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Oh To Squeeze Fiscal Discipline From a Debt Limit Turnip

01 Wednesday Feb 2023

Posted by Nuetzel in Fiscal policy, Monetary Policy

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Brinksmanship, British Consols, Congressional Budget Office, consumption tax, David Andolfatto, Debt Limit, Debt to GDP, Entitlement Trust Funds, Extraordinary Measures, Fed Independence, Federal Debt, Federal Default, Federal Reserve, Fiscal Restraint, Income Tax, Inflation tax, IRS, Janet Yellen, Joe Biden, John Cochrane, Josh Barro, Kevin McCarthy, Matt Levine, Modern Monetary Theory, Monetarist Arithmetic, Neil Wallace, Pandemic Benefits, Payment Prioritization, Perpetuities, Platinum Coin, Premium Bonds, Privatization, Rashida Tlaib, Rohan Grey, Saving Incentives, Thomas Sargent, Treasury Debt, Trillion Dollar Coin, Value Added Tax

It’s as if people view the debt limit controversy as a political nuisance rather than the stopgap enforcement mechanism for fiscal sanity that it’s intended to be. That’s a lesson in how far we’ve gone toward an unhealthy acceptance of permanent federal deficits. Oh, most people seem to realize the the government’s spending is prodigious and beyond our capacity to collect taxes, but many don’t grasp the recklessness of the ongoing blowout. Federal deficits are expected to average $1.6 trillion per year over the next decade, versus less than $0.9 trillion and $1.25 trillion over the two previous decades, respectively. That $1.25 trillion includes the massive (and excessive) transfers that took place during the pandemic, which is why we’ve bumped up against the debt limit earlier than had been expected. The trend isn’t abating, despite the fact that the pandemic is behind us. And keep in mind that the Congressional Budget Office has been too optimistic for the past 20 years or so. Take a look at federal debt relative to GDP:

Unpleasant Arithmetic

With federal debt growing faster than GDP, the burden of servicing the debt mounts. This creates a strain in the coordination of fiscal and monetary policy, as described by David Andolfatto, who last year reviewed the implications of “Some Unpleasant Monetarist Arithmetic” for current policy. His title was taken from a seminal paper written by Thomas Sargent and Neil Wallace in 1981. Andolfatto says that:

“… attempting to monetize a smaller fraction of outstanding Treasury securities has the effect of increasing the rate of inflation. A tighter monetary policy ends up increasing the interest expense of debt issuance. And if the fiscal authority is unwilling to curtail the rate of debt issuance, the added interest expense must be monetized—at least if outright default is to be avoided.

Andolfatto wrote that last spring, before the Federal Reserve began its ongoing campaign to tighten monetary policy by raising short-term interest rates. But he went on to say:

“Deficit and debt levels are elevated relative to their historical norms, and the current administration seems poised to embark on an ambitious public spending program. … In the event that inflation rises and then remains intolerably above target, the Federal Reserve is expected to raise its policy rate. … if the fiscal authority is determined to pursue its deficit policy into the indefinite future, raising the policy rate may only keep a lid on inflation temporarily and possibly only at the expense of a recession. In the longer run, an aggressive interest rate policy may contribute to inflationary pressure—at least until the fiscal regime changes.”

So it is with a spendthrift government: escalating debt and interest expense must ultimately be dealt with via higher taxes or inflation, despite the best intentions of a monetary authority.

Fiscal Wrasslin’

Some people think the debt limit debate is all a big fake. Maybe … there are spendthrifts on both sides of the aisle. Still, the current debt limit impasse could serve a useful purpose if fiscal conservatives succeed in efforts to restrain spending. There is, however, an exaggerated uproar over the possibility of default, meaning a failure to make scheduled payments on Treasury securities. The capital markets aren’t especially worried because an outright default is very unlikely. Establishment Republicans may well resort to their usual cowardice and accept compromise without holding out for better controls on spending. Already, in a politically defensive gesture, House Speaker Kevin McCarthy has said the GOP wishes to strengthen certain entitlement programs. Let’s hope he really means restoring solvency to the Social Security and Medicare Trust Funds via fundamental reforms. And if the GOP rules out cuts to any program, let’s hope they don’t rule out cuts in the growth of these programs, or privatization. For their part, of course, Democrats would like to eliminate the debt ceiling entirely.

One of the demands made by Republicans is a transformation of the federal tax system. They would like to eliminate the income tax and substitute a tax on consumption. Economists have long favored the latter because it would eliminate incentives that penalize saving, which undermine economic growth. Unfortunately, this is almost dead in the water as a political matter, but the GOP further sabotaged their own proposal in their zeal to abolish the IRS. Their consumption tax would be implemented as a national sales tax applied at the point of sale, complete with a new Treasury agency to administer the tax. They’d have done better to propose a value added tax (VAT) or a tax on a simple base of income less saving (and other allowances).

Gimmicks and Measures

We’ve seen proposals for various accounting tricks to allow the government to avoid a technical default and buy time for an agreement to be reached on the debt limit. Treasury Secretary Janet Yellen already has implemented “extraordinary measures” to stay under the debt limit until June, she estimates. The Treasury is drawing down cash, skipping additional investments in government retirement accounts (which can be made up later without any postponement of benefits), plus a few other creative accounting maneuvers.

Payment prioritization, whereby the Treasury makes payments on debt and critical programs such as Social Security and Medicare, but defers a variety of other payments, has also been considered. Those deferrals could include amounts owed to contractors or even government salaries. However, a deferral of payments owed to anyone represents a de facto default. Thus, payment prioritization is not a popular idea, but if push comes to shove, it might be viewed as the lesser of two evils. Missing payments on government bonds could precipitate a financial crisis, but no one believes it will come to that.

Two other ideas for avoiding a breach of the debt ceiling are rather audacious. One involves raising new cash via the sale of premium bonds by the Treasury, as described here by Josh Barro (and here by Matt Levine). The other idea is to mint a large denomination ($1 trillion) platinum, “commemorative” coin, which the Treasury would deposit at the Federal Reserve, enabling it to conduct business as usual until the debt limit impasse is resolved. I’ll briefly describe each of these ideas in more detail below.

Premium Bonds

Premium bonds would offer a solution to the debt limit controversy because the debt ceiling is defined in terms of the par value of Treasury debt outstanding, as opposed to the amount actually raised from selling bonds at auction. For example, a note that promises to pay $100 in one year has a par value of $100. If it also promises to pay $100 in interest, it will sell at a steep premium. Thus, the Treasury collects, say, $185 at auction, and it could use the proceeds to pay off $100 of maturing debt and fund $85 of federal spending. That would almost certainly require a “market test” by the Treasury on a limited scale, and the very idea might reveal any distaste the market might have for obviating the debt limit in this fashion. But distaste is probably too mild a word.

An extreme example of this idea is for the Treasury to sell perpetuities, which have a zero par value but pay interest forever, or at least until redeemed beyond some minimum (but lengthy) term. John Cochrane has made this suggestion, though mainly just “for fun”. The British government sold perpetuities called consols for many years. Such bonds would completely circumvent the debt limit, at least without legislation to redefine the limit, which really is long overdue.

The $1 Trillion Coin

Minting a trillion dollar coin is another thing entirely. Barro has a separate discussion of this option, as does Cochrane. The idea was originally proposed and rejected during an earlier debt-limit controversy in 2011. Keep in mind, in what follows, that the Fed does not follow Generally Accepted Accounting Principles (GAAP).

Skeptics might be tempted to conclude that the “coin trick” is a ploy to engineer a huge increase the money supply to fund government expansion, but that’s not really the gist of this proposal. Instead, the Treasury would deposit the coin in its account at the Fed. The Fed would hold the coin and give the Treasury access to a like amount of cash. To raise that cash, the Fed would sell to the public $1 trillion out of its massive holdings of government securities. The Treasury would use that cash to meet its obligations without exceeding the debt ceiling. As Barro says, the Fed would essentially substitute sales of government bonds from its portfolio for bonds the Treasury is prohibited from selling under the debt limit. The effect on the supply of money is basically zero, and it is non-inflationary unless the approach has an unsettling impact on markets and inflation expectations (which of course is a distinct possibility).

When the debt ceiling is finally increased by Congress, the process is reversed. The Treasury can borrow again and redeem its coin from the Fed for $1 trillion, then “melt it down”, as Barro says. The Fed would repurchase from the public the government securities it had sold, adding them back to its portfolio (if that is consistent with its objectives at that time). Everything is a wash with respect to the “coin trick”, as long as the Treasury ultimately gets a higher debt limit.

Lust For the Coin

In fairness to skeptics, it’s easy to understand why the “coin trick” described above might be confused with another coin minting idea that arose from the collectivist vanguard during the pandemic. Representative Rashida Tlaib (D-MI) proposed minting coins to fund monthly relief payments of $1,000 – $2,000 for every American via electronic benefit cards. She was assisted in crafting this proposal by Rohan Grey, a prominent advocate of Modern Monetary Theory (MMT), the misguided idea that government can simply print money to pay for the resources it demands without inflationary consequences.

Tlaib’s plan would have required the Federal Reserve to accept the minted coins as deposits into the Treasury’s checking account. But then, rather than neutralizing the impact on the money supply by selling government bonds, the coin itself would be treated as base money. Cash balances would simply be made available in the Treasury’s checking account with the Fed. That’s money printing, pure and simple, but it’s not at all the mechanism under discussion with respect to short-term circumvention of the debt limit.

Fed Independence

The “coin trick” as a debt limit work-around is probably an impossibility, as Barro and others point out. First, the Fed would have to accept the coin as a deposit, and it is under no legal obligation to do so. Second, it obligates the Fed to closely coordinate monetary policy with the Treasury, effectively undermining its independence and its ability to pursue its legal mandates of high employment and low inflation. Depending on how badly markets react, it might even present the Fed with conflicting objectives.

Believe me, you might not like the Fed, but we certainly don’t want a Fed that is subservient to the Treasury… maintaining financial and economic stability in the presence of an irresponsible fiscal authority is bad enough without seating that authority at the table. As Barro says of the “coin trick”:

“These actions would politicize the Fed and undermine its independence. In order to stabilize expectations about inflation, the Fed would have to communicate very clearly about its intentions to coordinate its fiscal actions with Treasury — that is, it would have to tell the world that it’s going to act as Treasury’s surrogate in selling bonds when Treasury can’t. …

These actions would interfere with the Fed’s normal monetary operations. … the Fed is currently already reducing its holdings of bonds as part of its strategy to fight inflation. If economic conditions change (fairly likely, in the event of a near-default situation) that might change the Fed’s desired balance sheet strategy.”

On With The Show

Discussions about the debt limit continue between the White House and both parties in Congress. Kevin McCarthy met with President Biden today (2/1), but apparently nothing significant came it. Fiscal conservatives wonder whether McCarthy and other members of the GOP lack seriousness when it comes to fiscal restraint. But spending growth must slow to achieve deficit reduction, non-inflationary growth, and financial stability.

Meanwhile, even conservative media pundits seem to focus only on the negative politics of deficit reduction, ceding the advantage to Democrats and other fiscal expansionists. For those pundits, the economic reality pales in significance. That is a mistake. Market participants are increasingly skeptical that the federal government will ever pay down its debts out of future surpluses. This will undermine the real value of government debt, other nominal assets, incomes and buying power. That’s the inflation tax in action.

Unbridled growth of the government’s claims on resources at the expense of the private sector destroys the economy’s productive potential, to say nothing of growth. The same goes for government’s insatiable urge to regulate private activities and to direct patterns of private resource use. Unfortunately, so many policy areas are in need of reform that imposition of top-down controls on spending seems attractive as a stopgap. Concessions on the debt limit should only be granted in exchange for meaningful change: limits on spending growth, regulatory reforms, and tax simplification (perhaps replacing the income tax with a consumption tax) should all be priorities.

In the meantime, let’s avoid trillion dollar coins. As a debt limit work-around, premium bonds are more practical without requiring any compromise to the Fed’s independence. Other accounting gimmicks will be used to avoid missing payments, of course, but the fact that premium bonds and platinum coins are under discussion highlights the need to redefine the debt limit. When the eventual time of default draws near, fiscal conservatives must be prepared to stand up to their opponents’ convenient accusations of “brinksmanship”. The allegation is insincere and merely a cover for government expansionism.

Trumpist In a Taxpot

06 Thursday Oct 2016

Posted by Nuetzel in Taxes

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Bronte Capital Management, consumption tax, Debt Paeking, Donald Trump, Hillary Clinton, John Cochrane, John Hempton, Megan McArdle, New York Times, Plaza Hotel, Tax Loss Carry Forward

img_3194

The media narrative around Donald Trump’s 1995 tax deduction of a business loss would have you think it had been the crime of the century. Last weekend, the New York Times presented an analysis of a Trump tax return from 1995 showing a loss of $916 million, which was eligible for “carry forward” to reduce taxes on his business income in future years. The Times characterized it as something of a scandal, and the Clinton campaign was quick to jump on board. However, the ability to deduct losses or carry them forward to deduct in future years are basic features of the U.S. income tax code. Hillary Clinton used the same tax provisions as recently as 2015, albeit on a smaller scale than Trump, and the Clinton’s have engaged in other forms of tax avoidance. The point here is that if your business realizes gains from some winning investments, but suffers losses on a few others, a basic and reasonable feature of the tax code is to allow the losses to offset a like amount of gains for tax purposes. Similarly, your winnings at the casino (assuming you report them) are not taxed without first netting out the bad bet you made at the roulette table. So far, so good.

When you or your business suffers a loss in a given year, the income tax code allows that loss to be carried forward to offset taxable income in subsequent years. Since the Times article, the term “net operating loss” has been thrown around in some circles as if it’s an arcane tax loophole, but it’s simply good tax policy. John Cochrane provides an example of an entity which alternately reaps gains of $1,000,000 in one year and losses of $900,000 in the next, with an average pre-tax income of $50,000. Without loss carry-forward, this entity would be forced out of business in short order by the IRS. The use of this provision is not uncommon, and it prevents the tax code, such as it is, from being even more threatening to enterprises and jobs that are otherwise viable. Suggesting the elimination of this provision leaves tax experts in disbelief. The effects would be punitive to many businesses, not just corporate behemoths, and would be destructive to the economy.

Cochrane also puts the “blame” for this much-maligned deduction where it should be: the existence of the income tax itself! A consumption tax would not be as sensitive to changes in income, as people tend to smooth their consumption levels over time.

Another question related to the Trump tax revelations would be more controversial, if true: that he might have engaged in so-called “debt parking“. That’s unproven, but Bronte Capital Management‘s John Hempton blogged that it’s highly likely that he did. The alleged sequence of events is as follows: Trump borrowed money and invested it in assets that resulted in massive losses. The losses meant the debt held by Trump’s lender was nearly worthless. If that debt had been forgiven and written off by the original lender, Trump would have been forced to report a large gain, offsetting the tax benefit of the loss on his assets. But as Hempton’s story goes, the lender did not write it off. Rather, in the meantime, Trump created an entity that bought the debt from the lender for pennies on the dollar. After the sale, the write-down taken by the lender was not attributable to Trump as income. Trump’s “entity” simply served as a place to “park” the debt, protecting Trump’s tax benefits via loss carry-forward.

Megan McArdle addresses this issue, but she first reinforces the policy wisdom of the loss provisions in the tax code. McArdle ridicules the notion that businesses seek to generate losses in order to obtain tax deductions. She then  debunks the debt-parking theory of Donald Trump’s tax management:

“This theory seemed to have a lot of credibility among folks on social media. Among the tax professionals I spoke to, it had none: the IRS would treat this sort of structure just as it would if a third party had forgiven the debt.

‘Look,’ says [tax attorney Ron] Kovacev, ‘you put a $900 million loss on your tax return, that’s audit bait. The IRS is going to look into it. The notion that you could just move the money and the IRS wouldn’t ask questions?’ There was a sort of incredulous pause before he finally said: ‘That’s hard to fathom.’“

One other question about the 1995 tax return is whether the $916 million loss proves that Trump is a lousy businessman. In fact, there is speculation that Trump’s losses around that time might well have been much larger than that. He suffered staggering failures in his casino business, his airline, and his investment in New York’s Plaza Hotel. It might not be so remarkable, however, to see a few losses on this scale for a developer investing in a variety of large projects. Big risk goes with the territory. Nevertheless, it doesn’t appear that Trump, having begun his business career with large amounts of family money, has achieved tremendous success with that capital over the years, on balance. Rather, it looks more like the kind of success an average investor would have achieved under the same initial circumstances. The losses claimed on his 1995 tax return obviously restrained his overall gains, but they don’t prove he’s a terrible businessman. He’s probably fairly average.

Both Trump and Clinton have exploited a rule in the income tax code that helps smooth after-tax profits and is a basic element of income tax rationality (given that it exists in the first place). It’s rather absurd for anyone to condemn them for it. Even more absurd for either of them to cast aspersions at the other on these grounds. Would Hillary Clinton do anything to restrict the longstanding ability to carry forward losses to deduct against future taxes? I’m thankful that I haven’t heard her say so!

 

 

Punitive Taxes Chase Off a Rational King

28 Thursday Aug 2014

Posted by Nuetzel in Uncategorized

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Burger King, consumption tax, corporate desertion, corporate income tax, economic patriotism, Greg Mankiw, Learned Hand, Megan McArdle, tax inversions

burger-king-fireplace 

The counterproductive U.S. corporate tax code was a major incentive for Burger King’s prospective merger with the Canadian doughnut chain Tim Hortons. The merger will allow BK to change its domicile to Canada, thereby reducing its tax bill. This is known as a corporate “tax inversion.” Canada’s tax system is less punishing because its corporate tax rate is lower than in the U.S., and Canadian taxes are based on territorial earnings, rather than global earnings as in the U.S. Megan McArdle explains that the latter is the more important consideration: “If we’re worried about inversion, then the U.S. government should follow the lead of other developed countries, and move to territorial taxation.”

The corporate income tax represents double taxation of income paid out as dividends and imposes, at least partly, a double tax burden on shareholders even when earnings are retained. Greg Mankiw believes that the corporate income tax should be abolished.

“The burden of the corporate tax is ultimately borne by people — some combination of the companies’ employees, customers and shareholders. After recognizing that corporations are mere conduits, we can focus more directly on the people.”

On the topic of “economic patriotism” and so-called “corporate desertion,” Mankiw quotes Learned Hand:

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.”

Mankiw also proposes a consumption tax as a replacement for federal income taxation, which has great merit, but it is a very ambitious plan and probably at odds with current political realities.

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