Streetwise Professor

December 21, 2017

Not Exactly What I Asked Santa For, But I’ll Take It

Filed under: Derivatives,Economics,Politics — The Professor @ 10:13 pm

Miracle of miracles, Congress has passed, and Trump will sign (perhaps after the New Year) a tax bill. It’s hardly perfect, but it’s an improvement on the existing system, and is about the best we could expect to get in the current political climate.

What do we want from a tax system, and how does this bill get us closer to that? One goal of the tax system–and the one that I prioritize–is to minimize the deadweight cost of raising the necessary revenue. All real world taxes involve distortions–deadweight losses–because they warp incentives at the margin. For instance, a tax on labor income drives a wedge between the marginal benefit of working an hour (the after tax wage) and the marginal cost (the value of lost leisure). This induces people to work too little and to consume too much leisure (or equivalently, consume too much leisure and too little goods and services) because they don’t capture the full benefit of their labor. Really inefficient tax systems are rife with such distortions. The US tax code provides numerous examples.

Taxes on capital or the returns to capital–taxes on dividends, corporate profits, and capital gains–are highly distorting. Steven Landsberg explains this as intuitively as anyone. The basic idea is that capital taxes are a form of double taxation that distort incentives to save and invest vs. consume. As Landsberg puts it, it is a surtax. With capital taxation, we have an incentive to consume too much and save and invest too little.

For about 30 years, economists have understood that in certain circumstances, the optimal rate of tax on returns to capital is zero. That is, a consumption tax is optimal.

There are caveats to this conclusion. Information-driven considerations can lead to a positive capital tax rate. For example, if people can disguise labor income as capital income to escape the income tax on labor earnings, a positive capital tax can be efficient in conjunction with a personal income tax. Disguising consumption as investment (is a new personal computer an investment or consumption?) can lead to a similar result. Distributive considerations (which inherently involve value judgments, I should note, whereas efficiency considerations do not) can also make it desirable to tax capital.

But even given these caveats, it is almost certainly the case that an efficient tax system imposes relatively low taxes on capital.

This efficiency effect is also related to another (possible) goal of the taxation system–to affect the distribution of income/wealth/consumption. For the impact of the tax on capital returns on investment affects who actually bears the burden of the tax.

This is an example of one of the issues that non-economists have a devil of a time understanding: tax incidence. Who bears the burden of a tax is not necessarily the party on whom the tax is levied. Taxes on labor aren’t necessarily paid by workers. Sales taxes assessed on firms aren’t necessarily paid by those firms. Who bears the tax burden depends on elasticities of supply and demand for the thing that is taxed.

Capital tax incidence is particularly unintuitive because there is a dynamic element to it. But the basic point is that even though a capital tax is formally levied on the owners of capital (or the return streams), over a long enough horizon the burden falls almost entirely on labor.

This is due to the impact of the capital tax on investment mentioned above. Tax capital, you get less investment. With less investment, there is less capital. With less capital, labor is less productive. Lower productivity translates into lower wages. Meaning that even though no supplier of labor writes a check to Uncle Sam to pay for the tax on capital, s/he pays it nonetheless, in the form of lower real wages.

The impact tends to increase over time, because the capital stock does not adjust immediately in response to a capital tax that depresses after-tax returns. But in standard models, the long run equilibrium after-tax return on capital is a constant (determined by the marginal utility of consumption, time preferences, and the long run growth rate of the economy). So if you raise capital taxes, a constant after-tax return requires a rise in the pre-tax return, which requires a fall in the capital stock. That’s what causes wages to fall. And the quicker the capital stock can adjust, the more rapidly the capital tax rise reduce wages.

And of course this works in the opposite direction if you cut capital taxes: the after tax return to capital initially rises, spurring investment, which raises productivity and hence wages.

Indeed, under some fairly standard assumptions, the a cut in capital taxes cause wages to rise more than the lost revenue in capital taxes. Meaning that in the long run, labor pays more than 100 percent of a tax formally levied on capital.

Again, these effects are not immediate, but if you see a surge of investment in the next couple of years, you can surmise that wages will surge too over that time frame.

This result can be expressed in elasticity terms. The supply of capital is perfectly elastic in the long run. Perfectly elastically supplied inputs do not bear any burden of a tax, even if that tax is formally levied on those inputs: instead, the burden is paid by the suppliers of other inputs (e.g., labor) or consumers (in the form of higher prices).

And even to the extent that owners of capital benefit in the short term, they are people too. And yes, many of them are wealthy, but many are workers who are also capitalists due to their participation in pension plans or 401Ks.

The focus of the recently passed tax bill is the reduction of capital taxes, most notably through reductions in the corporate tax rate to 21 percent (from 35 percent–very high by world standards), and through the immediate expensing of some investment expenditures.  This is the main reason the tax bill is a big improvement. Yes, I would prefer a Full Monty consumption tax, but this reduction in capital taxation is a movement towards a more efficient tax system, and one that will increase wages over time more rapidly than under the existing rates.

An efficient tax system should also focus on broadening the tax base and reducing marginal rates, because it is marginal rates that distort decisions to work and save. The current bill does a little on this dimension.

Tax preferences for certain kinds of consumption or investment are also usually a bad idea. The mortgage interest deduction is a classic example of this: the non-taxation of employee health insurance premiums paid by employers is another. The former encourages excessive consumption of/investment in housing. The latter favors employer-provided health coverage, which distorts labor markets (e.g., through job lock).  It also induces overconsumption of health care as compared to other goods and services.

The tax bill trims–but does not eliminate–the favored tax treatment of mortgage interest. So that’s good, but not great. It does nothing  on the health care premium issue, which is unfortunate.

The tax bill also limits corporate deductions of interest payments on debt. This is desirable, because it mitigates the incentive to finance with debt rather than equity. The bill should have gone further.

One largely hidden bad in the bill is the elimination of operating loss carry backs and limits on operating loss carry forwards. I understand the motivation here–it was done to offset revenue losses from other tax cuts. However, this will deter risk taking and lead to more hedging designed to reduce the variability of corporate income solely for the purpose of reducing taxes.

This effect is a little subtle, so I’ll try to explain. With no carry backs or carry forwards, them marginal tax rate when a company loses money is zero, and the marginal tax rate on positive corporate profits is the full corporate rate (now 21 percent). Thus, if a company has a positive probability of losing money, its marginal tax rate is non-decreasing with income, and increasing over some range. Due to Jensen’s inequality, this increasing marginal tax rate means that expected tax payments are increasing in the variance of corporate income.* Thus, increasing risk is costly because it transfers money (on average) to the government. Therefore, firms are more likely to pass up higher returning but riskier projects, and more likely to pay bankers to design hedging products to reduce corporate income volatility (which uses real resources, i.e., causes a deadweight loss), or to engage in diversifying mergers that reduce returns on average but also reduce the variability of corporate income.

In contrast, carry backs and carry forwards reduce the disparity between the marginal tax rate on gains and losses. This means that expected tax payments are less sensitive to the variance of corporate profits, which reduces distortions in risk taking and risk management decisions.

Another negative in the bill is the retention of tax subsidies for electric vehicles and renewables.

But even despite these negatives, all in all, I say two cheers–or maybe 1.5 cheers-for the tax bill. It’s not exactly what I asked Santa for, but it’s better than a sharp stick in the eye.

But from the wailing on the left, you’d think that’s exactly what happened to them. In both eyes, in fact.

The left’s reaction is hysterical, in both senses of the word. It is hysterical in the sense of:

a psychological disorder (not now regarded as a single definite condition) whose symptoms include conversion of psychological stress into physical symptoms (somatization), selective amnesia, shallow volatile emotions, and overdramatic or attention-seeking behavior.

Especially the “shallow volatile emotions, and overdramatic or attention-seeking behavior” parts. Several Democrats (notably Nancy Pelosi) referred to the tax bill as “Armageddon.” Talk about overdramatic hyperbole. A common shriek (especially on Twitter) is that the tax bill will KILL thousands (or is it millions?) of Americans. People on the left seem to be in a competition to show who can be the most OUTRAGED OVER THIS OUTRAGE.

A good deal of this idiocy reflects a basic misunderstanding of tax incidence (which I discussed above). The left confuses who writes the tax check (corporations) with who actually foots the bill (in the medium and long run, wage earners). Another good deal of this idiocy reflects the bill’s limitation on the deductibility of state and local taxes, which hits high tax states like New York, New Jersey, Connecticut, and California–which also happen to be solidly Democratic. So this is a matter of whose ox is gored.

This is rather amusing, because these same Democrats claim to favor making the rich pay more taxes. But not their rich people, who will be hit hardest by the limits on SALT deductibility. I guess income redistribution should be achieved by taxing all those rich rednecks in Mississippi more heavily.

The left’s reaction is hysterical in the other sense of the word, meaning “extremely funny.” The reaction is so overwrought, so over-the-top, so disproportionate, so emotional, and so lacking in intellectual seriousness that it makes me laugh.

And I guess that’s another reason to support it. If those people think it’s horrible, it must be pretty good, right?

In all seriousness, evaluating the bill using some basic economics rather than what you might learn in primal scream therapy, it’s not bad, especially considering the source–a dysfunctional ruling class in DC. It mitigates some of the worst inefficiencies in the existing tax code. It could go further, but the fact that it goes anywhere at all is rather amazing, and a welcome holiday present.

*For those who said “WTF?” when they read “Jensen’s inequality” perhaps an example will help. Consider a company that has two investment opportunities. One pays $100 for certain. The other pays -$100 with a 50 percent probability, and $310 with a 50 percent probability. The expected return on the risky project is actually higher ($105 vs. $100), so from an efficiency perspective, that’s what we’d like the company to choose.

But it won’t if the corporate tax rate is 35 percent on gains, but the firm receives no payment from the government if it loses money: this means that the marginal tax rate on gains is positive, but the marginal rate on losses is zero. With this tax system, the after-tax return of the certain project is $65. The after tax return of the risky project is .5x-$100+.5x.65x$310=50.75.

The difference here is that the expected tax payment is higher when income is riskier. The expected tax payment in the certainty case is $35. In the risky case, it is .5x.35x$310=$54.25.

Carry backs and carry forwards allow the company to use the losses to offset gains in other years. If the firm faced the same payoff structure year after year, it could always carry back or carry forward the -$100 losses from bad years to offset gains in the good years. Thus, tax payments in the good years would fall to .5x.35x$210=$36.75, and its average after tax return would be $105-$36.75=$68.25>$65. So the company would take the project with the higher return.

Of course, the distortion attributable to the elimination of carry backs and limitation on carry forwards is greater, the higher the corporate tax rate. Thus, the reduction in the statutory rate to 21 percent dampens the effect of the reduction in the carry backs/forwards. But since the corporate tax rate is still positive, risk taking and risk management decisions are still distorted.

 

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11 Comments »

  1. Hysterical?! How dare you use a sexist insult derived from the Greek term for uterus! That just goes to show you that the so-called party of so-called family values…nah, I’m kidding of course. I’m just glad I got to use that line, finally. I do find etymologies interesting.
    My wish on this tax bill is that it could have remained focused on the business side, with a progressive tax increase on individuals to make it deficit neutral. I’m no massive deficit hawk, but at some point, we need to at least nod in the direction of a constant-percentage-of-GDP budget deficit. I like the pro growth arguments. Not so much the starve the beast ones.
    I would actually love someone to run the numbers on what personal income taxes would need to go to if there were no corporate income taxes at all. We are a nation of (wo)men, not of legal fictions. Natural persons should pay taxes, not legal entities willed into existence by the state. I know personal taxes will be higher, but other nations seem to do just fine.
    Anyway, what I really wanted to say was I appreciate your posts much more when they focus on the issues and not so much folks’ reactions thereto. As you point out, there are enough people yelling and screaming on Twitter and elsewhere. I insulate myself pretty well (if what you are relaying is accurate: I don’t see such mania), but even my media diet has some overdone panic in it. Blowhardery is a well served market, and (backhanded compliment incoming) you’re not as good at it. So I liked this post up until the part where it talks about hysteria. The rest wasn’t helpful, but not for etymological reasons. 😀

    Comment by Anonpls — December 21, 2017 @ 11:44 pm

  2. How funny to hear a Trumpist complain about hysterics of the left when we had to listen for 8 years how Obama was a socialist, how the ACA was going to kill people, how there were death squads. But if you have a short term memory then let me remind you that those same people are now hysterical about a FBI led coup. So please spare me the BS about hysterics on the left when on a daily basis we have to listen to morons forecasting armageddon, and yes those morons are also Trumpsters.

    Comment by Carsten — December 22, 2017 @ 8:08 am

  3. “If those people think it’s horrible, it must be pretty good, right?” Not a logical necessity, and distastefully cynical. And yet so often true; it’s a funny old world.

    Comment by dearieme — December 22, 2017 @ 9:53 am

  4. This decent apology makes the same assertions made during the Reagan tax cuts. There is no mention made of increased deficits. Will be interesting to see IF actually cutting capital gains taxes does in fact translate to increased workers compensation. The assertions made by the author in this regard have not necessarily panned out in reality, though the theory is quite airtight–like so much of Economic theory. The author above, like so many, refer to the 35% tax rate as if that was the effective tax rate. Very few companies actually paid near that amount.

    Comment by sirr — December 22, 2017 @ 12:26 pm

  5. Thank you for this post, SWP. Silly me – I had always thought that taxes were for raising revenue for legitimate functions of government, and not for social engineering or vote-getting. At any rate, I also enjoyed the brief commentary in your post about the shrieking hysteria from the left – more TDS (Trump Derangement Syndrome), of course.

    If the current tax system went away, what would politicians have left to sell?

    For some reason, the old familiar ditty kept coming to mind through all the usual shrieking and screaming and rending of garments by the left:

    “let’s not tax you
    let’s not tax me
    let’s tax that fellow
    behind the tree”

    Thanks again for this post – very informative.

    Comment by elmer — December 23, 2017 @ 6:34 am

  6. Also, according to the American left, Trump is provoking WW3 by supplying weapons to Ukraine to fight against Russia, who he is also colluding with. Sounds like a sure thing, given that WW3 will destroy any evidence of the collusion.

    Comment by Ivan — December 23, 2017 @ 3:50 pm

  7. Also he is selling Javelins and SAMs to Georgia to help them defend themselves from Russia, which has our northern neighbor fuming.

    Comment by Andrew — December 25, 2017 @ 3:04 am

  8. Paul Krugman is still short the stock market and says the world is ending.

    Comment by Jeffrey R. Carter — January 2, 2018 @ 9:23 am

  9. @Jeffrey–Knowing that Krugman is short the market makes me happy. Does this make me a bad person?

    The ProfessorComment by The Professor — January 3, 2018 @ 9:12 pm

  10. Now if only I could find a medium to short Krugman…what do I need to do to get CBOE/CME to launch that futures contract?

    Comment by Default tranche gamma — January 10, 2018 @ 12:35 pm

  11. @Default–We need to create KrugCoin.

    The ProfessorComment by The Professor — January 10, 2018 @ 9:43 pm

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