Category Archives: Fiscal policy

Fiscal Inflation Is Simple With This One Weird Trick

03 Thursday Feb 2022

Posted by in Fiscal policy, Inflation

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I’ll get to the weird trick right off the bat. Then you can read on if you want. The trick really is perverse if you believe in principles of sound credit and financial stability. To levy a fiscal inflation tax, all the government need do is spend like a drunken sailor and undermine its own credibility as a trustworthy borrower. One way to do that: adopt the policy prescriptions of Modern Monetary Theory (MMT).

A Theory of Deadbeat Government

That’s right! Run budget deficits and convince investors the debt you float will never be repaid with future real surpluses. That doesn’t mean the government would literally default (though that is never outside the realm of possibility). However, given such a loss of faith, something else must give, because the real value government debt outstanding will exceed the real value of expected future surpluses from which to pay that debt. The debt might be in the form of interest-bearing government bonds or printed money: it’s all government debt. Ultimately, under these circumstances, there will be a revised expectation that the value of that debt (bonds and dollars) will be eroded by an inflation tax.

This is a sketch of “The Fiscal Theory of the Price Level” (FTPL). The link goes to a draft of a paper by John Cochrane, which he intends as an introduction and summary of the theory. He has been discussing and refining this theory for many years. In fairness to him, it’s a draft. There are a few passages that could be written more clearly, but on the whole, FTPL is a useful way of thinking about fiscal issues that may give rise to inflation.

Fiscal Helicopters

Cochrane discusses the old allegory about how an economy responds to dollar bills dropped from a helicopter — free money floating into everyone’s yard! The result is the classic “too much money chasing too few goods” problem, so dollar prices of goods must rise. We tend to think of the helicopter drop as a monetary policy experiment, but as Cochrane asserts, it is fiscal policy.

We have experienced something very much like the classic helicopter drop in the past two years. The federal government has effectively given money away in a variety of pandemic relief efforts. Our central bank, the Federal Reserve, has monetized much of the debt the Treasury issued as it “loaded the helicopter”.

In effect, this wasn’t an act of monetary policy at all, because the Fed does not have the authority to simply issue new government debt. The Fed can buy other assets (like government bonds) by issuing dollars (as bank reserves). That’s how it engineers increases in the money supply. It can also “lend” to the U.S. Treasury, crediting the Treasury’s checking account. Presto! Stimulus payments are in the mail!

This is classic monetary seigniorage, or in more familiar language, an inflation tax. Here is Cochrane description of the recent helicopter drop:

“The Fed and Treasury together sent people about $6 trillion, financed by new Treasury debt and new reserves. This cumulative expansion was about 30% of GDP ($21,481) or 38% of outstanding debt ($16,924). If people do not expect that any of that new debt will be repaid, it suggests a 38% price-level rise. If people expect Treasury debt to be repaid by surpluses but not reserves, then we still expect $2,506 / $16,924 = 15% cumulative inflation.”

FTPL, May I Introduce You To MMT

Another trend in thought seems to have dovetailed with the helicopter drop , and it may have influenced investor sentiment regarding the government’s ever-weakening commitment to future surpluses: that would be the growing interest in MMT. This “theory” says, sure, go ahead! Print the money government “must” spend. The state simply fesses-up, right off the bat, that it has no intention of running future surpluses.

To be clear, and perhaps more fair, economists who subscribe to MMT believe that deficits financed with money printing are acceptable when inflation and interest rates are very low. However, expecting stability under those circumstances requires a certain level of investor confidence in the government fisc. Read this for Cochrane’s view of MMT.

Statists like Bernie Sanders, Alexandria Ocasio-Cortez, and seemingly Joe Biden are delighted to adopt a more general application of MMT as intellectual cover for their grandiose plans to remake the economy, fix the climate, and expand the welfare state. But generalizing MMT is a dangerous flirtation with inflation denialism and invites economic disaster.

If This Goes On…

Amid this lunacy we have Joe Biden and his party hoping to find avenues for “Build Back Better”. Fortunately, it’s looking dead at this point. The bill considered in the fall would have amounted to an additional $2 trillion of “infrastructure” spending, mostly not for physical infrastructure. Moreover, according to the Congressional Budget Office, that bill’s cost would have far exceeded $2 trillion by the time all was said and done. There are ongoing hopes for separate passage of free community college, an extended child tax credit for all families, a higher cap for state and local income tax deductions, and a host of other social and climate initiatives. The latter, relegated to a separate bill, is said to carry a price tag of over $550 billion. In addition, the Left would still love to see complete forgiveness of all student debt and institute some form of universal basic income. Hey, just print the money, right? Warm up the chopper! But rest easy, cause all this appears less likely by the day.

Are there possible non-inflationary outcomes from ongoing helicopter drops that are contingent on behavior? What if people save the fresh cash because it’s viewed as a one-time windfall (i.e., not a permanent increase in income)? If you sit on such a windfall it will erode as prices rise, and the change in expectations about government finance won’t be too comforting on that score.

There are many aspects of FTPL worth pondering, such as whether bond investors would be very troubled by yawning deficits with MMT noisemakers in Congress IF the Fed refused to go along with it. That is, no money printing or debt monetization. The burgeoning supply of debt would weigh heavily on the market, forcing rates up. Government keeps spending and interest costs balloon. It is here where Cochrane and critics of FTPL have a sharp disagreement. Does this engender inflation in the absence of debt monetization? Cochrane says yes if investors have faith in the unfaithfulness of fiscal policymakers. Excessive debt is then every bit as inflationary as printing money.

Real Shocks and FTPL

It’s natural to think supply disruptions are primarily responsible for the recent acceleration of inflation, rather than the helicopter drop. There’s no question about those price pressures in certain markets, much of it inflected by wayward policymakers, and some of those markets involve key inputs like energy and labor. Even the median component of the CPI has escalated sharply, though it has lagged broader measures a bit.

Broad price pressures cannot be sustained indefinitely without accommodating changes in the supply of money, which is the so-called “numeraire” in which all goods are priced. What does this have to do with FTPL or the government’s long-term budget constraint? The helicopter drop certainly led to additional money growth and spending, but again, FTPL would say that inflation follows from the expectation that government will not produce future surpluses needed for long-term budget balance. The creation of either new money or government debt, loaded the chopper as it were, is sufficient to accommodate broad price pressures over some duration.

Conclusion

Whether or not FTPL is a fully accurate description of fiscal and monetary phenomena, few would argue that a truly deadbeat government is a prescription for hyperinflation. That’s an extreme, but the motivation for FTPL is the potential abandonment of good and honest governing principles. Pledging an inflation tax is not exactly what anyone means by the full faith and credit of the U.S. government.

Joe Biden’s Fat Cooked-Goose Tax Plan

03 Saturday Apr 2021

Posted by in Fiscal policy, Taxes

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I recently wrote on this blog about the damaging impact of corporate taxes on workers, consumers, and U.S. competitiveness. Phil Kerpen tweeted the chart above showing the dramatic reduction in the distribution of corporate tax rates across the world from 1980 through 2020. Yes, yes, Joe Biden’s posture as a fair and sensible leader aside, most countries place great emphasis on their treatment of business income and their standing relative to trading partners.

Kerpen’s tweet was a response to this tweet by economist Justin Wolfers:

Apparently, Wolfers wishes to emphasize that Biden’s plan, which raises the statutory corporate rate from 21% to 28%, does not take the rate up to the level of the pre-Trump era. Fair enough, but compare Wolfers’ chart with Kerpen’s (from the Tax Foundation) and note that it would still put the U.S. in the upper part of the international distribution without even considering the increment from state corporate tax rates. Also note that the U.S. was near the top of the distribution in 1980, 2000, and 2010. In fact, the U.S. had the fourth highest corporate tax rate in the world in 2017, before Trump’s tax package took effect. Perhaps Biden’s proposed rate won’t be the fourth highest in the world, but it will certainly worsen incentives for domestic U.S. investment, the outlook for wage growth, and consumer prices.

And in the same thread, Wolfers said this:

That’s certainly true, but let’s talk about those “loopholes”. First, much of U.S. corporate income is “passed though” to the returns of individual owners, so corporate taxes understate the true rate of tax paid on corporate income. Let’s also remember that the corporate tax represents a double taxation of income, and as a matter of tax efficiency it would be beneficial to consolidate these taxes on individual returns.

Beyond those consideration, the repeal of any corporate tax deduction or credit would have its own set of pros and cons. As long as there is a separate tax on corporate income, there is an economic rationale for most so-called “loopholes”. Does Wolfers refer to research and development tax credits? Maybe he means deductions on certain forms of compensation, though it’s hard to rationalize treating any form of employee compensation as income taxable to the business. Then there are the massive tax subsidies extended for investments in renewable energy. Well, good for Wolfers if that last one is his gripe! The CARES Act of 2020 allowed publicly-traded companies to use losses in 2020( presumably induced by the pandemic) to offset income in prior years, rather than carrying them forward. Did Wolfers believe that to be inappropriate? I might object to that too, to the extent that the measure allows declining firms to use COVID to cloak inefficiencies. Does he mean the offshoring of income to avoid U.S. corporate taxes? Might that be related to relative tax rates?

In any case, Wolfers can’t possibly imagine that the U.S. is the only country allowing a variety of expenses to be deducted against corporate income, or credits against tax bills for various activities. So, a comparison of statutory tax rates is probably a good place to start in assessing the competitive thrust of tax policy. But effective tax rates can reveal much more about the full impact of tax policy. In 2011, a study showed that the U.S. had the second highest effective corporate tax rate in the world. Today, among developed countries, the OECD puts the U.S. roughly in the middle of the pack, close to Germany but higher than Canada, Mexico and Japan, and lower than the UK. This article from 2019 reaches the same conclusion, though the rankings and rates differ from the OECD’s calculations. So it’s not as if the U.S. is the only country to offer tax incentives, or “loopholes” in Wolfers’ preferred terminology.

The corporate tax hikes proposed by the Biden Administration are intended to fund the massive outlays in the so-called infrastucture bill, which of course has very little to do with real infrastructure. Both the tax and spending proposals are bad policy. So far, however, passage of the bill is not a given. Let’s hope all of the Republicans and at least one Democrat senator have the sense to vote it down, but I’m not optimistic. The best hope for resistance among Democrats is Joe Manchin of West Virginia, but even he has signaled his support. Biden’s appointment of Gayle Manchin to a key administration post couldn’t have hurt.

The Dirt On the Corporate Income Tax

23 Tuesday Mar 2021

Posted by in Fiscal policy, Tax Incidence

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The Biden Administration is proposing a substantial increase in the corporate income tax rate from 21% to 28%. This is another case of a self-destructive policy that serves as a virtue signal to the progressive Left. See? We’re taxing the rich and their powerful corporations! What none of them realize is that the tax on corporate income is actually a regressive tax on consumers and workers; it is a disincentive to the formation of productive capital; and it is a highly wasteful tax due to compliance costs and the impact of avoidance. And the Biden proposal would make the U.S. less competitive internationally, as the chart above from Joseph Sullivan demonstrates. Maybe some of the proponents realize it, but they still like it because it sounds so good to their base!

It’s not as if all these unhealthy characteristics of the corporate tax are new findings. Milton Friedman explained some of the basics in 1971 when he said:

“The elementary fact is that ‘business’ does not and cannot pay taxes. Only people can pay taxes. Corporate officials may sign the check, but the money that they forward to Internal Revenue comes from the corporation’s employees, customers or stockholders. A corporation is a pure intermediary through which its employees, customers and stockholders cooperate for their mutual benefit.”

In 1984, two giants of public finance economics, Richard and Peggy Musgrave, investigated how the corporate tax was shifted to households. Here’s a description of their findings from a recent paper by Edward Lane and L. Randall Wray:

“… the bottom quintile pays 4.6–5.5 percent of its income toward the corporate profits tax, the top decile pays 2.5–3.7 percent of its income, and the ninth decile pays 2.4–2.9 percent of its income. They conclude that the corporate profits tax is largely regressive while the federal personal income tax is progressive.”

The incidence of the corporate tax rate falls primarily on workers in the form of lower wages and lost jobs, and on consumers in the form of higher prices. Lane and Wray cite several influential studies over the years showing a substantial negative association between corporate taxes and wages. As the authors note, major corporations often have pricing power in both product and labor markets, at least relative to their power in capital markets where they must raise capital. Capital markets are highly competitive, so they don’t provide much opportunity for shifting the burden of the tax to owners of equity and debt. There are limits on a firm’s ability to pass the tax along to customers and workers as well, of course, but shareholders are relatively well-insulated from the burden of the tax.

There are still other reasons to avoid increasing the corporate income tax rate. It currently raises about $200 billion annually for the U.S. Treasury, or about 7% of estimated federal tax revenue for the 2021 fiscal year. It also has extremely high compliance costs. Lane and Wray quote a 2016 Tax Foundation estimate that U.S. businesses face tax compliance costs on the order of $193 billion a year. Not all of that figure applies to corporations, and not all of it is for federal tax compliance, but a great deal of it is. There are also a number of ways the tax can be avoided, such as off-shoring operations and using overstated transfer prices of inputs obtained from units overseas. This is not an economically efficient way to generate tax revenue.

Moreover, the corporate income tax creates perverse incentives. When new investment in productive, physical capital is penalized at the margin, you can expect less capital investment, lower wages, and fewer jobs. Alan D. Viard explains that the dynamics of this mechanism take time to play out, but the longer-run decay in the capital stock is perhaps the most damaging aspect of a high corporate tax rate. And indeed, while there are probably short-run effects, the reduction in the incentive to invest is the real mechanism linking a higher corporate tax to reduced wages and higher prices, not to mention reduced economic growth.

Finally, there is a pernicious political-economic aspect of the corporate income tax owing to the difficulty for the general public in identifying its true incidence. This was also discussed by Milton Friedman:

“… Indirect effects make it difficult to know who ‘really’ pays any tax. But this difficulty is greatest for taxes levied on business. That fact is at one and the same time the chief political appeal of the corporation income tax, and its chief political defect. The politician can levy taxes, as it appears, on no one, yet obtain revenue. The result is political irresponsibility. Levying most taxes directly on individuals would make it far clearer who pays for government programs.

If the government intends to tax the owners of corporate wealth (a significant share of which is held in retirement savings accounts), it should be honest about doing so. That would mean taxing capital income in a more consolidated way, as Lane and Wray put it, at the individual level. That kind of transparency might be too much to hope for because the politics of doing so are much less favorable.

Meanwhile, the Biden Administration wants to have it all: higher corporate taxes and higher taxes on relatively high-earning individuals. But a significant burden of the corporate tax increase ultimately is shifted to individual workers and consumers. It is a regressive tax, and it is an inefficient tax with outrageously high compliance costs. It is a destructive tax because it undermines the economy’s growth in productive capacity. And it offers tax revenue to politicians who have little budgetary resolve, and with little political consequence.

Trump’s Payroll Tax Ploy

15 Tuesday Sep 2020

Posted by in Fiscal policy, Taxes

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President Trump’s memorandum to Treasury Secretary Steve Mnuchin on payroll tax deferral is bad economic policy, but it might ultimately prove useful as a political weapon. The memo, released in August, instructed the Treasury to allow employers to suspend withholding of the employee’s share of FICA taxes (6.2%) until the end of the year, but it does not forgive the taxes. Only Congress (with the President’s signature) can eliminate the tax obligation. There are several reasons I don’t like it:

  1. Assuming the tax obligation is forgiven, it would provide some relief to those who are already employed (and earning less than $4,000 every two weeks), but not to the unemployed. Thus, as relief from coronavirus-induced job losses, this doesn’t cut it.
  2. It does not reduce the cost of hiring, as would a permanent reduction in the employer’s share, so it does not improve hiring incentives.
  3. The deferral creates uncertainty: will the tax bill be forgiven? If not, will the employee be on the hook? Or the employer? What if an employee leaves the company having received a deferral?
  4. The measure will not be an effective stimulus to spending. It is not an addition to workers’ permanent income since it is a temporary “holiday”. Income perceived as temporary adds little to consumer spending. And it doesn’t constitute a temporary tax break unless employers participate (see below), and even then only if Trump is re-elected and if Congress agrees to forgive the tax.
  5. Trump suggested that the tax will be forgiven if he is re-elected. It’s a rather unsavory proposition: create an immediate tax benefit paired with a matching future obligation with forgiveness contingent upon re-election!
  6. Long-term funding of Social Security is already problematic. Adding a payroll tax holiday on top of that, assuming the taxes are forgiven, only aggravates the situation. Yes, I can imagine various “long-game” reform proposals that might attempt to leverage such a break, but I consider that highly unlikely.

It’s no surprise that a number of large employers are not participating in the tax deferral. such as CVS, JP Morgan Chase, UPS, Home Depot, and Wells Fargo.

Small employers have an even bigger problem to the extent that they lack sophisticated accounting systems to handle such deferrals. Here’s Warren Meyers’ take on the payroll tax suspension:

“We have 400 employees today, but since we are a summer seasonal business we will have fewer than 100 in January. If there is a catch-up repayment in January (meaning Congress chooses not to forgive the taxes altogether), most of my employees who would need to repay the tax will be gone. Do you think the government is just going to say, ‘oh well, I guess we lost that money’? Hah! You don’t know how the government works with tax liens. My guess is that for every employee no longer on the payroll for whom back employment taxes need to be collected, the government is going to say our company is responsible for those payments instead. We could be out hundreds of thousands of extra dollars. President Biden will just say, ‘well I guess you should not have participated in a Trump program.’

So this is the vise we are in: Either we participate in the program, and risk paying a fortune in extra taxes at some future date, or we don’t participate, and have every employee screaming at us for deducting payroll taxes when President Trump told them they did not have to pay it anymore. And what happens if Congress does come along later and forgive the taxes, what kind of jerk am I for not allowing my employees to benefit from the tax break?

A payroll tax rollback was considered for the Republican stimulus packages that failed in Congress this summer, but that provision was said to be “negotiable”. In any case, nothing passed. Surely Trump’s economic advisors know that the economics of the payroll tax memo are lousy, even if Trump doesn’t get it.

I can’t decide whether the whole thing is Machiavellian or just a goof. Perhaps Trump is so eager to be seen as a tax cutter that he is willing to gloss over the distinction between a tax cut and a deferral. If the taxes owed are not forgiven, it won’t be on his watch. And Trump might believe he can weaponize the payroll tax deferral against obstinate Democrats in Congress as well as Joe Biden. Maybe he can.

Multipliers Are For Politicians

02 Wednesday May 2018

Posted by in Big Government, Fiscal policy, Stimulus

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Here’s a major macroeconomic sacred cow among professional economists and the politicians whose fiscal profligacy they enable: the presumed salutary effect of an increase in government spending on economic activity, including its so-called “multiplier effect”. Government fiscal stimulus is prescribed by the Keynesian school of economics to remedy any decline in the total demand for goods. A classic case is “underconsumption”, or excess saving, such that labor and capital resources are in excess supply. The idea is that government will mop-up some of this excess saving by borrowing and spending the proceeds on goods and services, putting resources back to work. In the standard telling, digging holes and refilling them is as effective as anything else. The increased income earned by those resources will be re-spent, creating income for the recipients and leading to repeated rounds of re-spending, each successively smaller due to “leakage” into saving. Adding up all these rounds of extra spending yields a multiple of the original government stimulus, hence the Keynesian multiplier effect. The stimulation of the demand for goods and services pushes the economy back in the direction of full employment, thus correcting the original problem of underconsumption. Nice story.

Keynesian economics is a short-run, demand-based framework that delineates behavior by the constructs of national income accounting, segmenting demand into consumer spending, investment in productive capital, government spending, and net foreign spending (net exports). Except for the limit imposed by full employment, the supply side of the economy and the processes giving rise to growth in productive capacity are ignored.

Within the Keynesian framework, can offer many qualifications to the story of a shortfall in demand to which even a dyed-in-the-wool Keynesian would agree. First, government stimulus cannot have an effect on the real economy at a time when the economy is operating at full capacity, or full employment. The increased government spending will only lead to bidding against other uses of the same resources, increasing the level of wages and prices.

Another qualification within the Keynesian framework is that the leakage from spending at each round of re-spending is made greater by taxes on marginal income, thus reducing the magnitude of the multiplier. In addition, some of the extra income will be spent on foreign goods — another leakage that reduces the multiplier effect on the domestic economy. In fact, this is why multipliers for spending at local levels are thought to be relatively small. The more local the analysis, the more income will be re-spent outside the locality at each round. More fundamentally, private parties should know that increased government borrowing must be repaid eventually. At some level, they know that additional taxes (or an inflation tax) will be necessary to do so. Therefore, their reaction to the additional income derived from government demand will be muted by the need to save for those future liabilities. Put differently, consumers do not view the gain as an increase in their permanent income. That’s essentially the mechanism underlying the “Ricardian equivalence” between methods of funding government spending (government debt or taxes).

In the “real world” there are many other practical problems that lead to ineffectual and even counter-productive government stimulus. One is the problem of cost control endemic to the public sector. Related to this are seemingly unavoidable timing issues. These factors have a strong tendency to make counter-cyclical fiscal programs too costly and too late. There is also the tendency toward graft and cronyism wherever the government spreads its largess. The “perfectibility of man” is certainly not evident in the execution of government stimulus programs. Their economic impacts often become pro-cyclical, or even worse, they become permanent increases in spending authority. More on the latter below.

Deeper objections to the Keynesian framework have to do with its demand-side orientation and the conceit that government, solely by borrowing and spending, can contribute to “real demand” and add to a nation’s output. And even if government spending takes up slack at a time of unemployed resources or excess supplies, it is unlikely to resolve the conditions that led to the decline in private demand. Therefore, even if government stimulus is successful in spurring a temporary increase in actual production and utilization of resources, it is likely to delay or prevent the downward wage and price adjustments necessary to permanently do so.

Recessions are typically characterized by an effort to work off over-investment in various sectors: housing, commercial structures, oil and gas extraction and processing, technology assets, inventories, or factories. Over-inflation of asset values is usually at the root of malinvestment, often accompanied by overinflation of wages and prices. These dislocations do not occur evenly, but the market process acts to correct misallocations and mispricing precisely where they occur. It might take time, but if government steps in to prop-up weak sectors, forgive the economic consequences of mistakes, and place more upward pressure on wages and prices, the dislocations will persist. So again, even if stimulus and the multiplier effect offer a short-term palliative, the benefits are illusory in a real sense. The long-run consequences of failing to allow markets to repair the damage will be negative.

One of the greatest skills that economists should possess is the ability to discern the most plausible counterfactual in a given situation: the world as it would have played out in the absence of a particular event, often a policy initiative. This is a great shortcoming among those who subscribe to the efficacy of government stimulus programs. In the scenario just described, there will be a decline in capital investment, consumption, and saving, but that saving, whatever its level, will still be channeled into capital investments unless the funds sit idle in bank vaults. If the saving is instead absorbed by the government’s effort to fund a stimulus program, even that reduced level of investment will not take place. The net effect is zero! Thus, the Keynesian stimulus and multiplier effect represent a failure of the economics profession to “see the unseen”, as Frederic Bastiat would have put it. Unless government can produce something of value to generate income, perhaps something that improves private returns, it will not contribute to income growth.

Permanent displacement of private capital investment is the most fundamental detriment of government fiscal activism. That it might well supplant private production should come as no surprise. Matthew D. Mitchell and Jakina R. Debnam describe the phenomenon this way:

“The tendency for ostensibly temporary spending to become permanent spending helps explain why policy makers fail to take the Keynesians’ advice when it comes to surpluses. Though governments invariable go into deficit during recessionary periods, they rarely run surpluses during expansionary periods.”

Mitchell and Debnam provide an interesting quote:

“… Richard Wagner and Nobel Laureate James Buchanan concluded: ‘Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian message, politicians can spend and spend without the apparent necessity to tax.'”

In a footnote, Mitchell and Debnam note that Milton Friedman once said, “Nothing is so permanent as a temporary government program.” The Keynesian prescription for stimulus allows politicians to assert that they are empowered to rescue the unemployed or those suffering a loss of income. They want you to believe that they can do something. The multiplier gives license to still greater mischief on the part of politicians, because it can help politicians sell almost any pork-barrel project. But continuing government expansion requires that it extract resources from the private economy. That’s true whether the government spends directly on goods or redistributes, and the mechanics of these processes involve additional resource costs. As long as government can borrow private savings, politicians will disguise the true cost of their munificence to constituents. Economists should not be their enablers.