Tag Archives: Scott Sumner

The House GOP Tax Plan’s Disparate Treatment of Income Sources

09 Thursday Nov 2017

Posted by in Taxes

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Update: In writing the following post, I neglected to devote sufficient attention to the rules that would govern taxation of pass-through income under the House GOP tax plan. Those rules significantly alter some of the conclusions below. Those rules are discussed in a later post: Stumbling Through Pass-Through Tax Reform.

Double taxation of corporate income is a feature of the U.S. income tax code that is partially addressed in the tax reform bill proposed by the House GOP. Corporate income is taxed to the firm and again to owners on their receipt of dividends or when a company’s growth results in capital gains. Ultimately, the total rate of taxation matters more than whether it is implemented as single or double taxation of income flows. However, there is an unfortunate tendency to view corporate taxes as if they are levied on entitites wholly separate from their owners, so double taxation carries a stench of politically sneakiness. It also creates multiple distortions in the decisions of investors and the separately managed firms they own.

Non-corporate income taxation is reduced by the House plan even more substantially than the cut in taxes on corporate-derived income. However, the plan does not reduce taxes on high-earning professionals, many of whom are situated similarly to successful business owners and investors from an economic perspective.

Tax Burdens and Distortions

The federal corporate tax is not borne 100% by shareholders, as discussed in the previous post on Sacred Cow Chips. Some part of the burden is borne by labor via reduced wages. It is difficult to correct for this distortion in terms of calculating an effective marginal tax rate on corporate income. For example, suppose a new 35% tax would reduce corporate income from $100 to $65. The firm finds, however, that it can reduce wage payments by half of the expected tax payment, or $17.50. The firm would now earn $117.50 before tax and $76.38 after tax. Relative to the new level of pre-tax income, the tax rate is still 35%. It is no less than that by way of the reduction in wages, though the impact on the firm’s pre-tax income is mitigated.

The discussion here of tax rates, and even double taxation, is not intended as commentary on tax fairness. It might or might not be fair that the burden of the tax is shared with labor. Instead, the issue is the magnitude of the economic distortions caused by taxes. Tax rates themselves are a reasonable starting point for such a discussion, and they are easy to measure. Lower tax rates beget fewer distortions in economic outcomes than high tax rates. Low rates provide greater incentives to save and invest in productive assets, which enhances labor productivity, wages, and economic growth. Indeed, businesses go to great lengths to avoid taxes altogether, if possible, but typically those are non-productive uses of resources, which demonstrates the very distortions at issue.

Current and Proposed Marginal Tax Rates

Under current law, the top personal income tax rate on dividends is 20%. It is 23.8% if we include the Obamacare surtax. Adding that to the corporate rate yields the effective top tax rate paid by shareholders: 23.8% + 35% = 58.8%. The GOP bill does not alter the 23.8% top rate on dividends or capitals gains. By virtue of the corporate tax reduction, however, the plan would reduce the overall top rate on shareholders to 23.8% + 20% = 43.8%.

The income earned by investors in pass-through entities like proprietorships, partnerships and S-corporations is taxed as personal income under current law at rates ranging from 15% to 39.6% (43.4% at the top, including the surtax). Thus, under present law, the owner of a pass-through company is taxed less heavily at the top rate than the owner of a public company (43.4% vs. 58.8%). (I am ignoring the 15.3% FICA payroll tax owed by self-emloyed individuals in proprietorships or partnerships on incomes up to $127,200, and 2.9% above that level. The combined tax rates would be almost equal even if we include the FICA tax.)

The tax on pass-through business income would be reduced under the GOP bill via a cap of 25% on federal business income taxes. Presumably, this cap would nullify the House plan’s “bubble tax” of 6% on personal income between $1.2 million and $1.6 million of income, as well as the Obamacare surtax. Thus, the tax advantage for pass-through entities over corporations would be somewhat wider under the House plan than under current law (25% vs. 43.4%). (The FICA tax on owners of proprietorships and partnerships would not quite equalize the overall marginal tax rates over a certain income range.)

In addition, the House plan rewards the owners of pass-through businesses relative to individuals earning high levels of wage and salary income. If anything, the bill would penalize these individuals. For example, while the owner of a high-earning pass-through would face a 25% tax rate, a high-earning professional or corporate employee would pay the top marginal rate (39.6%) plus the surtax (3.8%) and possibly the bubble tax (6%). This is one reason why Scott Sumner says it looks as if the House plan was designed by Bernie Sanders!

The Upshot

The tax system should be neutral across different sources of income. Divergent effective tax rates on owners of corporations, pass-throughs, and high wage-earning individuals is undesirable and introduces arbitrary elements into private decision-making. If anything, the House GOP tax plan exacerbates those differences. By cutting marginal tax rates, it would reduce the magnitude of business tax distortions both for corporate and pass-through organizations and their owners, but the relative advantage of pass-throughs would increase relative to corporations, and owners of corporations and pass-throughs benefit relative to high-earning individuals. Let’s hope this is fixed as the bill evolves, but more balanced reductions in rates would require higher rates on business owners than contemplated in the current plan.

Our Homicidal Drug War

17 Tuesday Oct 2017

Posted by in Prohibition, War On Drugs

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Drug prohibition and the war on drugs are destructive policies and most burdensome to communities that can least afford it: impoverished and often minority neighborhoods. Drug laws and their enforcement likely account for the bulk of homicides that occur there, directly or indirectly. A post on SacredCowChips last week discussed the violence that frequently beleaguers communities that are home to unassimilated minorities. Drug prohibition compounds the tragedy in several ways: deadly rivalry among supplier organizations; violent confrontations with law enforcement; user criminality; drug-related incarceration; degraded user productivity; and tainted supplies that exacerbate health risks for users.

Ultimately, bad laws are distinguished by their failure to achieve broad compliance. The thing is, people who want to do drugs will do so regardless of their legality. Most recreational users are sufficiently imbued with a survival instinct and the self-control to govern their use effectively, without ostensible harm. Nearly all recreational users believe they are engaging in a harmless activity, and most of them are right. That is, quite simply, why the drug war just doesn’t work, and it won’t ever work. It doesn’t work for pot, LSD, cocaine, or anything else, including opioids and heroin. (Also see this.)

Prohibition, however, delivers the drug trade into the hands of gangs and mobsters. The supply side of the business attracts individuals having few legitimate market opportunities, who happen to be concentrated in economically depressed neighborhoods. The drug trade’s illegality transforms it into a risky and violent enterprise, and efforts to enforce prohibition magnify those dangers and expose law enforcement to great risk as well. Then, there are the effects of mass incarceration on individuals and their home communities. The situation is self-reinforcing, adding to the instability of these struggling areas.

There is ample evidence that drug prohibition is a driver of crime and responsible for a large number of homicides in the U.S. A Chicago prosecutor was quoted by HuffPo in 2013 as saying that 80% of homicides in the city were gang-related, and therefore primarily drug-related. Economist Jeffrey Miron has linked drug prohibition to international differences in violent crime rates. Scott Sumner has this take on the drug war and crime rates, including a brief analysis of the drop in homicides (40%) after alcohol prohibition was repealed. In 1991, Milton Friedman stated that the repeal of drug laws would eliminate about 10,000 U.S. homicides every year, which at the time would have been about a 40% reduction. And here is Yale’s Dan Kahan on the subject of drug laws and homicide:

“The weight of the evidence pretty convincingly shows that drug-related homicides generated as a consequence of drug prohibition are tremendously high and account for much of the difference in the homicide rates in the U.S. and those in comparable liberal market societies.“

In my last post on the U.S. homicide rate, I drew on Britigne Shaffer’s On the Banks blog post entitled “Michael Owen Nails the Gun Debate“. As log as we have prohibition and a drug war, the U.S. homicide rate is likely to exceed most other industrialized countries:

“We have a system in place where the government subsidizes poverty in urban areas, imposes economic blight in those same areas through heavy taxes and regulations, renders the residents permanently unemployable via the ‘criminal justice’ (sic) system, and creates a lucrative black market in drugs by restricting supply (not to mention increasing demand as people are desperate to escape their circumstances by getting high), meaning the only game in town is often entering the drug trade. The drug trade is violent because those in it have no access to courts to settle disputes. Powerful industries lobby to keep the drug war going; the top spenders are law enforcement unions, the prison industry, big alcohol, tobacco, and pharma.“

The CATO Institute‘s Handbook for Policymakers, Issue #23, advocates the following: repeal of the Controlled Substances Act; allowing states to pursue their own initiatives without federal interference; complete repeal of mandatory minimum sentences; and termination of the Drug Enforcement Administration (DEA). These actions would allow the federal government to focus its resources on real threats, rather than fighting an unending war with an underworld empowered by those very laws, and with Americans who wish to exercise freedom over their use of drugs for medicinal or recreational use. From the CATO Handbook:

“Repeal of prohibition would take the astronomical profits out of the drug business and destroy the drug kingpins who terrorize parts of our cities. It would reduce crime even more dramatically than did the repeal of alcohol prohibition. Not only would there be less crime: reform would also free federal agents to concentrate on terrorism and espionage and would free local police agents to concentrate on robbery, burglary, and violent crime. … The war on drugs has lasted longer than Prohibition, longer than the Vietnam War. Prohibition has failed, again, and should be repealed, again.”

Despite the destructive effects of prohibition, a great many Americans—and politicians—base their opinions about drug laws on flawed moral reasoning that somehow it is more “wrong” or more “dangerous” to do drugs than to drink alcohol, itself a drug posing great danger to abusers, but a legal one. Responsible drug use, like responsible drinking, is a victimless act, or would be without the engagement of underworld suppliers. But it’s clear that President Donald Trump and Attorney General Jeff Sessions are committed to a continuation of the failed drug war, as are a majority of both Democrats and Republicans in Congress. The drug-related killings will continue, as will the ongoing damage to so many American families and communities. The refusal to end the drug war is a tragedy of many tragedies past and future.

Dynamism and Punishment

20 Wednesday Apr 2016

Posted by in Income Distribution, Taxes

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The “squeeze” on the U.S. middle class is a fiction. If you don’t believe it, take a look at the “gif” above. It first appeared in The Financial Times (FT) with a misleading description about how “…technological change and globalization drive a wedge between the winners and losers in a splintering US society.” It’s obvious that the middle class, as statically defined by the FT, is shrinking only because it is moving up to higher real income levels (i.e., adjusted for inflation). Mark Perry uses this and other supporting charts in noting that “…so many middle-income households have become better off“. Some of these gains are related to an aging population, but the gains are not remotely consistent with FT’s dramatization. One point of emphasis that the chart should make obvious, but doesn’t quite, is that groups appearing to remain within a particular income range over time are never comprised of the same individuals. There is always movement up and down across all of these groups from year-to-year.

There is a stagnation story here, but it’s more limited than suggested by FT’s narrative. It is twofold: first, the financial crisis in 2007-2009 put a temporary stop to the upward income migration, and its resumption during the Obama presidency has been less robust; second, the very lowest-income segment, $0 – $10,000 of annual income, has expanded in each time interval shown since 1991, from just above 1% of adults to roughly 2.5%. A primary reason for the tepid growth of the U.S. economy since the recession’s trough in 2009, and the weaker migration, has been weak physical investment in the productive economy from its recession lows. That form of spending usually takes a lead role in economic recoveries. A number of observers have attributed the poor performance this time around to “regime uncertainty“, or the risk that regulatory and tax regimes could take an even more destructive toll in the future, essentially devouring returns to capital. As for the increases in the lowest-income sliver of the chart, Scott Sumner says:

“It could be due to expansion of the welfare state, the break-up of the traditional family, or perhaps growth in the underground economy. Nonetheless, it is cause for concern. But it has nothing to do with the mythical decline in the ‘middle class.’“

A related fiction is that the U.S. tax system is unfair to the middle class, and that higher income groups do not pay their “fair share”. This is put to rest in an “Issue Brief” from the Peter G. Peterson Foundation (PPF), using data from the Tax Policy Center and the Congressional Budget Office. The analysis shows that while high-income taxpayers benefit from tax breaks, those breaks offset high marginal tax rates and do not diminish the fact that the tax system is highly progressive:

“The Tax Policy Center estimates that 69 percent of taxes collected in 2015 will come from those in the top quintile, or those earning an income above $138,265 annually. Within this group, the top one percent of income earners — those earning more than $709,166 in income per year — will contribute over a quarter of all federal revenues collected.“

Apparently, the PPF analysis does not account for the impact of transfer payments on progressivity, which make average effective tax rates negative at low income levels. However, PPF does acknowledge that the tax system is unnecessarily complex and creates a web of distortions and poor incentives that limit economic growth. It’s a wonder that the dynamic of upward migration in real income was possible at all.

 

The Government Inequality Machine

17 Wednesday Jun 2015

Posted by in Big Government

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Cronyism cartoon

Some perceive the government as an ideal agent of redistribution, but they fail to apprehend the many ways in which government policy undermines equality. Scott Sumner and Kevin Erdmann have written an excellent essay on this point entitled “Here’s What’s Driving Inequality” at National Review. They focus on three areas of government action with the unavoidable side-effect of upward redistribution: housing policy (at all levels of government), regulation, and excessive protections for intellectual property.

Sumner and Erdmann briefly cover Thomas Piketty’s controversial view that wealth becomes increasingly concentrated under conditions of secular stagnation. However, they note that over the past few decades:

“... almost the entire change in the share of domestic income going to capital in major developed economies was explained by rising rents on residential real estate. Non-rental capital income (including the corporate sector) still has a fairly stable share of domestic income.“

Housing policy has driven rents upward in myriad ways. For example, restrictive zoning laws, environmental regulation of new building and regulation of bank lending have all made homeownership less feasible and renting more expensive. If you’re already in your own home, you’re safe! If not, welcome to the have-nots! Here’s a story on government insurance programs that offer massive subsidies to wealthy homeowners. All these redistributional effects are compounded by a tax code that has inflated housing prices through the home mortgage interest deduction, and at the same time inflated rents via the incidence of higher taxes on rental income and real estate capital gains.

Regulation of private business activity is often viewed naively as a necessary, protective function of government, but regulation acts in perverse ways:

“Unfortunately, many government regulations tend to favor larger firms. In recent years we have seen the passage of some extremely complex regulations involving thousands of pages of rules, such as Sarbanes-Oxley, Dodd-Frank, and the Affordable Care Act. The Food and Drug Administration, the Department of Defense, and the public health-care complex tend to create opportunities for uber-firms within industries, which act as clearinghouses for public contracts and regulatory demands.”

Large firms tend to pay higher wages and salaries than small firms. By favoring large firms, regulation in turn favors their relatively high-income workers. In addition, regulation such as occupational licensing, labor regulations and local wage controls damage the health and growth potential of small firms and the mobility of individuals at the bottom of the economic ladder.

Finally, Sumner and Erdmann discuss the often bizarre extension of intellectual-property (IP) rights and the way it favors large firms:

“Copyright protections once lasted for 14 years, applied only to maps and books, and could be renewed once if the author was still alive. Now they’ve been extended to many other products, extend for 50 years after the death of the author, and last for at least 95 years for corporations. These extensions are widely seen as reflecting the lobbying power of companies such as Disney. In the high-tech sector, patents are often granted for seemingly minor and obvious innovations.“

Sacred Cow Chips featured a piece on IP several months ago called “Is The Patent a Perversion?” The Libertarian view of IP is skeptical, to say the least, and favors limited protection at most. In that post, I quoted Jeffrey Tucker of the Beautiful Anarchy blog:

“Through intellectual property laws, the state literally assigned ownership to ideas that are the source of innovation, thereby restricting them and entangling entrepreneurs in endless litigation and confusion. Products are kept off the market. Firms that would come into existence do not. Profits that would be earned never appear. Intellectual property has institutionalized slow growth and landed the economy in a thicket of absurdity.“

There is little doubt that economic mobility is not well served by excessive grants of IP rights that extend monopolies indefinitely.

Government fosters inequality in many other ways. The mere existence of a confiscatory mechanism for legal revenue collection, and a complex bureaucracy in charge of distributing the spoils and making rules, will always attract high-powered rent-seeking resources and encourage cronyism. It is a graft machine. The very complexity of the tax code creates fertile ground for transfers via obscure breaks and carve-outs, while higher tax rates on others are required to fund the exceptions. Here’s another: the Export-Import Bank, which subsidizes exports for large corporations. A nice run-down of some of the many areas of “Welfare for the Rich” was provided a few years ago by Robert P. Murphy in The Freeman.

Unfortunately, direct efforts by the government to help the poor are often mere palliatives. At the same time, many of these programs are notorious for destroying work incentives, which undermines equality and economic mobility.

Government is simply not as well-suited to promoting equality as well-functioning markets, free of government meddling and government grants of monopoly. Profits in such markets attract new resources that compete away excess returns and bid prices downward, actions that tend to promote equality. The opportunity to compete without restraint not only vitiates artificial or permanent claims to profits; along with strong property rights, it encourages invention, economic mobility and growth.

Strangling By Stimulus

01 Sunday Feb 2015

Posted by in Government

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Stimulus-Credit-Card

Will more government spending fix a weak economy? That is certainly a common refrain heard from economists and other pundits, including prominent members of the private business community. The historical record suggests otherwise, however, and there are practical reasons to doubt the efficacy of this sort of “fiscal stimulus.” Some of these are explored in “‘Timely, Targeted and Temporary?’ An Analysis of Government Expansions Over the Past Century“, from the Mercatus Center. In particular, countercyclical spending efforts have violated the “three Ts” often said to be required for successful demand-side policies. These efforts have been systematically late, badly targeted, and have resulted in permanent expansions in the resources absorbed by the government sector.

“Fiscal stimulus efforts going back to the 1930s consistently fail to meet the three Ts objective:

  • Improper timing. Policymakers have consistently struggled to properly time fiscal stimulus spending. In every postwar recession in the 20th century where stimulus spending was attempted, government spending peaked well after the economy was already in recovery. Policy lags—recognition, decision-making, implementation, and impact—are largely responsible for this fact.
  • Inefficient targeting. Going back to the New Deal, policymakers have targeted stimulus funds on the basis of politics rather than what delivers the most bang for the taxpayer buck. Further, individual policymakers cannot possess all the collective knowledge required to allocate and direct economic resources in the most efficient and effective manner, as markets do.
  • Permanent expansion of government. Stimulus funding has almost always led to permanent expansion in the size and scope of government. Indeed, the alleged need for immediate stimulus opens the door for expansions in government that might not have occurred under normal circumstances. On the rare occasions that the increased spending has been temporary, the costs have generally outweighed the benefits.“

As for inefficient targeting, I often hear that our nation’s infrastructural needs clinch the argument for stimulus spending. But those needs should be the focus of long-term planning and addressed on a continuing basis, not in bursts dictated by the state of the business cycle. Good projects should not be neglected in good times or bad, and there is no justification for undertaking a project if is not worthwhile on its merits. If increased spending can stabilize a weak economy, government should simply do something it does well: write checks. Who does infrastructure spending  help in those bad times? It certainly fails to address the basic human needs left unmet in a weak economic environment; it may or may not add high-paying construction jobs. (An aside: in the last recession, the stimulus program didn’t so much add construction jobs as it did accelerate certain “shovel-ready” projects.)

Proponents of government stimulus always have a culprit in mind for the economy’s ills: weak demand or under-consumption. They say government can lead the way out with more spending. This post on Sacred Cow Chips, “Keynesian Bull Chips“, disputes this point of view and provides some links on the topic, including this post by John Cochrane that is now ungated on his blog. Stimulus efforts are usually billed as temporary but rarely are. The expanded budgets always seem to remain expanded, and government absorbs an increasing share of the nation’s spending. Meanwhile, the value of government’s contribution to output is overstated, since most of the output is not subject to a market test or valuation.

The growth of government increasingly burdens private sector. Apart from tax distortions, the resources available to the private sector are gradually crowded and squeezed by the growth of public spending. Private investment is curtailed as government deficits absorb a growing share of private saving. Increasingly detailed regulation diminishes the private sector’s productivity. Robert Higgs at the Mises Institute asks: “How Much Longer Can the U.S. Economy Bear the Burdens?” That’s a very good question.

The opposite of expansionary fiscal policy is fiscal austerity: lower spending, and lower deficits. The budget sequester, originally passed in 2011, is a good example. Keynesians typically contend that austerity will weaken the economy, but the evidence often suggests the contrary. Here is a Scott Sumner post on that point. For robust economic growth, cut spending broadly, cut taxes, and deregulate.

Fractured Fiscal Fairy Tales: Moot Multipliers

03 Wednesday Sep 2014

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Scott Grannis asserts that the multiplier associated with fiscal stimulus is roughly zero, and evidence over the past few years suggests that he may be right. He appeals to a form of the classic “crowding out” argument: that debt-financed increases in government spending absorb private saving, leaving less funding available for private capital investment. In the present case, federal deficits ($7.4 trillion since 2009) have soaked up more than 80% of the corporate profits generated over that time frame. Profits are a major source of funds for private capital projects, risky alternatives against which the U.S. Treasury competes.

There are other reasons to doubt the ability of fiscal policy to offset fluctuations in economic activity. Transfers, which have grown dramatically as a percentage of federal spending, can create negative work incentives, thereby diminishing the supply of labor and adding cost to new investment. The growth of the regulatory state adds risk to privately invested capital as well as hiring. Government projects also offer tremendous opportunities for graft and corruption, at the same time diverting resources into uses of questionable productivity (corn, solar and wind subsidies are good examples). Many federal programs in areas such as education fail basic tests of success. Federal bailouts tend to prop up unproductive enterprises, including the misbegotten cash-for-clunker initiative. Even government infrastructure projects, heralded as great enhancers of American productivity, are often subject to lengthy delays and cost overruns due to regulatory and environmental rules. Is there any such thing as a federal “shovel-ready” infrastructure project?

In recent years, research has found that spending multipliers are small and often negative in the long run, contrary to what statists and old-time adherents of Keynes would have you believe. Empirical multipliers tend to be smaller in more open economies and under more flexible exchange rate regimes. Of growing importance to many developed economies, however, is that spending multipliers tend to be zero or even negative in the long run when government debt is high relative to GDP. This is broadly consistent with the classic crowding-out explanation for low multipliers, whereby public debt burdens absorb private saving. U.S. government debt-to-GDP is now well above 60%, an empirical point of demarcation separating high and low-multiplier countries. Finally, some economists believe that fiscal stimulus is frequently offset by countervailing monetary tightening under an implicit policy of nominal GDP targeting. Scott Sumner describes this as the story of the past few years, as neither the fiscal expansion of the 2009 stimulus plan nor the contraction of the fiscal cliff and sequestration had much if any observable impact on economic growth.

Politicians, the mainstream press and eager Keynesian economists are seemingly always ready to pitch fiscal policy and higher federal spending as the solution to any macroeconomic problem. Sadly, that is unlikely to end any time soon, because the story they tell is so simple and tempting, and they are blind its insidious nature.