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The Dreaded Social Security Salvage Job

24 Friday Mar 2023

Posted by Nuetzel in Privatization, Social Security

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Angus King, Bernie Sanders, Bill Cassidy, COLAs, Discretionary Spending, Donald Trump, Entitlement State, Federal Asset Sales, FICA Tax, George W. Bush, Insolvency, Internal Rate of Return, Joe Manchin, John Kennedy, Lump-Sum Payouts, Medicare, Mike Pence, Non-Discretionary Spending, OASDI, Opt-Out, Paygo, Payroll Tax, Present Value, Private Accounts, Privatization, Redistribution, Robert Shiller, Seeking Alpha, Social Security, Social Security Trust Fund, Todd Henderson, Universal Basic Income

Government budget negotiations never fail to frustrate anyone of a small-government persuasion. We have a huge, ongoing federal budget deficit. Spending’s gone bat-shit out of control over the past several years and too few in Congress are willing to do anything about it. Democrats would rather see politically-targeted tax increases. While some Republicans advocate spending cuts, the focus is almost entirely on discretionary spending. Meanwhile, the entitlement state is off the table, including Social Security reform.

Fiscal Indiscretion

Sadly, non-discretionary outlays (entitlements) today make a much larger contribution to the deficit than discretionary spending. That includes the programs like Social Security (SS) and Medicare, in which spending levels are programmatic and not subject to annual appropriations by Congress. When these programs were instituted there were a large number of workers relative to retirees, so tax contributions exceeded benefit levels for many decades. The revenue excesses were placed into “trust funds” and invested in Treasury debt. In other words, surpluses under non-discretionary SS and Medicare programs were used to finance discretionary spending!

The aging of Baby Boomers ultimately led to a reversal in the condition of the trust funds. Fewer workers relative to retirees meant that annual payroll tax collections were not adequate to cover annual benefits, and that meant drawing down the trust funds. Current projections by the system trustees call for the SS Trust Fund to be exhausted by 2035. Once that occurs, benefits will automatically be reduced by roughly 20% unless Congress acts to shore up the system before then.

A Few Proposals

I’ve written about the need for SS reform on several occasions (though the first article at that link is not germane here). It seems imperative for Congress and the President to address these shortfalls. By all appearances, however, many Republicans have put the issue aside. For his part, Joe Biden has apparently accepted the prospect of an automatic reduction in benefits in 2035, or at least he’s willing to kick that can down the road. He has, however, endorsed taxes on high earners to fund Medicare. Senator John Kennedy (R-LA) suggests raising the retirement age, or at least raise the minimum age at which one may claim benefits (now 62). Senators Bill Cassidy (R-La.) and Angus King (I-Maine) were working on a compromise that would create an investment fund to fortify the system, but the specifics are unclear, as well as how much that would accomplish.

Meanwhile, Senator Bernie Sanders (S-VT) proposes to expand SS benefits by $2,400 a year and add funding by extending payroll taxes to earners above the current limit of $160,000. Senator Joe Manchin (D-WV) has endorsed the latter as a “quick fix”.

There is also at least one proposal in Congress to end the practice of taxing a portion of SS benefits as income. I have trouble believing it will gain wide support, despite the clear double-taxation involved.

Then there are always discussions of reducing benefits at higher income levels or even means-testing benefits. In fact, it would be interesting to know what proportion of current benefits actually function as social insurance, as opposed to a universal entitlement. The answer, at least, could serve as a baseline for more fundamental reforms, including changes in the structure of payroll taxes, voluntary lump-sum payouts, and private accounts.

More Radical Views

There are a few prominent voices who claim that SS is sustainable in its current form, but perhaps with a few “no big deal” tax increases. Oh, that’s only about a $1 trillion “deal”, at least for both Medicare and SS. More offensive still are the scare tactics used by opponents of SS reform any time the subject comes up. I’m not aware of any serious reform proposal made over the past two decades that would have affected the benefits of anyone over the age of 55, and certainly no one then-eligible for benefits. Yet that charge is always made: they want to cut your SS benefits! The Democrats made that claim against George W. Bush, torpedoing what might have been a great accomplishment for all. And now, apparently Donald Trump is willing to use such accusations to damage any rival who has ever mentioned reform, including Mike Pence. Will you please cut the crap?

The System

The thing to remember about SS is that it is currently structured as a pay-as-you-go (PAYGO) system, despite the fact that benefits are defined like many creaky private pensions of old. SS benefits in each period are paid out of current “contributions” (i.e., FICO payroll taxes) plus redemptions of government bonds held in the Trust Fund. Contributions today are not “invested” anywhere because they are not enough to pay for current benefits under PAYGO.

The Trust Fund was accumulated during the years when favorable demographics led to greater FICO contributions than benefit payouts. The excess revenue was “invested” in Treasury bonds, which meant it was used to fund deficits in the general budget. It’s been about 15 years since the Trust Fund entered a “draw-down” status, and again, it will be exhausted by 2035.

SSA Says It’s a Good Deal

A participant’s expected “rate of return” on lifetime payroll tax payments depends on several things: lifetime earnings, age at which benefits are first claimed, life expectancy at that time, marital status, relative earning levels within two-earner couples, and the “full retirement age” for the individual’s birth year. Payroll tax payments, by the way, include the employer’s share because that is one of the terms of a hire. A high rate of return is not the same as a high level of benefits, however. In fact, relative to career income, SS has a great deal of progressivity in terms of rates of return, but not much in terms of benefit levels.

The Social Security Administration (SSA) has calculated illustrative real internal rates of return (IRR) for many categories of earners given certain assumptions. (An IRR is a discount rate that equalizes the present value (PV) of a stream of payments and the PV of a stream of payoffs.) The SSA’s most recent update of this exercise was in April 2022. The report references Old Age, Survivors, and Disability Insurance (OASDI), but the focus is exclusively on seniors.

Three basic scenarios were considered: 1) current law, as scheduled, despite its unsustainability; 2) a payroll tax increase from 12.4% (not including the Medicare tax) to 15.96% starting in 2035, when the Trust Fund is exhausted; and 3) a reduction in benefits of 22% starting in 2035.

The authors of the report conclude that “… the real value of OASDI benefits is extraordinarily high.” This theme has been echoed by several other writers, such as here and here. This conclusion is based on a comparison to returns earned by investments that SSA judges to have comparably low risk.

I note here that I’ve made assertions in the past about relative SS returns based on nominal benefits, rather than inflation-adjusted values. Those comparisons to private returns might have seemed drastic because they were expressed in terms of hypothetical future nominal values at the point of retirement. The gaps are not as large in real terms or if we consider SS returns broadly to include those accruing to low career earners. Medium and high earners tend to earn lower hypothetical returns from SS.

A Mixed Bag

SSA’s calculated IRRs are highest for one-earner couples followed by two-earner couples. Single males do relatively poorly due to their higher mortality rates. Low earners do very well relative to higher earners. Earlier birth years are associated with higher IRRs, but these are not as impressive for cohorts who have not yet claimed benefits. The ranges of birth years provided in the report make this a little imprecise, but I’ll focus on those born in 1955 and later.

Of course the returns are highest under the current law hypothetical than for the scenarios involving a benefit reduction or a payroll tax hike. The current law IRRs can be viewed as baselines for other calculations, but otherwise they are irrelevant. The system is technically insolvent and the scheduled benefits under current law can’t be maintained beyond 2034 without steps to generate more revenue or cut benefits. Those steps will reduce IRRs earned by hypothetical SS “assets” whether they take the form of higher payroll taxes, lower benefits, a greater full retirement age, or other measures.

The tax hike doesn’t have much impact on the IRRs of near-term retirees. It falls instead on younger cohorts with some years of employment (and payroll tax payments) remaining. The effect of a cut in benefits is spread more evenly across age cohorts and the reductions in IRRs is somewhat larger.

With higher payroll taxes after 2034, the average IRRs for birth years of 1955+ range from about 0.5% up to about 6.25%. The returns for single females and two-earner couples are roughly similar and fall between those for single males on the low end and one-earner couples on the high end. In all cases, low earners have much higher IRRs than others.

The reduction in benefits produces returns for the 1955+ age cohorts averaging small, negative values for high-earning single men up to 5.5% to 6% for low-earning, one-earner couples.

But On the Whole…

The IRR values reported by SSA are quite variable across cohorts. Individuals or couples with low earnings can usually expect to “earn” real IRRs on their contributions of better than 3% (and above 5% in a few cases). Medium earners can expect real returns from 1% to 3% (and in some cases above 4%). Many of the returns are quite good for a safe “asset”, but not for high earners.

Again, SSA states that these are real returns, though they provide no detail on the ways in which they adjust the components used in their IRR formula to arrive at real returns. Granting the benefit of the doubt, we saw persistently negative real returns on a range of safe assets in the not-very-distant past, so the IRRs are respectable by comparison.

Qualifications

There are many assumptions in the SSA’s analysis that might be construed as drastic simplifications, such as no divorce and remarriage, uniform career duration, and no relationship between earnings and mortality. But it’s easy to be picky. Many of the assumptions discernible from the report seem to be reasonable simplifications in what could otherwise be an unruly analysis. Nonetheless, there are a few assumptions that I believe bias the IRRs upward (and perhaps a few in the other direction).

In fact, SSA is remarkably non-transparent in their explanation of the details. Repeated checking of SSA’s document for clear answers is mostly futile. Be that as it may, I’m forced to give SSA the benefit of the doubt in several respects. One is the reinvestment of cumulative remaining contributions at the IRR throughout the earning career and retirement. A detailed formula with all components and time subscripts would have been nice.

… And Major Doubts

As to my misgivings, first, the IRRs reported by SSA are based on earners who all reach the age of 65. However, roughly 14% – 15% of individuals who live to be of working age die before they reach the age of 65. Most of those deaths occur in the latter part of that range, after many years of contributions and hypothetical compounding. That means the dollar impact of contributions forfeited at death before age 65 is probably larger than the unweighted share of individuals. These individuals pay-in but receive no retirement benefit in SSA’s IRR framework, although some receive disability benefits for a period of time prior to death. It wouldn’t bother my conscience to knock off at least a tenth of the quoted returns for this consideration alone.

A second major concern surrounds the method of calculating benefits and discounted benefits. SSA assumes that benefits continue for the expected life of the claimant as of age 65. If life expectancy is 19 years at age 65, then “expected” benefits are a flat stream of benefit payments for 19 years. Discounting each payment back to age 65 at the IRR yields one side of the present value equality. This constant cash flow (CCF) treatment is likely to overstate the present value of benefits. Instead of CCFs, each payment should be weighted by the probability that the claimant will be alive to receive it with a limit at some advanced age like 100. CCF overcounts present values up to the expected life, but it undercounts present values beyond the expected life because the assumed CCF benefits then are zero!! Weighting benefit payments by the probability of survival to each age produces continuing additions to the PV, but increasing mortality and decaying discount factors become quite substantial beyond expected life, leading to relatively minor additions to PV over that range. The upshot is that the CCFs employed by SSA overstate PVs by front-loading all benefits earlier in retirement. For a given PV of contributions, an overstated PV of benefits requires a higher (and overstated) IRR to restore the PV equality, and this might be a substantial source of upward bias in SSA’s calculations.

Third, when comparing an SS “asset” to private returns, a big difference is that private balances remaining at death become assets of the earner’s estate. Meanwhile, a single beneficiary forfeits their SS benefits at death (except for a small death benefit), while a surviving spouse having lower benefits receives ongoing payments of the decedent’s benefits for life. This consideration, however, in and of itself, means that private plans have a substantial advantage: the “expected” residual at death can be “optimized” at zero or some higher balance, depending on the strength of the earner’s bequest motive.

Finally, in a footnote, the SSA report notes that their treatment of income taxes on Social Security benefits for claimants with higher incomes might bias some of the IRRs upward. That seems quite likely.

It would be difficult to recast SSA’s report based on adjustments for all of these qualifications. However, it’s likely that the IRRs in the SSA report are sharply overstated. That means many more beneficiaries with medium and higher earnings records would have returns in the 0% to 2% range, with more IRRs in the negative range for singles. Low earners, however, might still get returns in a range of 3% to 5%.

The SSA analysis attempts to demonstrate some limits to the risks faced by participants, given the scenarios involving a payroll tax increase or a benefits reduction in 2035. Nevertheless, there are additional political risks to the returns of certain classes of current and future retirees. For example, payroll taxes could be made much more progressive, benefits could be made subject to means testing, or indexing of benefits could be reduced. In fact, there are additional demographic risks that might confront retirees several decades ahead. Continued declines in fertility could further undermine the system’s solvency, requiring more drastic steps to shore up the system. As a hypothetical asset, by no means is SS “risk-free”.

Better Returns

Now let’s consider returns earned by private assets, which represent investments in productive capital. For stocks, these include the sum of all dividends and capital gains (growth in value). For compounding purposes, we assume that all returns are reinvested until retirement. Remember that private returns are much less variable over spans of decades than over durations of a few years. Over the course of 40 year spans (SSA’s career assumption), private returns have been fairly stable historically, and have been high enough to cushion investors from setbacks. Here is Seeking Alpha on annualized returns on the basket of stocks in the S&P 500:

“… the return on the S&P 500 since the beginning of valuation in 1928, is 10.22%, whereas the inflation-adjusted return on the market since that time is 7.01%…”

That real return would generate benefits far in excess of SS for most participants, but it’s not an adequate historical perspective on market performance. A more complete picture of real returns on the S&P, though one that is still potentially flawed, emerges from this calculator, which relies on data from Robert Shiller. The returns extend back to 1871, but the index as we know it today has existed only since 1957. The earlier returns tend to be lower, so these values may be biased:

Real stock market returns over rolling 40-year time spans varied considerably over this longer period. Still, those kind of stock returns would be superior to the IRRs in the SSA report going forward in all but a few cases (and then only for low and very low earners).

Most workers facing a choice between investing at these rates for 40 years, with market risk, and accepting standard SS benefits, uncertain as they are, couldn’t be blamed for choosing stocks. In fact, if we think of contributions to either type of plan as compounding to a hypothetical sum at retirement, the stock investments would produce a “pot of gold” several times greater in magnitude than SS.

However, we still don’t have a fair comparison because workers choosing a stock plan would essentially engage in a kind of dollar-cost averaging over 40 years, meaning that investments would be made in relatively small amounts over time, rather than investing a lump-sum at the beginning. This helps to smooth returns because purchases are made throughout the range of market prices over time, but it also means that returns tend to be lower than the 40-year rolling returns shown above. That’s because the average contribution is invested for only half the time.

To be very conservative, if we assume that real stock returns average between 5% and 6% annually, $1 invested every year would grow to between $131 – $155 after 40 years in constant dollars. At returns of 1% to 2% from SS, which I believe are typical of the IRRs for many medium earners, the cumulative “pot” would grow to $49 – $60. Assuming that the tax treatment of the stock plan was the same as contributions and benefits under SS, the stock plan almost triples your money.

Dealing With the Transition

Privatization covers a range of possible alternatives, all of which would require federal borrowing to pay transition costs. Unfortunately, the Achilles heel in all this is that now is a bad time to propose more federal borrowing, even if it has clear long-term benefits to future retirees.

Todd Henderson in the Wall Street Journal suggests a seeding of capital provided by government at birth along with an insurance program to smooth returns. Another idea is to offer an inducement to delay retirement claims by allowing at least a portion of future benefits to be taken as a lump sum. If retirees can privately invest at a more advantageous return, they might be willing to accept a substantial discount on the actuarial value of their benefits.

In fact, there is evidence that a majority of participants seem to prefer distributions of lump sums because they don’t value their future benefits at anything like that suggested by the SSA analysis. In fact, many participants would defer retirement by 1 – 2 years given a lump sum payment. Discounts and/or delayed claims would reduce the ultimate funding shortfall, but it would require substantial federal borrowing up front.

Additional federal borrowing would also be required under a private option for investing one’s own contributions for future dispersal. The impact of this change on the system’s long-term imbalances would depend on the share of earners willing to opt-out of the traditional SS program in whole or in part. More opt-outs would mean a smaller long-term obligations for the traditional system, but it would be hampered by a costly transition over a number of years. Starting from today’s PAYGO system, someone still has to pay the benefits of current retirees. This would almost certainly mean federal borrowing. Spreading the transition over a lengthy period of time would reduce the impact on credit markets, but the borrowing would still be substantial.

For example, perhaps earners under 35 years of age could begin opting out of a portion or all of the traditional program at their discretion, investing contributions for their own future use. Thus, only a small portion of contributions would be diverted in the beginning, and amounts diverted would contribute to the nation’s available pool of saving, helping to keep borrowing costs in check. By the time these younger earners reach retirement age, nearly all of today’s retirees will have passed on. Ultimately, the average retiree will benefit from higher returns than under the traditional program, but since they won’t be (fully) paying the benefits of current or near-term retirees, the public must come to grips with the bad promises of the past and fund those obligations in some other way: reduced benefits, taxes, or borrowing.

Another objection to privatization is financial risk, particularly for lower-income beneficiaries. Limiting opt-outs to younger earners with adequate time for growth would mitigate this risk, along with a reversion to the traditional program after age 45, for example. Some have proposed limiting opt-outs to higher earners. Bear in mind, however, that the financial risk of private accounts should be weighed against the political and demographic risk already inherent in the existing system.

One more possibility for bridging the transition to private, individually-controlled accounts is to sell federal assets. I have discussed this before in the context of funding a universal basic income (which I oppose). The proceeds of such sales could be used to pay the benefits of current and near-term retirees so as to allow the opt-out for younger workers. Or it could be used to pay off federal debt accumulated in the process. The asset sales would have to proceed at a careful and deliberate pace, perhaps stretching over several decades, but those sales could include everything from the huge number of unoccupied federal buildings to vast tracts of public lands in the west, student loans, oil and gas reserves, and airports and infrastructure such as interstate highways and bridges. Of course, these assets would be more productive in private hands anyway.

The Likely Outcome

Will any such privatization plan ever see the light of day? Probably not, and it’s hard to guess when anything will be done in Washington to address the insolvency we already face. Instead, we’ll see some combination of higher payroll taxes, higher payroll taxes on high earners through graduated payroll tax rates or by lifting the earnings cap, reduced benefits on further retirees, limits on COLAs to low career earners, and means-tested benefits. Some have mentioned funding Social Security shortfalls with income taxes. All of these proposals, with the exception of automatic benefit cuts in 2035, would require acts of Congress.

Fiscal Foolishness a Costly Salve For Midterm Jitters

05 Friday Aug 2022

Posted by Nuetzel in Fiscal policy, Inflation

≈ 2 Comments

Tags

Alternative Minimum Corporate Tax, Brad Polumbo, Carried Interest, Chuck Schumer, CMS, Drug Price Controls, Eric Boehm, Fossil fuels, Green Energy, Inflation Reduction Act, IRS, Joe Biden, Joe Manchin, Kyrsten Sinema, Lois Lerner, Medicare Part D, Obamacare Subsidies, Private equity, Stock Buybacks, Sweat Equity, Tax Burden, Tax Enforcement, Tax Incidence, Wharton Economics, William C. Randolf

The “Inflation Reduction Act” (IRA) is about as fatuous a name for pork-barrel spending and taxes as its proponents could have dreamt up! But that’s the preposterous appellation given to the reconciliation bill congressional Democrats hope to approve. Are we to believe that Congress suddenly recognizes the inflationary effects of governments deficits? Well, the trouble is the projected revenue enhancements (taxes) and cost savings are heavily backloaded. It’s mostly spending up front, which is exactly how we got to this point. There are a number of provisions intended to increase domestic energy production in the hope of easing cost-push, supply-side price pressures. However, provisions relating to fossil fuel production are dependent on green energy projects in the same locales. So, even if we get more oil, we’ll still be pissing away resources on wind and solar technologies that will never be reliable sources of power. Even worse, the tax provisions in the bill will have burdens falling heavily on wage earners, despite the Administration’s pretensions of taxing only rich corporations and their shareholders.

The Numbers

The IRA (itself an irritating acronym) would add $433 billion of new federal outlays through 2031 (*investments*, because seemingly every federal outlay is an “investment” these days). At least that’s the deal that Chuck Schumer and Joe Manchin agreed to. As the table below shows, these outlays are mostly for climate initiatives, but the figure includes almost $70 billion of extended Obamacare subsidies. There is almost $740 billion of revenue enhancements, which are weighted toward the latter half of the ten-year budget window.

The deal reduces the federal budget deficit by about $300 billion over ten years, but that takes a while… somewhat larger deficits are projected through 2026. I should note that the Congressional Budget Office has issued a new score this week that puts the savings at a much lower $102 billion. However, that “new” score does not reflect the changes demanded by Kyrsten Sinema (R-AZ).

Spending

Budget projections are usually dependent on assumptions about the duration of various measures, among many other things like economic growth. For example, the increased Obamacare subsidies are an extension, and the scoring assumes they end in 2026. It’s hard to believe they won’t be extended again when the time comes. Over ten years, that would cut the deficit reduction roughly in half.

The bill is laden with green energy subsidies intended to reduce CO2 emissions. They will accomplish little in that respect, but what the subsidies will do is enrich well-healed cronies while reducing the stability of the electric grid. Tax credits for electric vehicles will be utilized primarily by wealthier individuals, though there are tax credits for energy-efficient appliances and the like, which might benefit a broader slice of the population. And while there are a few provisions that might address supplies of fossil fuels and investment in nuclear energy, these are but a sop to Joe Manchin and misdirection against critics of Joe Biden’s disastrous energy policies.

Revenue

Should we be impressed that the Democrats have proposed a bill that raises revenue more than spending? For their part, the Democrats insist that the bill will impose no new taxes on those with taxable incomes less than $400,000. That’s unlikely, as explained below. As a matter of macroeconomic stability, with the economy teetering on the edge of recession, it’s probably not a great time to raise taxes on anyone. However, Keynesians could say the same thing about my preferred approach to deficit reduction: cutting spending! So I won’t press that point too much. However, the tax provisions in the IRA are damaging not so much because they depress demand, but because they distort economic incentives. Let’s consider the three major tax components:

1. IRS enforcement: this would provide about $80 billion in extra IRS funding over 10 years. It is expected to result in a substantial number of additional IRS tax audits (placed as high as 1.2 million). Democrats assert that it will raise an additional $400 billion, but the CBO says it’s likely to be much lower($124 billion). This will certainly ensnare a large number of taxpayers earning less than $400,000 and impose substantial compliance costs on individuals and businesses. A simplified tax code would obviate much of this wasteful activity, but our elected representatives can’t seem to find their way to that obvious solution. In any case, pardon my suspicions that this increase in funding to enforce a Byzantine tax code might be used to weaponize the IRS against parties harboring disfavored political positions. Shades of Lois Lerner!

2. Carried Interest: Oops! Apparently the Democrat leadership just bought off Kyrsten Sinema by eliminating this provision and replacing it with another awful tax…. See #3 below. The next paragraph briefly discusses what the tax change for carried interest would have entailed:

The original bill sought to end the favorable tax treatment of “carried interest”, which is earned by private equity managers but is akin to the “sweat equity” earned by anyone making a contribution to the value of an investment without actually contributing a proportionate amount of capital. I’ve written about this before here. Carried interest income is taxed at the long-term capital gains tax rate, which is usually lower than tax rates on ordinary income. This treatment is really the same as for any partnership that allocates gains to partners, but populist rhetoric has it that it is used exclusively by nasty private equity managers. Changing this treatment for private equity firms would represent gross discrimination against firms that make a valuable contribution to the market for the ownership control of business enterprises, which helps to discipline the management of resources in the private sector.

3. Tax on Corporate Stock Buy-Backs: it’s not uncommon for firms to use cash they’ve generated from operations to repurchase shares of stock issued in past. Unaccountably, Democrats regard this as a “wasteful” activity designed to unfairly enrich shareholders. However, it is a perfectly legitimate way for firms to return capital to owners. The tax would create an incentive for managers to choose less efficient alternatives for the use of excess funds. In any case, the unrestricted freedom of owners to empower managers to repurchase shares is a fundamental property right.

A tax on corporate stock buybacks can result in the triple taxation of corporate profits. Profits are taxed at the firm level, and if the firm uses after-tax profits to repurchases shares, then the profits are taxed again, and further, any gain to shareholders would be subject to capital gains tax. This is one more violation of the old principle that income should be taxed once and only once.

The proposed excise tax on buy-backs now added to the IRA is *expected* to raise more revenue than the carried interest revision would have, but adjustments to behavior have a way of stymying expectations. Research has demonstrated that firms who buy back their shares often outperform their peers. But again, there are always politicians who wish to create more frictions in capital markets because firms and investors are easy political marks, and because these politocos do not understand the key role of capital markets in allocating resources efficiently between uses and across time.

4. Corporate taxes: Imposing a minimum tax rate of 15% on corporate book income above $1 billion is a highly controversial part of the IRA. While supporters contend that the burden would fall only on wealthy shareholders, in fact the burden would be heavily distributed across lower income ranges. First, a great many working people are corporate shareholders through their individual or employer-sponsored savings plans. Second, corporate employees shoulder a large percentage of the burden of corporate taxes via reduced wages and benefits. Here’s Brad Polumbo on the incidence of the corporate tax burden:

“William C. Randolph of the Congressional Budget Office found that for every dollar raised by the corporate tax, approximately 70 cents comes out of workers’ wages. Further confirming this finding, research from the Kansas City Federal Reserve concluded that a 10% increase in corporate taxes reduces wages by 7%.”

This again demonstrates the dishonesty of claims that no one with an income below $400,000 will be taxed under the IRA. In addition, almost 50% of the revenue from this minimum tax will come from the manufacturing sector:

As Eric Boehm states at the last link, “So much for improving American manufacturers’ competitiveness!” Incidentally, it’s estimated that the bill would cause differential increases in the effective corporate tax on investments in equipment, structures, and inventories. This is not exactly a prescription for deepening the stock of capital or for insulating the American economy from supply shocks!

5. Medicare Drug Prices: A final source of deficit reduction is the de facto imposition of price controls on certain prescription drugs under Medicare Part D. A small amount of savings to the government are claimed to begin in 2023. However, the rules under which this will be administered probably won’t be established for some time, so the savings may well be exaggerated. It’s unclear when the so-called “negotiations” with drug companies will begin, but they will take place under the threat of massive fines for failing to agree to CMS’s terms. And as with any price control, it’s likely to impinge on supply — the availability of drugs to seniors, and it is questionable whether seniors will reap any savings on drugs that will remain available.

Do Words Have No Meaning?

The IRA’s vaunted anti-inflationary effects are a pipe dream. A Wharton Study found that the reduction in inflation would be minuscule:

“We estimate that the Inflation Reduction Act will produce a very small increase in inflation for the first few years, up to 0.05 percent points in 2024. We estimate a 0.25 percentage point fall in the PCE price index by the late 2020s. These point estimates, however, are not statistically different than zero, thereby indicating a very low level of confidence that the legislation will have any impact on inflation.”

Over 230 economists have weighed in on the poor prospects that the IRA will achieve what its name suggests. And let’s face it: not even the general public has any confidence that the IRA will actually reduce inflation:

Conclusion

The Inflation Reduction Act is a destructive piece of legislation and rather galling in its many pretenses. I’m all for deficit reduction, but the key to doing so is to cut the growth in spending! Reducing the government’s coerced absorption of resources relative to the size of the economy prevents “crowding out” of private, voluntary, market-tested activity. It also prevents the need for greater tax distortions that undermine economic performance.

The federal government has played host to huge pandemic relief bills over the past two years. Then we have Joe Biden’s move to forgive student debt, a benefit flowing largely to higher income individuals having accumulated debt while in graduate programs. And then, Congress passed a bill to subsidize chip manufacturers who were already investing heavily in domestic production facilities. All the while, the Biden Administration was doing everything in its power to destroy the fossil fuel industry. So now, Democrats hope to follow-up on all that with a bill stuffed with rewards for cronies in the form of renewable energy subsidies, financed largely on the backs of the same individuals who they’ve sworn they won’t tax! The dishonesty is breathtaking! This crowd is so eager to do anything before the midterm elections that they’ll shoot for the nation’s feet!

Fueled, Ignored, Misdiagnosed in DC, Inflation Broadens

18 Monday Jul 2022

Posted by Nuetzel in Inflation

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Tags

Cleveland Fed, Consumer Price Index, Consumer Sentiment, David Beckworth, infrastructure, Joe Biden, Joe Manchin, Median CPI, Pandemic Emergency Powers, Price Controls, Trimmed CPI, Vladimir Putin, Wholesale Price Index

Inflation accelerated at the consumer level in June and the advances continued to broaden. That’s confirmed by the median item in the Consumer Price Index (CPI) and a measure of the CPI that “trims” out items with the largest and smallest price hikes (see chart above from the Cleveland Fed). Wholesale inflation also picked up in June. At this point, there’s a very real danger that increasing expectations of future inflation are getting embedded into current pricing decisions. Once that happens, the cycle is very hard to break. And wage rates are not keeping pace, so inflation is reducing real incomes for many workers. The sad fact is that inflation takes its greatest toll on the well being of low income earners.

And why did inflation accelerate from 1.4% in January 2021 to 9.2% in June? Don’t ask Joe Biden, at least not if you want a straight answer. He’s been changing his tune almost every month, with a rotating cast of the characters coming in for blame. First, the story was that higher inflation was just transitory; then too, the Administration said it only hurt the rich, a wholly preposterous assertion; the blame then shifted to the oil companies; then to Putin; and then big corporations generally; more recently, it’s independent gas retailers! Nothing is said about Biden’s early pledge to shut down fossil fuels. Nothing is said about the federal government’s profligate spending and the money printing that paid for it. Nothing is said about the extended payment of unemployment benefits, which pinched labor supply. More generally, nothing is said about the extension of Biden’s pandemic emergency powers, which allows continued Medicaid and food stamp benefits to many who are otherwise ineligible. The federal spigot has been wide open!

So here’s a quick synopsis of events leading to our inflationary surge: demand strengthened as pandemic restrictions were lifted across the country. Unfortunately, businesses were not ready to meet that level of demand. Operations had been sharply curtailed during the pandemic all along business supply chains. Hiring staff was next to impossible for many firms, especially given the Biden Administration’s ineptitude with respect to labor incentives. The Administration also set out to starve the fossil fuel industry of capital and to shut down drilling and refining operations through restrictions and binding regulations. The price of oil began to soar early in the Administration, which has been working its way into the prices of other goods and services, including food and transportation. Reinforcing these ill effects was the broader regulatory onslaught instigated at many agencies by Biden, actions which tend to increase costs while limiting competition in many industries.

Most of the factors just listed were limitations on supply. However, the price pressure was accelerated on the demand side by government stimulus payments. And in fact, none of this inflation would be sustainable without easy monetary policy — and monetization of government debt.

Later, of course, Vladimir Putin’s invasion of Ukraine exacerbated worldwide energy and food shortages. Meanwhile, Democrat efforts to push through additional social spending, née “infrastructure”, were unrelenting. They are still pushing for more climate change regulation, not to mention funding “investments” intended to improve the “equity” of highways! Thank God for Joe Manchin for shutting it down, though even he seems intent on imposing drug price controls. Biden now says he’ll impose green energy policy via executive order.

Until about March of this year, Federal Reserve policy remained extremely accommodative, despite the central bank having completely missed its so-called inflation target rate of 2% well before that. Take another look at the chart at the top of this post. CPI inflation shot above 2% in early 2021. The Fed did not really react until March 2022. The chart below shows that growth in the GDP deflator was slightly more muted than the CPI, but it too was above 2% in the first quarter of 2021 and accelerated from there. It’s as if there had been no Fed target at all!

The story, again, was “not to worry, it’s transitory”. Moreover, the Fed was convinced the inflation was driven entirely by supply problems. In fairness, it’s true that tighter monetary policy won’t stop inflation from supply shocks without great cost in terms of lost output. But monetary accommodation, which is what happened in 2021, simply validates inflation and runs the risk of allowing inflation expectations to become embedded in pricing. And again, that’s hard to undo.

Despite the dominance of supply-side inflation pressures early in 2021, it’s no wonder that a different kind of pressure has cropped up since then. The following chart from David Beckworth is helpful:

We now have primarily demand-side inflation fueled by the earlier accommodation of supply constraints and the monetization of government deficits. Sure, there remain significant supply constraints, whether induced by the actions of Russia, Biden, or lingering pandemic dysfunctions. But supply-side inflation cannot sustain without monetary accommodation. An early reading for the second-quarter GDP deflator will be available in late July, but it may well show accelerating pressures from both the demand side and the supply side.

There is no way to eliminate the inflation surge without curtailing the growth of liquidity. Unfortunately, the risk that monetary tightening by the Fed will induce a recession is already very high, even a likelihood at this point. A fairly reliable signal of recession is an inversion of the yield curve, and we now see two-year Treasury debt yielding 15 – 20 basis points more than 10-year bonds. Again, real wages are declining. Real retail sales are down two months in a row and down from a year ago. Here’s a chart showing the most recent dismal reading on the index of consumer sentiment:

Whether a recession has already begun is not clear, but inflation certainly hasn’t abated, and the Fed is expected to continue tightening, albeit belatedly. Meanwhile, the Biden Administration and key Democrats don’t seem to want to make the Fed’s job any easier. They simply don’t comprehend the reality and their role in fostering the upward price trends we’re experiencing. They still cling to hopes of another big spending package that would add to deficits and the inflation tax, despite contemplating tax hikes on private employers, but so far Manchin has put the kabash on that. Still, we’re nowhere close to putting our fiscal and monetary houses in order.

Infrastructure Or Infra-Stricture? The Democrats’ $3.5 Trillion Reconciliation Bill

16 Thursday Sep 2021

Posted by Nuetzel in Big Government, Central Planning, infrastructure, Uncategorized

≈ 3 Comments

Tags

Antonia Ocasio-Cortez, Bernie Sanders, Biden Administration, Budget Reconcilation Bill, Capital Gains, Civilian Climate Corps, Clean Energy, corporate income tax, dependency, Federal Reserve, Fossil fuels, Green Cards, infrastructure, Joe Manchin, Legal Permanent Residency, Paid Family Leave, Physical Investment, Productivity Growth, Social Infrastructure, Tax the Rich, Tragedy of the Commons, Universal Pre-School, Welfare State

The Socialist Party faithful once known as Democrats are pushing a $3.5 trillion piece of legislation they call an “infrastructure” bill. They hope to pass it via budget reconciliation rules with a simple majority in the Senate. The Dems came around to admitting that the bill is not about infrastructure in the sense in which we usually understand the term: physical installations like roads, bridges, sewer systems, power lines, canals, port facilities, and the like. These kinds of investments generally have a salutary impact on the nation’s productivity. Some “traditional” infrastructure, albeit with another hefty wallop of green subsidies, is covered in the $1.2 trillion “other” infrastructure bill already passed by the Senate but not the House. The reconciliation bill, however, addresses “social infrastructure”, which is to say it would authorize a massive expansion in the welfare state.

What Is Infrastructure?

Traditionally, public and private infrastructure are underlying assets that facilitate production or consumption in one way or another, consistent with the prefix “infra”, meaning below or within. For example, a new factory requires physical access by roads and/or rail, as well as sewer service, water, gas and/or electric supply. All of the underlying physical components that enable that factory to operate may be thought of as private infrastructure, which has largely private benefits. Therefore, it is often privately funded, though certainly not always.

Projects having many beneficiaries, such as highways, municipal sewers, water, gas and electrical trunk lines, canals, and ports may be classified as public infrastructure, though they can be provided and funded privately. Pure public infrastructure provides services that are non-rivalrous and non-excludable, but examples are sparse. Nevertheless, the greater the public nature of benefits, the greater the rationale for government involvement in their provision. In practice, a great deal of “public” infrastructure is funded by user fees. In fact, a failure to charge user fees for private benefits often leads to a tragedy of the commons, such as the overuse of free roads, imposing a heavier burden on taxpayers.

The use of the term “infrastructure” to describe forms of public support is not new, but the scope of government interventions to which the term is applied has mushroomed during the Biden Administration. Just about any spending program you can think of is likely to be labeled “infrastructure” by so-called progressives. The locution is borrowed somewhat questionably, seemingly motivated by the underlying structure of political incentives. More bluntly, it sounds good as a sales tactic!

$3.5 Trillion and Chains

Among other questionable items, the so-called budget reconciliation “infrastructure” bill allocates funds toward meeting:

“… the President’s climate change goals of 80% clean electricity and 50% economy-wide carbon emissions by 2030, while advancing environmental justice and American manufacturing. The framework would fund:
• Clean Energy Standard
• Clean Energy and Vehicle Tax Incentives
• Civilian Climate Corps
• Climate Smart Agriculture, Wildfire Prevention and Forestry
• Federal procurement of clean technologies
• Weatherization and Electrification of Buildings
• Clean Energy Accelerator
”

The resolution would also institute “methane reduction and polluter import fees”. Thus, we must be prepared for a complete reconfiguration of our energy sector toward a portfolio of immature and uneconomic technologies. This amounts to an economic straightjacket.

Next we have a series of generous programs and expansions that would encourage dependence on government:

“• Universal Pre-K for 3 and 4-year old children
• High quality and affordable Child Care
•
[free] Community College, HBCUs and MSIs, and Pell Grants
• Paid Family and Medical Leave
• Nutrition Assistance
• Affordable Housing
”

If anything, pre-school seems to have cognitive drawbacks for children. Several of these items, most obviously the family leave mandate, would entail significant regulatory and cost burdens on private businesses.

There are more generous provisions on the health care front, which are good for further increasing the federal government’s role in directing, regulating, and funding medical care:

“• new Dental, Vision, and Hearing benefit to Medicare
• Home and Community-Based Services expansion
• Extend the Affordable Care Act Expansion from the ARP
• Close the Medicaid “Coverage Gap” in the States that refused to expand
• Reduced patient spending on prescription drugs
”

Finally, we have a series of categories intended to “help workers and communities across the country recover from the COVID-19 pandemic and reverse trends of economic inequality.”

“• Housing Investments
• Innovation and R & D Upgrades
• American Manufacturing and Supply Chains Funding
• LPRs for Immigrants and Border Mangt. • Pro-Worker Incentives and Penalties
• Investment in Workers and Communities • Small Business Support

I might suggest that a recovery from the pandemic would be better served by getting the federal government out of everyone’s business. The list includes greater largess and more intrusions by the federal government. The fourth item above, grants of legal permanent residency (LPR) or green cards, would legalize up to 8 million immigrants, allowing them to qualify for a range of federal benefits. It would obviously legitimize otherwise illegal border crossings and prevent any possibility of eventual deportation.

Screwing the Pooch

How many of those measures really sound like infrastructure? This bill goes on for more than 10,000 pages, so the chance that lawmakers will have an opportunity to rationally assess all of its provisions is about nil! And the reconciliation bill doesn’t stop at $3.5T. There are a few budget gimmicks being leveraged that could add as much as $2T of non-infrastructure spending to the package. One cute trick is to add certain provisions affecting revenue or spending years from now in order to cut the bill’s stated price tag.

A number of the bill’s generous giveaways will have negative effects on productive incentives. It’s also clear that some items in the bill will supplement the far Left’s educational agenda, which is seeped in critical theory. And the bill will increase the dominance of the federal government over not only the private sector, but state and local sovereignty as well. This is another stage in the metastasis of the federal bureaucracy and the dependency fostered by the welfare state.

Taxing the Golden Goose

But here’s the really big rub: the whole mess has to be paid for. The flip side of our growing dependency on government is the huge obligation to fund it. Check this out:

“American ‘consumer units,’ as BLS calls them, spent a net total of $17,211.12 on taxes last year while spending only $16,839.89 on food, clothing, healthcare and entertainment combined,”

Democrats continue to dicker over the tax provisions of the bill, but the most recent iteration of their plan is to cover about $2.9 trillion of the cost via tax hikes. Naturally, the major emphasis is on penalizing corporations and “the rich”. The latest plan includes:

  • increasing the corporate income tax from 21% to 26.8%;
  • increasing the top tax rate on capital gains from 20% to 25%;
  • an increase in the tax rate for incomes greater than $400,000 ($450,000 if married filing jointly)
  • adding a 3% tax surcharge for those with adjusted gross incomes in excess of $5 million;
  • Higher taxes on tobacco and nicotine products;
  • halving the estate and gift tax exemption;
  • limiting deductions for executive compensation;
  • changes in rules for carried interest and crypto assets.

There are a few offsets, including the promise of tax reductions for individuals earning less than $200,000 and businesses earning less than $400,000. We’ll see about that. Those cuts would expire by 2027, which reduces their “cost” to the government, but it will be controversial when the time comes.

The Dem sell job includes the notion that corporate income belongs to the “rich”, but as I’ve noted before, the burden of the corporate income tax falls largely on corporate workers and consumers. Lower wages and higher prices are almost sure to follow. This would deepen the blade of the Democrats’ political hari-kari, but they pin their hopes on the power of alms. Once bestowed, however, those will be difficult if not impossible to revoke, and the Dems know this all too well.

The assault on the “rich” in the reconciliation bill is both ill-advised and unlikely to yield the levels of revenue projected by Democrats. Like it or not, the wealthy provide the capital for most productive investment. Taxing their returns and their wealth more heavily can only reduce incentive to do so. Those investors will seek out more tax-advantaged uses for their funds. That includes investments in non-productive but federally-subsidized alternatives. Capital gains can often be deferred, of course. These penalties also ensure that more resources will be consumed in compliance and tax-avoidance efforts. The solutions offered by armies of accountants and tax attorneys will tend to direct funds to uses that are suboptimal in terms of growth in economic capacity.

What isn’t funded by new taxes will be borrowed by the federal government or simply printed by the Federal Reserve. Thus, the federal government will not only compete with the private sector for additional resources, but the monetary authority will provide fuel for more inflation.

Fracturing Support?

Fortunately, a few moderate Democrats in both the House and the Senate are balking at the exorbitance of the reconciliation bill. Senator Joe Manchin of West Virginia has said he would like to see a package of no more than $1.5 trillion. That still represents a huge expansion of government, but at least Manchin has offered a whiff of sanity. Equally welcome are threats from radical Democrats like Senator Bernie Sanders and Rep. Antonia Ocasio-Cortez that a failure to pass the full reconciliation package will mean a loss of their support for the original $1.2 trillion infrastructure bill, much of which is wasteful. We should be so lucky! But that’s a lot of pork for politicians to walk away from.

Infra-Shackles

The so-called infrastructure investments in the reconciliation bill represent a range of constraints on economic growth and consumer well being. Increasing the government’s dominance is never a good prescription for productivity, whether due to regulatory and compliance costs, bureaucratization of decision-making, minimizing the role of price signals, pure waste through bad incentives and graft, and public vs. private competition for resources. The destructive tax incentives for funding the bill are an additional layer of constraints on growth. Let’s hope the moderate Democrats hold firm, or even better, that the tantrum-prone radical Democrats are forced to make good on their threats.

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