view this as a good reason for electing them.

The New York City subway system is way too metaphysical for me

Apologies if I offered approximately this entry a year or two ago - I had the same experience and it struck me the same way, and I don't recall if I posted about it. But anyway.

Last night I had to take the F train all the way out to Coney Island for a Brooklyn Cyclones minor league baseball game. Today I had to take the F in the other direction, to Roosevelt Island for some early morning tennis.

Each time, a train that was NOT labeled an F train approached on the F track - a D train yesterday, and an E train today.

Each time the garbled PA system said something like the following: "This is a [D/E] train traveling on the F track." I had to make a snap decision: do I take the train or not? The trains that they were labeled as would potentially take me to the wrong place (actually, the D might have worked yesterday, but definitely not the E today). In each case time was of the essence. So should I board the train or not?

Each time I did and it worked out for me. But my view was that, if these trains were traveling on the F track and making F stops, then they were F trains. They were not, at least for the duration of the journey, D or E trains traveling on the F track. A train is defined by the stops it makes.

The MTA, by contrast, appears to be essentialist (is that the right word here?) about train definitions. It thinks of a train as a D train or an E train, if that is its nature or how it is labeled, even while it is traveling on the F track and making only F stops.

Perhaps they could have clarified things a bit, without necessitating the metaphysical dispute, had they said that the trains were "traveling on the F track and making all F stops." Then I would still disagree with them about what the trains really were, but it would have been immaterial instead of causing initial anxiety.

Then again, perhaps I am over-thinking the whole situation a bit.

Alice in Wonderland riddles solved

In Alice in Wonderland, as Alice falls down the giant rabbit hole at the start, she keeps asking herself "Do cats eat bats?" And, since she can't answer it anyway, also "Do bats eat cats?"

A definitive evidence answer to the first of these two questions is now available right here.

Another famous riddle from Alice is the Mad Hatter's query, "Why is a raven like a writing desk?" Though both he and the March Hare profess to have not the slightest idea when Alice gives up, some decades later a Lewis Carroll fan (I forget who it was), gave what strikes me as the best possible answer: "Because there's a b in both."