The Times on Taxes

The New York Times’ Sunday lead editorial (12/30) is simply breathtaking. The title is “Why the economy needs tax reform.” It starts well,

Over the next four years, tax reform, done right, could be a cure for much of what ails the economy…

OK, say I, the sun is out, the birds are chirping, my coffee is hot, and for once I’m going to read a sensible editorial from the Times, pointing out what we all agree on, that our tax system is horrendously chaotic, corrupt, and badly in need of reform. Let’s go – lower marginal rates, broaden the base, simplify the code.

That mood lasts all of one sentence.

Higher taxes,…

Words matter. “Reform” twice, followed by paragraphs of “higher taxes,” with no actual “reform” in sight. The Times is embarking on an Orwellian mission to appropriate the word “reform” to mean “higher taxes” not “fix the system.”

Let’s be specific. What is the Times’ idea of tax “reform?”

tax capital gains at the same rates as ordinary income…. a restoration of the estate tax, higher tax rates or surcharges on multimillion-dollar incomes, and higher corporate taxes..

That’s just to get started. Since, as the Times refreshingly admits,

..the new revenue would only slow the growth of the debt in the near term..

before the health care entitlement deluge hits,

… Mr. Obama would be wise to instruct the Treasury Department to start work on tax reform now, exploring carbon taxes, both to raise revenue and to protect the environment; a value-added tax,… and a financial transactions tax…

That’s “reform?”

What will all those taxes do? The Times has a little bit of deficit reduction on its mind,

 More revenue would also reduce budget deficits, helping to put the nation’s finances on a stable path.

But with “reduce,” “help,” and “stable path,” you can tell that eliminating deficits and paying off the debt are not a real high priority here. The Times has bigger fish to fry, starting with a red herring and ending with a red whale.

Higher taxes, raised progressively, could encourage growth by helping to pay for long-neglected public investment in education, infrastructure and basic research…

We’ve been spending more and more on education for years. While performance steadily declines. The trouble with schools is not lack of money.

Yes, infrastructure is crumbling, as a few New Yorkers may have figured out when their power went off, while their politicians – and the Times – instead of talking about burying electric lines and putting in a modern grid, wished instead to stem the rise of oceans and sugar in their soft drinks. But infrastructure spending is a tiny component of the Federal budget; we could support anyone’s wish list without a Federal income tax.  Basic research spending could be doubled on about 10 minutes worth of Federal spending. Red herring.

The whale comes last:

Greater progressivity would reduce rising income inequality, and with it, inequality of opportunity that is both an economic and social scourge. 

The Times is arguing forthrightly for confiscatory taxation of income and wealth, in order simply to  reduce post-tax incomes. This isn’t “redistribution,” it’s “off with their heads!”

Inequality of opportunity? No, President Obama’s kids should not go to Sidwell Friends, they should go to DC public schools like everyone else?  Mayor Rahm Emanuel’s kids shouldn’t go to the University of Chicago Lab school (mine go there too, but I don’t preach this stuff), they should have to go to Chicago public schools like everyone else? These are “economic and social advantages” arising from unequal income. Big ones, that motivate a lot of parents to work hard so they can afford the tuition.  French President Francois Hollande has a better idea: ban homework, so kids with smart parents can’t get an advantage because they get help on homework. Too bad you can’t ban homework in China and India. No concierge medicine either. Stand in line for medicaid like the rest of us.

And to accomplish this leveling, we’ll just take money from “the rich” until all are equally impoverished.

Am I being alarmist? No. Read the sentence again, carefully. Words matter. What else can it possibly mean?

It’s just astounding. When has a society ever grown, become prosperous, and raised opportunities for its citizens–of any background–by confiscatory taxation, transferring wealth to the State, with the deliberate aim of reducing the opportunities of a segment of its population? The examples I can think of – French and Russian revolutions, the whole communist world – ended rather badly.  Even more modest attempts, say postwar Britain, do not augur well. The evidence of Europe’s current high-tax “austerity” (another word Orwellianly appropriated to mean “high taxes”) and the weight of academic research (most recently from the IMF and Alberto Alesina) stand before us: Fiscal retrenchment led by higher marginal tax rates simply does not work.

Moving from outcome to opportunity, as the Times does, when has a society ever accomplished equal and plentiful opportunities by confiscatory taxation and heavy regulation? I can think of lots of societies that by these means became much less equal, with opportunity dependent on political and family connections, and thus out of reach of even the most talented and industrious people without connections. 

What of us naysayers? On taxing “capital gains at the same rate as ordinary income,”  

That is an indefensible giveaway to the richest Americans. Research shows that the tax breaks do not add to economic growth but do contribute to inequality. Currently, the top 1 percent of taxpayers receive more than 70 percent of all capital gains, while the bottom 80 percent receive only 6 percent.

Three more fish and a whopper.

We might start with the interesting assertion that any tax rate is a “giveaway.” Who gives what to whom, dear Times?

“Research shows” is another fascinating choice of words.  “Research shows” means “all research shows,” or “the consensus of research shows,” without actually saying it. The facts are “some research shows,” or in this case, really, “two unpublished papers we found on the web claim.”

The links point to a report by the Congressional Research service and a one-page screed from the Urban Institute.  Both pieces of “research” simply plot the usual pointless correlations ignoring the hundreds of other causes, effects, and things not held constant. Aspirin causes colds you know: Look, there is a strong correlation between asprin-taking and colds. Neither one is even submitted let alone published in a refereed journal, which is no guarantee of anything but at least it’s the minimum standard for “research.” If this were indeed what constitutes “research,"  and "science,"  vast new funding for fundamental research in economics might well be warranted.

Fortunately, that is not the case.  What real research concludes, as much as anything in economics concludes, is that capital gains taxes are about the easiest to avoid (see Buffett, Warren).  Real research shows that when capital gains rates were reduced in the 1980s, revenue increased. Real public finance, the rest of the world’s tax systems, and the broad conclusion of just about everybody until the world lost its head in 2008, was that capital gains taxation is a bad idea.

And the whale: "Receive” capital gains? Dear Times, capital gains are not a check sent by great-grandma’s trust fund. Let me educate you on where capital gains come from: People work, and earn money, and pay taxes on that money.  Rather than blow it all stimulating consumption demand, they save some of it, invest in stocks, or start businesses. When those investments pay off, they sell, and receive capital gains. A vast swath of retirees lives off capital gains, especially from their houses.Small business owners are “high income” in the one year they sell their businesses.

Words matter, again. “Receive” paints capital gains as passive receipts form a mysterious ill-gotten mountain of gold, ripe for plucking with neither tax avoidance, behavioral change, or economic consequence. That’s just not how our world works, but very revealing of the Times’ zero-sum, class-warfare worldview.

What about 

…higher corporate taxes..

Once again, one of the few things real “research shows,” and  economists agree on pretty heartily, is that corporate taxation – already higher in the US than the rest of the world – is a silly idea. All corporate taxes are passed on to people, through higher prices, lower wages, or lower returns to investors, primarily the former two. Tax people when they get the money. And corporations are much better at evasion, lobbying, moving abroad, and structuring operation in silly ways to avoid taxes.

The value added tax – the economist’s favorite, if coupled with elimination of other taxes – is famously “regressive,” the modern term (here are those important little words again) for “everybody pays the same rate."  Value added is, in Europe (along with 30-40% payroll taxes) the middle class tax that pays for middle class benefits. What about that, dear Times?

a value-added tax, coupled with provisions to protect lower-income taxpayers from higher prices, to tax consumption and encourage saving;

This is just incoherent. If you’re "protected from higher prices,” you’re not paying the tax. If we couple the VAT with a vast new income transfer program, adieu revenues.

At least we close with some humor. The VAT is there to encourage saving, while heavy taxation of interest, dividends, capital gains and estates, says just the opposite.

What about spending?

The big obstacle to comprehensive tax reform is the persistent Republican myth that spending cuts alone can achieve economic and budget goals. That notion was sounded rejected by voters during the election. Yet it still has adherents among many Republicans, which will make it that much harder for Congress to grapple with the bigger and more complex issue at the heart of tax reform: how to pay for government in the 21st century.

….All that [long list of taxes] would only be a start, because the new revenue would only slow the growth of the debt in the near term. After 10 years, the pressures of an aging population and health care costs would cause the debt to accelerate again.

Oh those evil Republicans, standing against “reform,” and reusing to grapple with “how to pay for government.” The size and scope of which is not under discussion. No, dear Times, it’s not “the pressures of  an aging population and health care costs.” It is the Federal Government’s promises to pay for it all. Which are, apparently, fixed stars.

Technical regress in any area is sad. Once upon a time, when we talked about taxes, there was a modicum of economics involved. When we thought about raising or lowering a rate, we thought seriously about the inevitable avoidance and distortions.  The first question was, “if we pass this law, will x actually pay more money, or will he simply change behavior to avoid the tax?” The second question was, “will his change in behavior hurt the economy?” Before we talk about what’s “fair” we talked about “what works.”

And we knew the sign of the answer: distorting taxation raises less revenue than you think, and reduces economic prosperity. The only question is how much. We did not indulge in magical thinking that appropriating anyone’s income would actually improve the economy, all on its own. We understood the damage, and tried to carefully balance the benefits of spending against that damage. This is how we got, for a while, to low marginal rates with a broad base (the latter since loopholed away), low capital gains, estate, and corporate taxes, and were headed messily towards a system that taxed consumption more than rates of return. 

As one glorious counterexample of all the Times’ monstrous confusions:

a financial transactions tax, to ensure that the financial sector, whose profits have substantially outpaced those of nonfinancial corporations, pay a fair share

A transactions tax is the easiest thing in the world to avoid with financial engineering.  How do you begin to figure out the “fair share” that financial vs nonfinancial corporations should pay? How about mutual funds whose beneficiaries are impoverished union schoolteachers? 

Orwellian language, blatant mistruths, and magical thinking aside, however, I want to applaud this editorial. No, I’m not kidding.

The Times is saying, out loud, that if we are to have the regulatory and welfare state we have enacted, it must be paid for with huge middle class taxes, as well as confiscatory taxes on anyone who dares to save, invest, or start a business. This is refreshing honesty. Up until about November 3, all we heard from them is that reversing the Bush tax cuts on the rich would pay for it all. At least a few of its readers may wake up and say, “wait, we voted for this?”

Really, my main complaint is that they left out the “if,” and its logical consequence, and any doubts that raising tax rates so massively might not produce the needed long-run revenue growth they hope for.

It is a mistake to dismiss this clear editorial. This isn’t the Village voice, or the Berkeley Free Press. This is the New York Times. This is how a wide swath of our fellow citizens, and majority of our fellow voters, see the world.   This is the agenda. They could not have been clearer if they had said “first we annex Austria and move against Czechoslovakia. Then we invade Poland and swing North and West.” Heed them.

Benefits trap art

Two charts from the UK, admittedly sprayed with too much chartjunk, but illustrating the poverty trap in Britain. (A previous post  on high marginal tax rates for low income people has more charts like this.)

Most of UK benefits are not time-limited, so people get stuck for life, and then for generations.

The original article, by Fraser Nelson, “Why the Poles keep coming” in the Spectator, is worth reading.  The article starts with the puzzling fact that

Britain’s employment figures are strong but most of the rise in employment so far under this government is accounted for by foreign-born workers (as was 99pc of the rise in employment under Labour). 

The author had the same epiphany that led me to economics all those years ago. No, it’s not culture, or “laziness.” Treat poor people as intelligent, responding to incentives, just like you and me, but with a lot bleaker choices. Try to look at the world through their eyes if you want to understand their behavior:

 if I was in a position of a British single mother I have not the slightest doubt that I would choose welfare. Why break your back on the minimum wage for longer than you have to, if it doesn’t pay? Some people do have the resolve to do it. I know I wouldn’t.

…Until our policymakers start to see things through the eyes of those ensnared in welfare traps, nothing will change. 

More great quotes:

If you had designed a system to keep the poor down, in would not look much different to the above.

…the cash-strapped British government is still creating still the most expensive poverty in the world.

Hat tip: Dan Mitchell writing at Cato@Liberty. His post is worth reading, as are the links. (Alas, the Spectator only cites the source of the graphs as “ an internal government presentation,” so I don’t know who to properly credit.)

Fiscal cliff or fiscal molehill?

Four thoughts, reflecting my frustrations with the “fiscal cliff” debate. 

1. Recession

How terrible will it be if we go over the cliff?

Bad, but for all the wrong reasons. If you, like me, didn’t think that “stimulus” from government spending raised GDP in the recession, you can’t complain that less government spending will cause a new recession now. The CBO’s projections of recession are entirely Keynesian. Pay them heed if you still think the key to prosperity is for the government to borrow money and blow it.

There are no “cuts” in sight anyway. “Cut” in Washington means “increase spending less than we previously said we would.” At worst a few programs will have to spend the same amount this year as last before spending increases resume.

It’s not even obvious that the “cuts” will happen. Will Congress really try to pay doctors 1/3 less? (Will doctors take any medicare patients if they do?) Or will they pass an “emergency” bill, exempting doctors just like Social Security? Sequestration has never actually been used.

To an economist, the main worry is that higher marginal tax rates mean more distortions, which are a drag on the economy.  But distortions take a while to kick in. It takes a while for people to change to easier jobs, not start businesses, move businesses offshore, not go to school, choose easier but less rewarding majors, find more tax shelters, and so on. So the danger is not so much a recession, which comes, and then ends, and we go back to growth. The danger is settling in to a decade of (even more) high-distortion, sclerotic growth.

The headline rate people are fighting about – 35% vs. 39.5 % federal income tax rate – is basically irrelevant to the larger issues. If we had a clear, functional, stable tax system, with a total (all taxes) 39.5% top marginal rate, the economy would heave a big sigh of relief and take off like a rocket.

We have instead a horrendously complex, nay corrupt, tax system. It’s chaotic, with teams of lobbyists descending now to carve out everyone’s exemption, deduction and subsidy. Tax reform is, in my judgment, more important than the headline marginal rate. More generally, I think the lessons of growth economics are pretty clear that over-regulation and the consequent politicization of economic decisions is a larger danger to growth than any stable clear and uniformly administered taxes with faintly reasonable marginal rates. If you can start a business and know for sure you’ll keep half the profits, that’s more enticing than never knowing what new holdup you will be subject to from 100 overlapping regulatory agencies.

Furthermore, economics cares about the total marginal tax rate – everything between the extra dollar you earn and the additional goods you receive – including Federal, state and local income taxes, deduction phaseouts, payroll taxes, taxes on rate of return between earning and spending, sales taxes, estate taxes if you leave it to your kids, property taxes if you buy property, excise taxes, and on and on. Some parts of Washington seems to finally have figured out that reducing deductions raises taxes with less distortionary effects on marginal tax rates.  They have not so successfully figured out that every phaseout or income test adds to marginal tax rates. In any case, it makes no sense at all to talk about the Federal income tax rate in isolation.  

Economics cares equally about taxes and benefits. Whether you send the government a check or they send you a check doesn’t matter, what matters is how that check changes based on your behavior. Marginal tax rates are high for lower income people too (earlier post on the subject). Asset tests are just as bad as income tests: If you save, and then an asset test takes away a benefit such as college aid, you might as well not bother saving. It makes no sense to talk about taxes and not benefits at the same time.

Economics cares about the overall impact of the Government on decisions, not just on-budget taxing and spending. If the government says “employers shall provide $15,000 worth of health insurance to every employee,” that does not show up on the budget – but it has exactly the same effect on the economy as a tax and benefit. If the government says “all gasoline shall contain 10% ethanol,” that has the same effect on the economy as a tax and subsidy.

2. Distribution

The same points apply even more to distributional questions – are the “rich” paying “their fair share,” should they “pay more,” and so on.  The headline Federal income tax rate is the tip of the iceberg. Economics tells us to consider the overall effect of the government at all levels on the distribution of individual consumption. (Not household, not income, not wealth.)

Obviously, we have to talk about taxes and benefits in the same breath here. We also need to talk about who benefits from government spending and intervention. There’s a lot of corporate welfare, which ends up in the pockets of some very rich people. If we remove a few hundred billion in green energy subsidies, and the Al Gores of the world can’t make another $100 million bucks on it, that ought to count as reducing the transfers to the rich just as much as raising their taxes.

Economics cares about the burden of taxation, not who pays taxes. This is clearest for gas taxes. It’s clear to everyone that the government is not socking it to those fat-cat gas station owners with gas taxes, they are simply passed on to you and me.

3. Politics (admittedly dangerous speculation for an economist)

What in the heck is going on? Why is our national discussion paralyzed over the tip of an iceberg?

Only one story makes sense to me. President Obama has been saying for four and a half years that he wants to raise taxes on “the rich,” and he means to do it. He wants to raise tax rates on the rich, for symbolic, social, political reasons as much as for anything in an economics textbook. Nothing else explains the Administration’s monomania on this point, especially given that it won’t make a dent in the deficit, the fact that it makes zero economic sense as a central policy to address our economic problems, and given the Administration's refusal to talk about reform – which would raise tax revenue and help economic growth – instead.

“The rich,” need to get with the program, like Warren Buffet. It remains open season for deductions, exclusions, special deals and loopholes. Notice Buffet never asks for removal of all the clever dodges he uses to pay less taxes, and nobody has mentioned that he might do so. Tax on unrealized capital gains anyone? Limit the exclusion of charitable donations, even to family foundations that employ family members to run them, from estate taxes? Boy, that would raise a lot of revenue from some truly “rich” people.

Quid pro quo here, though, rich people and the CEOs who recently visited the White House had better line up and support the Administration if they want their special deal, deduction, credit, Obamacare waiver, and no visits from the NLRB, EEOC, EPA, consumer financial protection bureau, and so on.

High statutory rates, a Swiss cheese of loopholes renegotiated in every annual crisis, and an army of regulators on the prowl, are a recipe for permanent Democratic government. The cliff is beautifully structured to make Republicans look bad. Things happen when they make sense. This path makes enormous political sense.

The amount of magical thinking on the economic left doesn’t help.  They used to claim that that economies like the US in the 1950s can still grow (for a while) despite high marginal tax rates (which nobody paid because of huge deductions). They used to claim that high tax rates wanted for other reasons don’t hurt too much. Now they’ve talked themselves into arguing that high marginal tax rates are actually good for growth.  Why not just say the obvious, this is a policy desired for political reasons, and the political outcome is more important than the economic damage?

4. The future (admittedly dangerous prognostication for one who says things are hard to predict)

The discussion around the cliff  sounds like we are finally settling some large issue. We are not. This is the fiscal molehill, not the fiscal cliff. This is Harpers Ferry, not Gettysburg. It’s the Anschluss, not D-day. It’s… Ok, I’m overdoing the military analogies, you get the point. This is the prelude to what looks to me like 10 years of constant crisis.

Here is the big issue. The US has already enacted European welfare and regulatory state with American characterstics – the bloated inefficiency, legalism, and red tape that is our specialty. We have not enacted the taxes to pay for it. We will either dramatically cut back the former, or rather dramatically raise the latter. On the table now is at most $100 billion out of a $1 trillion deficit, and likely much less. The fiscal molehill.

US Federal, State and Local spending is 40% of GDP. Pay attention to state and local, that’s a lot more than the 24% Federal we talk about a lot. Europe is more like 50% of GDP, so it sounds like we’re behind. But our government is bigger than it looks.

We have about a trillion dollars of “tax expenditures,” including the deduction for employer-provided health insurance, deduction for mortgage interest, and (small but annoying) credits for all sorts of things like checks to silicon valley CEOs too subsidize the electric cars they drive down t their private jets. These are no different than a trillion dollars of tax and another trillion dollars of spending, or another 6% of GDP. We’re at 46% right here.

Our government likes mandates and rules, which affect behavior and soak up the economy’s taxing capacity just as much as on-budget taxing and spending, but hide the fact. Europeans tax gas and energy, and people choose small cars and turn down the heat. We have mileage standards, energy efficiency standards, carpool lanes, electric-car sales mandates, and so on. Same real size of government. And so on.

Before the ACA, our government was paying for health care for about half the country, in our inimitably inefficient style, including medicare, medicaid, schip, and current and retired government employees. Under the ACA, we’re basically all in a European style system, funded by explicit or implicit (mandates) taxes. With those uniquely American characteristics.

The fact that government overall is about half of GDP matters to our tax debate. Properly measured, the average American must then pay about half his or her income in taxes. For every dollar taxed at a lower rate, another dollar has to be taxed at a higher rate. When we tax the average dollar at 50%, any progressivity  has to shift a lot of marginal rates well into the territory that destroys incentives and reduces revenue.

Europe pays for this stuff, and its middle class pays for this stuff. 30- 40% payroll taxes, 20% value added tax, $9 a gallon gas, 50% income taxes extending down to what we would call lower-middle-incomes, property taxes, estate taxes, wealth taxes. Sorry, Europe can’t quite pay for this stuff, even with those taxes.

But this is our choice. European taxes to pay for the regulatory and welfare state we’ve already enacted. With the European growth and eventually southern European corruption they entail. Or a sharp cutback in that state. We can decide before or after we experience the European debt crisis.

So, the fiscal cliff is just the beginning. This will be a long hard road, and my guess is that we will lurch from crisis to crisis, with patchwork last minute deals, for another decade. It doesn’t have to be so – the economic choices are clear. But given the size of the question at hand and how little anyone is talking about the real issues, it’s hard to see another way.

I think the deck is stacked towards the large-state camp.  There were two theories: “Starve the beast” said, cut taxes and eventually the size of the state will have to shrink. “Vote the benefits” said, increase spending and regulation, and eventually taxes will have to be raised to try to pay for it all. The latter seems to be winning.

I guess it’s appropriate that the Grumpy economist is playing the Grinch for Christmas!

The Fed's great experiment

So now you have it. QE4. The Fed will buy $85 billion of long term government bonds and mortgage backed securities, printing $85 billion per month of new money (reserves, really) to do it. That’s $1 trillion a year, about the same size as the entire Federal deficit. It’s substantially more each year than the much maligned $800 billion “stimulus.” Graph to the left purloined from John Taylor to dramatize the situation.

In addition, the Fed’s open market committee promises to

“..keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." [Whatever "anchored” means.] 

This is a grand experiment indeed. We will test a few theories.


First, just how much of the labor market’s troubles are the result of an ill-advisedly long maturity structure of government debt? How much is the result of 2% long term rates (negative in real terms) being too high and strangling credit? (If, in fact the Fed’s purchases have any sustained effect at all on long rates, which I doubt.) At zero interest rates does the split between reserves (which are, in the end, nothing more than floating-rate, overnight, electronic-entry US government debt) and other forms of government debt mean anything at all? In short, is monetary policy of the buy-bonds, print-money sort completely ineffective at zero rates, yes or no? At a trillion bucks a year we will soon find out. I bet no. (The WSJ calls this the “more cowbell” approach to policy.) But nobody can say it wasn’t big enough to test the theory.

Second, just how much is the economy suffering from a lack of promises from appointed officials? “Oh, well, sure, now I’ll build that new factory and start hiring people. I just wanted to hear that Bernanke ‘anticipates’ that he will think low rates are appropriate until until unemployment hits 6.5%, not just into the 6th year of the Biden administration.”

Fashionable new-Keynesian models give a big role to such pronouncements. I’m dubious.  Does the average Joe understand the difference between, say, the Administration’s promises that sure, next year we’ll cut entitlements, and the Fed’s promises?

One big hole in the argument:  Charlie Evans (Chicago Fed president) calls this “Odyssean” policy, after Odysseus who had himself tied to the mast so as to hear the sirens. But notice a big difference between Odysseus and Bernanke. Odysseus did not “anticipate that remaining near the mast will remain appropriate so long as the call of the sirens is not too beautiful, the sea not too rough, the sailors manning the rigging doing their jobs, and no other ships we might crash in to.”  Odysseus made an irreversible decision. Cortez burned his ships.

If you want people to believe you about the unemployment trigger, you have to remove the discretion to change your mind tomorrow if, say, the dollar crashes, Spain defaults, long term interest rates spike, the Chinese dump their bonds or whatever.  Otherwise, we know it is all hot air. If they can decide in this meeting 6.5% is the right target, they can decide in the next meeting, “whoops, no, we’ll print money until China starts buying Chevys.” (Sorry, that will be mumbo jumbo about “illiquid conditions in sovereign credit markets and global imbalances..”)

I’m not such a fan of new-Keynesian models (here, with hard academic article warning) so this lack of real commitment doesn’t trouble me that much. I don’t think we would get immediate benefit even from a completely credible tied-to-the-mast commitment to buy trillions of dollars until unemployment hits 6.5%. (I do think rules-based policy in general is a good idea, not this sort of discretionary commitment-making. But  I can think of a lot better rules, like “the price level shall be CPI=130 forever, period.”)

But we certainly will test whether this kind of open-mouth operation has any effect. My forecast: continued sclerosis, and, whatever happens, no evidence that these policies had any effect whatsoever.

Which puts me rather less critical of the Fed than many skeptics. I think money and bonds are perfect substitutes at the moment, so “no effect” means no hyperinflation either. The problems are not monetary, so the Fed is just trying to seem important though it’s powerless. The major damage that I see in current policy is the implied shortening of the maturity structure of debt: If markets force interest rates to rise to 5%, the deficit doubles due to interest payments, and the US experiences a Greek death spiral. But nobody is even talking about that.

ECB dilemma

It was announced yesterday that  Europe will have a new, central bank supervisor run by the ECB, much as our Fed combines monetary policy and bank supervision. Be careful what you wish for, you just might get it.

One big unified central agency always sounds like a good idea until you think harder about it. This one faces an intractable dilemma.

Here’s the problem. Why not just let Greece default?“ is usually answered with "because then all the banks fail and Greece goes even further down the toilet.” (And Spain, and Italy).

So, what should a European Bank Regulator do? Well, it should protect the banking system from sovereign default. It should declare that  sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure  to get rid of this obviously “systemic” “correlated risk” to their balance sheets. (They can just require banks to buy CDS, they don’t have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.


Moreover, it should encourage a truly European market. Greek, Spanish, Italian banks failing is no problem if large international banks can swoop in, pick up the assets, and open the doors the next day. Bankruptcy is recapitalization.  Greece needs a national banking system as much as Chicago (same population) does.

All well and good. And all diametrically opposed to the ECB’s “crisis-fighting” agenda. The right arm of the ECB should be protecting the banking system in this way. But the left arm of the ECB is using banks as sponges for sovereign debt.

In trying to manage the sovereign debt crisis, the ECB has bought huge amounts of sovereign debt. It has lent  euros to banks that in turn have bought large amounts of sovereign debt (often, I gather, with not so subtle pressure from their governments).  It has lent more euros to the same banks to replace deposits that are quite wisely fleeing out of those banks.

How can the right arm protect the banking system from sovereign default, while the left arm wants to stuff the banking system with sovereign debt?

Converesely, how can the left arm do anything but print euros like mad, now that the right arm has responsibility for the banking system?  Lending to banks who buy sovereign debt was always excused by the idea that the bank shareholders bear the credit risk and national supervisors take care of that problem. Now it’s in the ECB’s lap. Politically, can the ECB really shut down national banks, stiff the creditors, and let them be taken over by big pan-european banks?

I bet on the outcome: print euros like mad, keep pretending sovereign debt is risk free, and prop up existing banks. Let’s hope I’m too cynical. For once.

Billing codes

A while ago, an acquaintance saw her dermatologist for an annual check. She said, “oh, by the way, take a look at the place on my foot where we removed a wart a while ago.” The doctor looked at her foot, said everything is fine, then finished the exam. Checking the bill, there was a $400 extra charge for the wart examination!

This nice audio story from NPRs “third coast festival"  tells the story of billing codes. Answer: As insurers and medicare/medicaid reduce payment for services, doctors respond by writing up every billing code they legally can. There are whole conferences devoted to billing code maximization. It’s a lovely unintended-consequences story. Good luck with that "cost control.”

The piece quotes the Institute of Medicine that there are 2.2 people doing billing for every doctor, at a $360 billion dollar cost. I couldn’t find the source of these numbers. If any of you can, post a comment.

Of course, being NPR, the program leaves the impression that all this will be fixed in our brave new world of the ACA. But it wasn’t even that heavy handed on the point. Perhaps experience is gaining on hope.

Buffett Math

Warren Buffett, New York Times on November 25th 2012:

Suppose that an investor you admire and trust comes to you with an investment idea. “This is a good one,” he says enthusiastically. “I’m in it, and I think you should be, too.”

Would your reply possibly be this? “Well, it all depends on what my tax rate will be on the gain you’re saying we’re going to make. If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1 percent.” Only in Grover Norquist’s imagination does such a response exist.

MBA final exam question: Explain the mistake in this paragraph.

How do we decide whether to invest in a project?  Discounted cash flow.

For example, suppose you’re thinking of building a factory (or starting a business). Once built, your best guess is that the factory will produce $10 profit every year. Discounting at a 5% required return, typical of stock market investments, the value of that profit stream is 1/.05=20 times the yearly profit, or $200. If the factory costs $150 to build, it’s a good deal and will return more than its costs. You build it. If the factory costs $250 to build, you walk away.

Did you forget to put in after-tax cash flows? Whoops, that’s a B- now at best. For example, if the tax rate is 50%, then your after-tax profits are only $5 each year. Now the value of the profit stream is only $100. The factory still costs $150 to build however, so now you’d be a fool to do it. It truly is better to leave your money in the bank earning a quarter of a percent.

Mr. Buffett made an elementary accounting mistake. How did he get it wrong? Implicitly, he is thinking that he pays $100, then gets back $100 for sure, and only the profit is taxed. He’s thinking that a 5% rate of return gets cut to 2.5%, which is still better than 0.025%. But when you build a factory or start a business, you are not guaranteed return of principal. You only get the profits, if any. If the government taxes half the profits, that’s like taking half the initial investment away.

This is perhaps an understandable mistake for a financial investor such as Mr. Buffett. In my example, the market value of the factory was $200, and falls to $100 when the tax is imposed. Mr. Buffett doesn’t build factories or start businesses, he buys them.  Now, Mr. Buffett – ever the “value” investor – can swoop in, buy the factory for $100, and a $5 per year after-tax cashflow generates the same 5% rate of return. But nobody will build new factories, and that’s the economic damage.

Ok, now you get an A. Let’s go for the A+.

Mr Buffett ignored risk. If somebody offers you a 5% rate of return, risk free, when Treasury bills offer you a quarter of 1 percent, his name is Madoff, not Buffett-Buddy.

Mr. Buffett wants you to think his investments are arbitrage opportunities, and a 2.5% arbitrage is as attractive as a 5% arbitrage. That’s false. Investments involve bearing risk, and taxes make those investments directly worse.

Now, the effect of taxes here is subtle. Yes, a 50% tax rate cuts a 5% expected return down to 2.5%. But it also cuts volatility too. Isn’t this just like deleveraging? Answer: no, because unless you’re investing in green energy boodoggles only available to Administration cronies, the government takes your profits, but does not reimburse your losses.

If the investment makes 10%, you get 5%. If it makes 5%, you get 2.5%. But if it loses 10%, you lose 10%. It’s a strictly worse investment when taxed. (Yes, you might be able to sell the losses if the IRS doesn’t notice what you’re up to… but now you know why Buffett is a “master of tax avoidance.”)

And there is always another margin: If rates of return on investment look lousy, just stop investing at all and go on a consumption binge. The estate tax is a big subsidy to the round-the-world cruise and private jet industries. 

I am really amazed by how this argument has evolved. Only a few months ago, supporters of the Administration’s plans for higher tax rates admitted the plain fact that higher tax rates on investment are bad for growth. But, they argued that higher taxes would be good for other goals, like “fairness,” redistribution, or winning elections important for other policies they like such as ACA. (These taxes are not going to put a dent in the deficit.)  And we had a sensible argument about how bad the growth effects would be, and how long it would take for them to kick in.

Now they’re trying to argue that taxes aren’t bad for the economy at all.  Some are suggesting higher investment tax rates are actually good for the economy.  All in the face of the natural experiment playing out in front of us across the Atlantic. The contortions needed to make this argument are just embarrassing. As above.

It seems clear to me that the Administration wants to raise the tax rate on high income people for political reasons, whether or not they raise tax revenues from such people; witness the deafening silence about reforming the chaotic tax code. The Buffetts of the world who can exploit the loopholes in the tax code and lobby for more will do fine in the new world. But they shouldn’t stoop to such obvious silliness to try to fool the rest of us that pain don’t hurt.

(Thanks to Cliff Asness who brought this to my attention and suggested some of the arguments.)

Truth stranger than fiction?

From the New York Times. I checked, it really is not from the Onion. 

WASHINGTON — House Republicans said on Thursday that Treasury Secretary Timothy F. Geithner presented the House speaker, John A. Boehner, a detailed proposal to avert the year-end fiscal crisis with $1.6 trillion in tax increases over 10 years, an immediate new round of stimulus spending, home mortgage refinancing and a permanent end to Congressional control over statutory borrowing limits.

…In exchange for locking in the $1.6 trillion in added revenues, President Obama embraced $400 billion in savings from Medicare and other entitlements, to be worked out next year, with no guarantees.

The upfront tax increases in the proposal go beyond what Senate Democrats were able to pass earlier this year. Tax rates would go up for higher-income earners, as in the Senate bill, but Mr. Obama wants their dividends to be taxed as ordinary income, something the Senate did not approve. He also wants the estate tax to be levied at 45 percent on inheritances over $3.5 million, a step several Democratic senators balked at. The Senate bill made no changes to the estate tax, which currently taxes inheritances over $5 million at 35 percent.

Meanwhile, Costco is in the news, for borrowing $3 billion dollars, and paying it out as a special dividend before dividend taxes rise.  Stock rose 6%. Tax arbitrage is so cool.

Experimental evidence on the effect of taxes

Much of our “fiscal cliff” debate revolves around the incentive effects of raising marginal taxes on high incomes. High tax advocates used to say that taxes won’t hurt growth that much, and advocated them for other reasons.  Now they are advocating that even a 91% federal income tax rate, on top of state, sales, etc, as we had in the 1950s, (not counting all the loopholes!) will actually be good for the economy and also raise lots of revenue.

This seems to me like magical thinking, and a great testament to how people can persuade themselves of anything if it suits the partisan passion of the moment.  But wouldn’t it be nice if someone would run an experiment for us?

Fortunately, Europe has been running a very useful set of experiments on what happens if you address yawning deficits with high income, wealth and property taxes. Which brings me to a report from the Telegraph

Almost two-thirds of the country’s million-pound earners disappeared from Britain after the introduction of the 50p (percent) top rate of tax, figures have disclosed.

In the 2009-10 tax year, more than 16,000 people declared an annual income of more than £1 million to HM Revenue and Customs.

This number fell to just 6,000 after Gordon Brown introduced the new 50p top rate of income tax shortly before the last general election….

It is believed that rich Britons moved abroad or took steps to avoid paying the new levy by reducing their taxable incomes.

George Osborne, the Chancellor, announced in the Budget earlier this year that the 50p top rate will be reduced to 45p from next April.

Since the announcement, the number of people declaring annual incomes of more than £1 million has risen to 10,000.

However, the number of million-pound earners is still far below the level recorded even at the height of the recession and financial crisis….

Far from raising funds, it actually cost the UK £7 billion in lost tax revenue

That’s just one year. Usually, we think that it takes a while for high taxes to have effects. It takes a while for people to move, shelter income, close down businesses, not start businesses, not go to school, etc. Hitting the Laffer limit in one year is pretty impressive.

Update: Thanks to JM Pinder below I went back to the HMRC report which is indeed more detailed. Some highlights:

The 50 per cent additional rate of income tax was introduced on 6 April 2010. It was the first increase in the highest rate of tax in the UK for over 30 years, and was expected to yield around £2.5 billion…

This report provides the first comprehensive ex-post assessment of the additional rate yield using a range of evidence including the 2010-11 Self Assessment returns. The analysis shows that there was a considerable behavioural response to the rate change, including a substantial amount of forestalling: around £16 billion to £18 billion of income is estimated to have been brought forward to 2009-10 to avoid the introduction of the additional rate of tax. …[This is a suggestion that it’s a one time loss. We’ll see]
…
The modelling suggests the underlying behavioural response was greater than estimated previously in Budget 2009 and in March Budget 2010, decreasing the pre-behavioural yield by at least 83 per cent. This result is also consistent with that contained in the Mirrlees review, and suggests the additional rate is a highly distortionary form of taxation.

Don’t miss the bigger point here. The US discussion harks back to the great old 1950s, ignoring the much more relevant evidence right before us from Europe: Want to try cutting deficits (very slightly) with high marginal taxes, especially on investment, along with minor “cuts” (declines in growth rates) of spending, but no substantial change in the welfare state? Hey, they just tried it! Their economies sink, and they don’t get much revenue.

Taxes and cliffs

(Update: John Batchelor show radio interview on this blog post)

The whole tax debate is supremely frustrating to anyone who survived econ 1.

The ill effects of taxation – the “distortions” – depend on the total, marginal rate including transfers. If I earn an extra dollar, how much more stuff do I get, or how much more of someone else’s services can I receive? That calculation has to include all taxes, federal, payroll, state, local, sales, excise, etc. and phaseouts.

And, if you receive a benefit from the government that phases out with income, so every dollar of income above (say) $30,000 reduces your benefit by 50 cents, then you face a 50 percent marginal tax rate even if you pay no “taxes” at all. Taxes and benefits – both in level and on the margin – need to be considered together.
 
I’ve been looking for good calculations of marginal rates.  The CBO has just issued a nice report titled “Effective Marginal Tax Rates for Low- and Moderate-Income Workers” that begins (begins!) to shed some light on the right question.  Here’s one important graph, titled “Marginal Tax Rates for a Hypothetical Single Parent with One Child, by Earnings, in 2012”;

The CBO’s headline (first page) says these low-income workers

face a marginal tax rate of 30 percent, on average, under the provisions of law in effect in 2012. … Over the next two years, CBO estimates, various provisions of current law will cause marginal tax rates among this population to rise, on average, to 32 percent in 2013 and to 35 percent in 2014.

30% and rising to 35% is already news. (A lot of the rise reflects means-tested insurance subsidies under the ACA). But digging a bit deeper I see a more chilling story in the CBO report

…CBO also finds that under provisions of law in effect between 2012 and 2014, marginal tax rates vary greatly across earnings ranges and among individuals within the same earnings range.

Consider again the graph on the top. The marginal tax rate is not an even 30%. There are slices of income where the marginal rate approaches 100%. And, the graph is really misleading because it doesn’t graph the “cliffs."  The figure caption says

The dotted lines indicate income limits for Medicaid and CHIP where taxpayers face “cliffs.” Similar spikes in marginal tax rates when the taxpayer loses eligibility for TANF and SNAP are not illustrated.

The CBO’s artists apprently did not want to graph the vertical spikes in an honest solid line. (The CBO’s "average” is, as far as I can tell, an average across taxpayers. No taxpayer reported income at exactly the cliff income, not one dollar more or less, otherwise the “average” would have been infinite. The CBO is not taking an “average” across income, which would include the cliffs.)

Another figure gets at the situation better, I think, though it takes more sophistication to digest

Now the “cliffs” show up. Overall, disposable income is very flat from $0 to $30,000 of income, and there are swaths where a discrete jump in income produces no increase in overall income.

Cliffs are particularly pernicious incentives. Even if people overlook marginal incentives for a while, “if you take this job you’ll lose your health insurance” really focuses the mind.
 
And, this is only the start. Single parents with one child who are going to work need childcare, transportation, clothes, and so on. The calculation leaves out sales taxes and a range of additional means-tested programs and social services.  It  only represents marginal tax rates by people who actually do work and file taxes. The jump from out of the labor force, illegal work, or disability to employment is higher. (Box 3 p. 17 cites a 36% marginal tax rate for the jump to employment and 47 percent from part time to full time.)

Even within the same income group, there is a  tremendous variation in marginal tax rates.

 The CBO’ introductory graph makes somewhat the same point. The huge spread in effective tax rates is as interesting as the average value

These estimates are also  understatements, as they only scratch the surface. The actual marginal tax + loss of benefit rates people face is very complex. A quick poll of faculty at the Booth lunch table showed the usual range of opinion but no serious calculations. Maybe it’s deliberately complex so people will not make the obvious responses to big marginal tax rates!

And, in the name of simplicity, the CBO left out dozens if not hundreds of additional means-tested programs. As the CBO says (p. v) “Including additional programs would generally increase estimates of marginal tax rates.” Yes, it would.

Why is there so much variation in tax rate across people of the same income? (p.v) The CBO here is looking at actual taxpayers, and

Survey data show that the majority of lower-income families do not receive means-tested transfers, either because they do not meet additional, nonfinancial eligibility requirements or because they are eligible but do not apply for benefits. Of those who receive transfers, the majority participate in only one program.  

This is both heartening and chilling. Written into law is a much larger welfare state than we actually have. Americans don’t fully play the game. Yet. Witness the recent ad campaign to get more people to use food stamps. Once more people take more full advantage of the programs available to them, first the budget explodes. And second, they start to feel larger and larger marginal tax rates against growing out of the programs.

All of this  is official confirmation of the point Casey Mulligan has been making in his new book: Our system imposes huge disincentives for low-income people to move up. 
Greg Mankiw (H/T this is where I learned about the report) suggests

What struck me is how close these marginal tax rates are to the marginal tax rates at the top of the income distribution.  This means that we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity. 

The spread in tax rates means Greg is much more right than he knows. A $20,000 “universal lump sum grant"  and 30% flat tax rate would indeed be a better system – not because it would approximate the current system more simply, as Greg implies, but  because it would dramatically lower marginal tax rates for so many low-income families.

The idea is worth pursuing. A "lump sum grant” means $20,000 voucher for food, housing, health insurance, and eliminating all the programs and their administering bureacracies. I didn’t know Greg was such a radical!  However,  $20,000 x 100 million households = $2 trillion, on top of the military and all other federal spending. It’s not clear a flat 30% even with no deductions at all is going to pay for it.

Perhaps we keep the $20,000 as provided benefits, as they now are, just lousy enough that rich people abandon them voluntarily as they bail out of public schools. That limits the budget impact a bit, though it will be pretty hard to explain to a $50,000 wage earner now paying next to nothing in Federal income taxes that they’ll be writing a check for $15,000 next year, but don’t feel bad because now they get to use food stamps and be on medicare.

We’re going decidedly and inevitably in the other direction, which is the CBO’s point in its gentle and understated  admonition that the “average” marginal rate is going to rise to 35%.

The response to our budget woes is more means-testing: Leaving deductions in place but capping them, adding to the phaseouts in the tax system,  more means-testing for Social Security, Medicare, and Medicaid, all of the low-income subsidies for the ACA which phase out with income of hours on the job.

It all sounds great if you don’t understand margins.  Why should the government help rich people? But every time we do cap something or means-test it, we introduce another marginal tax. And some of the biggest marginal taxes hit the poor.

This is a deeply important point so let me reiterate it. If you means-test any benefit, you introduce a steep marginal tax rate at means-testing point. If you don’t means-test a benefit, you blow out the budget. It’s a hard nut, that you can’t get around.

This is not a little problem. We worry about the distribution of income in the US, and how low-income people seem stuck. Well, faced with these barriers of course they’re stuck. And the barriers are going to get worse. 

What to do?  To some extent this is why economics is called the dismal science. Draw the line any way you want, subject to the budget constraint that all redistributed money has to come from somewhere. If you make it high at the left end it has to have a low slope. Compassion breeds “dependency,” a pejorative word for the simple fact that poor people are smart and respond to incentives.

But we can do a lot better!  At least we can measure and talk about total marginal tax rates including phaseouts and benefits – and the CBO study is only a beginning – rather than the silly Warren Buffet vs. his Secretary stories about average personal Federal income taxes in isolation.

And, we can avoid the big variation and the cliffs. We can avoid some people facing 100% or more margins and others facing no margin. We can  bring everyone closer to the “average” 30% rate.  The costs of a high rate are larger than the benefits of a low rate (and varying rates cause people to clump up on the high rates.)

Finally, perhaps more time limit as well as income limit will work as a sensible compromise. Unemployment benefits are limited in time, which is what has kept the US from developing the permanent underclass on the dole of some European countries.

Half-joke:  the Republican response to the Democrat’s desire to raise the high bracket of  Federal income taxes to 39.5%, and raise the taxes on dividends and capital gains should be: Fine. You can have the Warren buffet lower limit. In return, we get the Greg Mankiw upper limit: (named after Greg’s 90% marginal tax rate) If any taxpayer can show that his total marginal tax rate, including payroll, Federal, phaseout, state, local, excise, share of corporate, sales, property, and removal of benefits exceeds 75%, then his Federal income tax rate shall be reduced to that level. Well, maybe we should take this seriously on the low end of the income distribution.

Personal story: This is how I became an economist. Taking econ 1 as my humanities distribution requirement at MIT (pause for laugh), the professor showed the budget constraint for people on welfare, which at the time reduced benefits one for one with income, and kicked people out of public housing. For years I had felt at sea in the moral and cultural arguments about welfare dependency. In a flash, I saw it, there but for the grace of good fortune go I.

Next topic. In week 2 of econ 1 you learn that the distributional effects of taxation also are not read off the headline rates of the Federal income tax, but also depend on all taxation, all spending, and the burden of taxation through higher prices and wages, not who actually pays the taxes. That political argument is even sillier.

Update:

An excellent comment arrived by email:

Dear John… Regarding your post on marginal tax rates, the best paper I’ve seen on the subject is by Larry Kotlikoff and David Rapson, “Does it Pay, at the Margin, to Work and Save? Measuring Effective Marginal Taxes on Americans’ Labor and Saving.” This includes state programs (in Massachusetts, if I recall correctly), which add even more phaseouts. (Link to the NBER version). The chart on page 45 of the file is particularly striking. [reproduced below]

[Kotlikoff’s abstract is great: 

The paper offers four main takeaways. First, thanks to the incredible complexity of the U.S. fiscal system, it’s impossible for anyone to understand her incentive to work, save, or contribute to retirement accounts absent highly advanced computer technology and software. Second, the U.S. fiscal system provides most households with very strong reasons to limit their labor supply and saving. Third, the system offers very high-income young and middle aged households as well as most older households tremendous opportunities to arbitrage the tax system by contributing to retirement accounts. Fourth, the patterns by age and income of marginal net tax rates on earnings, marginal net tax rates on saving, and tax-arbitrage opportunities can be summarized with one word – bizarre.]

 This anecdote from Jeff Liebman also illustrates the issue in a way that Kotlikoff’s charts might not:

Despite the EITC and child credit, the poverty trap is still very much a reality in the U.S. A woman called me out of the blue last week and told me her self-sufficiency counselor had suggested she get in touch with me. She had moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more. I told her I didn’t know what I could do for her, but agreed to meet with her. She showed me all her pay stubs etc. She really did come out behind by several hundred dollars a month. She lost free health insurance and instead had to pay $230 a month for her employer-provided health insurance. Her rent associated with her section 8 voucher went up by 30% of the income gain (which is the rule). She lost the ($280 a month) subsidized child care voucher she had for after-school care for her child. She lost around $1600 a year of the EITC. She paid payroll tax on the additional income. Finally, the new job was in Boston, and she lived in a suburb. So now she has $300 a month of additional gas and parking charges. She asked me if she should go back to earning $25,000…..

[Thanks! I also am not a specialist in this literature and am glad for pointers to good work.] 

Update 2: Another graph, thanks to MG.

Source, a great presentation by Gary D. AlexanderSecretary of Public Welfare Commonwealth of Pennsylvania at the AEI

Happy Thanksgiving

By Eric Cochrane (who also drew the grumpy economist). More here

Health economics update

Russ Roberts did a podcast with me in his “EconTalk” series, on my “After the ACA” article. Russ also put together a really nice list of readings with the podcast, at the same link.

I also found this very informative editorial “What the world doesn’t know about health care in America” by Scott Atlas. It goes a good way to answering the persistent “What about how great health care is in Europe” comments. Some choice quotes:

Affirming 2005’s Chaoulli v. Quebec, in which [Canadian] Supreme Court justices famously concluded “access to a waiting list is not access to health care,” [my emphasis] countless studies document grave consequences from prolonged waits…

I love this little quote, because the deliberate confusion of “insurance” with “access” has long bugged me about the US debate.

Lots and lots of things are dysfunctional about US health care, but not the long waits that others endure

…“waiting lists are not a feature in the United States,” as stated in a 2007 study and separately underscored by the OECD .

They’re talking months here, not 6 hours in the ER.

Americans would be stunned to hear the reality of nationalized insurance:

• In its latest “care guarantee,” Sweden found it necessary to stipulate that patients must be able to see a doctor within seven days; patients should not wait more than 90 days to see a specialist; and treatment should be scheduled within 90 days…six months from presentation;…

• England’s 2010 “NHS Constitution” declared that no patient should wait beyond 18 weeks for treatment (after GP referral). Even given this long leash, the number of patients not being treated within that time soared by 43% to almost 30,000 in January.

How about all those wellness visits, the idea that under socialized medicine, people will get lots of cost-effective preventive care so they don’t  wind up at the ER with something expensive? It turns out that’s better in the US despite our chaotic system:

…treatment of diagnosed high blood pressure, the focus of preventing heart failure and stroke, was highest in the US (53%), lowest in England (25%), then Sweden and Germany (26%), Spain (27%), Italy (32%), and Canada (36%). In 2010, drug treatment was higher in the US than all European countries, including Austria, Denmark, France, Germany, Greece, Italy, Netherlands, Spain, Sweden, and Switzerland. In 2011, nearly 70% of Britons with known hypertension were left untreated.

And when you do get something serious?

Waits for diagnosis and treatment of heart disease, the leading cause of death in the US and Europe, plague nationalized health systems. OECD reported delays of several weeks to months for treatment in Australia, Canada, Finland, England, Norway, and Spain – not including waiting for specialist appointments. In 2008-2009, the average wait for CABG (coronary artery bypass) in the UK was 57 days. Swedes waited a median of 55 days, even though 75% were “imperative” or “urgent.” Canada’s heart surgery patients wait more than 10 weeks after seeing the doctor, and two months for CABG even after cardiologist appointments. 

The obvious point: Of course, under the ACA, many new patients and “cost control” price caps, we are surely heading in the same direction: rationing by wait time.

The less obvious point: Remember all the critics I cited in "After the ACA“ painting the picture that sick people need treatment now, and can’t possibly shop? That really is a misleading picture.

The bottom line

..gradually, Europeans are circumventing their systems. Half a million Swedes now use private insurance, up from 100,000 a decade ago. Almost two-thirds of Brits earning more than $78,700 have done the same. But what might really surprise those who assert the excellence of nationalized insurance systems is that throughout Europe, from Britain to Denmark to Sweden, when faced with their inability to deliver timely access, the government’s solution is increasingly to enable access to private health care.

I don’t know enough about European "private health insurance” to know how it works. Individual, private health insurance is so screwed up in this country that it’s not clear we will have this option.  And, the point of After the ACA, paying with your own money doesn’t do much good if there is not a competitive market supplying health services.

Debt Maturity

Another essay, a bit shorter this time, on maturity structure of  US debt. I was asked to give comments on a paper by Robin Greenwood, Sam Hanson, and Jeremy Stein ^*at a conference at the Treasury. It’s a really nice paper, and (unusually) I didn’t have much incisive to say about it, except to say it didn’t go far enough. And, I only had 10 minutes. So I gave a speech instead. (The pdf version on my webpage may be better reading, and will be updated if I ever do anything with this.) 

Having your cake and eating it too: The maturity structure of US debt
John H. Cochrane ¹
November 15 2012

Robin Greenwood, Sam Hanson, and Jeremy Stein ² nicely model two important considerations for the maturity structure of government debt: Long–term debt insulates government finances from interest-rate increases. Short-term debt is highly valued as a “liquid” asset, providing many “money-like” services, and potentially displacing run-prone financial intermediaries as suppliers of “liquidity.” Long-term debt also provides some liquidity and collateral services, (Krishnamurthy and Vissing-Jorgensen³ (2012)) but not as effectively as short-term debt. How do we think about this tradeoff?

Posing the question this way is already a pretty radical departure. The maturity structure of U.S. debt is traditionally perceived as a relatively technical job, to finance a given deficit stream at lowest long-run cost, as Colin Kim eloquently explained in the panel. Greenwood, Hanson and Stein, along with the other papers at this conference, are asking the Treasury’s Office of Debt Management to consider large economic issues far beyond this traditional question. For example, saying the Treasury should provide liquid debt because it helps the financial system and can substitute for banking regulation, whether or not that saves the Treasury money, asks the Treasury to think about its operations a lot more as the Fed does. Well, times have changed; the maturity structure of US debt does have important broader implications. And getting it right or wrong could make a huge difference in the difficult times ahead.

Go Long!

As I think about the choice between long and short term debt, I feel like screaming⁴ “Go Long. Now!” Bond markets are offering the US an incredible deal. The 30 year Treasury rate as I write is 2.77%. The government can lock in a nominal rate of 2.77% for the next 30 years, and even that can be paid back in inflated dollars! (Comments at the conference suggested that term structure models impute a negative risk premium to these low rates: They are below expected future short rates, so markets are paying us for the privilege of writing interest-rate insurance!)

Our Government has taken the opposite tack. When you include the Fed (The Fed has bought up most of the recent long-term Treasury issues, in a deliberate move to shorten the maturity structure) the US rolls over about half its debt every two years⁵.

Here’s the nightmare scenario: Suppose that four years from now, interest rates rise 5 percent, i.e. back to normal, and the US has $20 trillion outstanding. Interest costs alone will rise $1 trillion (5% of $20 trillion⁶ ) – doubling already unsustainable deficits! This is what happened to Italy, Spain, and Portugal. Don’t think it can’t happen to us. It’s even more likely, because fear of inflation – which did not hit them, since they are on the Euro – can hit us.

Moreover, the habit of rolling over debt every two years leaves us vulnerable to a rollover crisis. Each year our Treasury does not have to just borrow $1 trillion to fund that year’s deficits. It has to borrow about $4 trillion more to pay off maturing debt. If bond markets say no, we have a crisis on our hands.

Going long buys us insurance against all these events. And bond markets are begging us to do it! Most large companies are issuing as much long-term debt as they can.

I emphasize “insurance.” Long rates are low, and interest rate volatility is low. This isn’t about the forecast (you can’t buy insurance against something expected) and it’s not about volatility. It’s about a big left tail. What if the 4% growth underlying our already depressing deficit forecasts turns into another 4 years of sclerotic 1.5% growth, the CBOs static revenue forecasts from higher tax rates fail to materialize, inflation picks up, budget chaos raises the risk premium of US debt, and China⁷ stops buying?

The world has changed. In the past, the Treasury could adjust maturity structure thinking only about liquidity or term premiums. The fiscal risks were small, since the overall amount of debt was small. With debts above GDP, and 5 times Federal revenues, the old rules go out the window.

Fix the accounting

Why not go long? I suspect the Treasury is reluctant to go long because, under current accounting, moving $10 trillion of debt to long-term would add $277 billion to interest costs, which makes the current deficit look much worse.

But this accounting makes no economic sense. Yield to maturity is not the same thing as the annual cost of borrowing, which includes capital gains and losses. Confusing yield and one-year return is a classic fallacy. (It makes even less sense given that the Fed is buying all the long term debt, so that the maturity hasn’t really changed at all!)

If this consideration is holding the Treasury back, we should fix the accounting. Politically difficult you say. We’ll get accused of cooking the books, you say. OK, but is it really worth running the country into a fiscal crisis because we can’t fix the accounting? In simple ways that every business follows?

Simply marking to market capital gains and losses, and including that in the budget would be a good start. Then, we need to calculate and report expected capital gains and losses during the next year.

According to the expectations hypothesis, which holds well at well at the relevant multiple-year horizons, and perfectly if we are willing to footnote “expectation” with “risk-neutral,” the expected cost is independent of the maturity structure. An upward sloping yield curve means that the government expects to make capital gains on long-term bond issues that just offset their higher yields. I expect that the Treasury would use a more sophisticated term structure model, to isolate risk premia and liquidity premia as well as expectations effects. That would be all well and good, but the overwhelming effect would still be to remove the confusion of yield with return. You might see 20 or 30 basis point cost of going long, but not 2.77%.

Now, accounting is not miraculous. Interest costs don’t disappear. Higher long-term yields correspond to higher future interest rates, and thus higher interest costs in future years. But here, the calculation would correctly show that the US will pay these higher future expected interest costs independently of the maturity structure. Today’s 2.77% 30 year yield is not “paid” today, in any meaningful sense. It is paid when interest rates actually do rise. And rolled-over short term debt would pay the same costs, at the same time.

Go even longer, and more liquid

Why stop at 30 years? The Treasury should issue perpetuities – bonds with no principal repayment date. When the government wants to pay down the debt, it simply buys them back at market value.

Perpetuities pay a set coupon – say $1 – forever. Their price varies as interest rates rise and fall. It would be better for the Treasury to sell only one coupon amount – say $1 – rather than adjust the coupon amount so that the bond sells at par. After all, a $2 coupon is just two perpetuities, unlike the case of coupon bonds. (If it really matters to sell bonds at “par,” then the Treasury can simply bundle the perpertuities. At a 1% yield, one $1 perpetuity costs $100, so sells at par. If yields rise to 2%, so the price of a single perpetuity falls to $50, the Treasury can issue them in bundles of 2, at “par.” Or maybe people can figure this out on their own.)

Perpetuities do not age, so perpetuities issued at different times are identical securities. There will be no more on-the-run / off-the-run spreads, no more liquidity premiums, no more arbitrages between economically-equivalent bonds because one can’t be delivered when the other has been shorted. And there will be no need to roll over of maturing debt, ever.

This standardization would also sharply increase the liquidity of long-term debt. In turn, raising that liquidity should lower the overall rate the government pays. It’s a win-win all around.

(While we’re at it, the Treasury should also issue an inflation-protected perpetuity, with a fixed real coupon, and adjust that coupon downwards for deflation symmetrically with upwards adjustments for inflation. The coupon pays $1 2012 dollars, forever. That would be a better and more liquid version of its current TIPS. Finally, the Treasury should issue variable-coupon debt. The coupon on this debt would act like corporate dividends, and variable-coupon debt would function like an equity source of government financing. By cutting the dividend in bad times, the government could reduce its debts without the calamities of default or inflation. By raising the coupon in good times, the government would establish a reputation that makes the bonds saleable, and convince investors to hold on through coupon reductions. Coupon adjustments should be made by Congress, of course.)

Go modern

If we go long, what about the liquidity advantages of short-term debt? Just a little financial engineering could avoid the apparent tradeoff between long and short term debt, allow the Treasury to quickly go longer without having to dramatically reform the maturity structure of government securities, which will take far more time than we have, and it could help to get around faulty accounting.

In modern finance, exposure is no longer tied to investment amounts. With aggressive use of interest rate swaps, (and, potentially, futures, interest-rate options, or CPI swaps,) the Treasury could buy the interest rate protection the government urgently needs, supply as much short-term debt as liquidity demands, and satisfy the political demands of budget accounting. There need be no tradeoff at all. We can have our cake and eat it too.

For example, suppose the Treasury issues only one-month debt, but then swaps it all to fixed rate. The Treasury agrees to pay to swap counterparties the fixed (2.77%) rate and receive the floating one-year rate. Now, it has issued $16 trillion of one-month debt, surely satisfying any liquidity demand to the utmost. But the Treasury is fully protected against interest rate rises just as if it had issued the entire amount in 30 year bonds. The investment amount is one month, the risk exposure is 30 years. Every bank routinely uses swaps to adjust its interest-rate exposure without touching its low-cost source of funds (sticky liabilities) or its profitable but illiquid assets (loans). The Treasury should do the same!

(I don’t know enough about deficit accounting to know where swap payments go, but I’ll leave it as an article of faith that the sharpies at Goldman Sachs who made Greek debt disappear in 2006 can get around that one too.

Yes, we need to make sure that swap counterparties are not too-big-to-fail banks, of course! But swap contracts are collateralized, so counterparty credit risk is not really that big an issue. The lower posts enough collateral that the winner can replace the contract in the event the loser defaults And if Dodd-Frank is good for anything, it ought to be good for keeping plain-vanilla interest rate risk off the balance sheets of “systemically important” banks.

Finally, I say “Treasury,” but what matters of course is the consolidated government. If it makes more sense for the Treasury to issue and pass on government interest-rate risk management to the Fed, so be it. The Fed can more explicitly be the Treasury’s asset management service.)

The bigger point: The Treasury should enlarge its “maturity” selection beyond the 18th century choice of maturity among coupon bonds, to include at least 20th century plain-vanilla modern fixed income instruments.

Go long, again

I don’t know if I’ve pounded my fists on the table enough. Historically normal interest rate rises will send the US into a fiscal tailspin, with interest costs doubling our deficit, and thus forcing a true fiscal crisis. The markets are offering to take this risk from us for next to nothing. For a while.

I don’t exaggerate much when I say, the fate of the Republic is in your hands!

Go Short

On the other side, Greenwood, Hanson, and Stein remind us of the liquidity value of short-term US Treasury debt. For example, it is the most widely accepted form of collateral, even in crises. Owning a one-month Treasury always allows you to borrow. Many accounting rules treat short-term Treasury debt as equal to cash. More of that too seems a good idea. Again, though, we can do better, and we can avoid the tradeoff.

Why stop at traditional Treasury bills? These have awkward properties: They are only issued in large denominations, and they are rolled over frequently. The Treasury should go beyond bills, and issue floating-rate debt, held in electronic book-entry form. Either the Treasury can directly allow small denomination, or it can encourage money-market funds to intermediate for retail clients.

The most “liquid” floating-rate debt has a constant principal value of $1.00, always. It’s like a money-market fund, where each share is always worth $1, and interest is paid on top of that. That can be achieved by a daily auction, as overnight repo rates were set in a market each day. However, a daily auction is not necessary, if the Treasury simply guarantees the value at 1.00 like a money market fund. Then the rate can then be indexed or simply adjusted at a periodic auction to adjust the quantity outstanding. (The Treasury maintains an account at the Fed, and uses that buffer to freely trade bonds for reserves at 1.00 between interest-rate reset periods.)

Yes, this is interest-paying money, issued by the Treasury. Every collateral, liquidity, or money-like feature of one-month Treasury debt I can think of works better with such fixed-value floating rate debt. Why bother “money-like” monthly Treasuries, when we can have money itself, without suffering any interest cost?

Overnight, floating-rate, electronic-entry Federal debt already exists. It’s called bank reserves. However, bank reserves are only available to banks, so have to be intermediated again to be available to the rest of the financial system. Also the Fed’s current “exit strategy” involves reestablishing a spread between reserves and market rates, which means reducing the quantity of reserves and sending the financial system off to other sources of “liquidity.”

Fixed-value, floating-rate, Treasury debt – interest on reserves for everyone – allows us to live the “optimum quantity of money” described by Milton Friedman. With an interest cost, people unnecessarily economize on money balances by spending more time and effort economizing on money balances. Without an interest cost, they voluntarily hold huge money balances and save all that time, effort, and cash-conserving financial engineering.

The advantages for our modern financial system are much deeper. With abundant floating-rate, fixed-value government debt, there is simply no need for all the complicated and run-prone “liquidity creation” that engulfed the financial system. Special purpose vehicles holding mortgage tranches funded by short-term debt, overnight repo, money market funds holding Lehman Brothers debt and promising fixed value, even bank deposits funding mortgages all become unnecessary for the purpose of creating liquid assets. Rather than allow all this intermediation and then hope that regulation can stop the next run, why not fully satisfy the demand for such assets directly? Then we need not fear requiring that anyone who wants to hold risky or illiquid liabilities match those liabilities with similar assets, eliminating runs and the need for extensive risk regulation. Greenwood, Hanson and Stein call it “crowding out,” and a partial substitute for regulation. Yes, but let’s crowd out entirely and substitute for a lot more regulation!

No theory of inflation says there is any problem with the creation of such “money-like” assets, any more than the liquidity value of one-month bonds causes a problem for price-level control. Keynesian and new-Keynesian models say that the level of interest rates, which the Fed still controls by announcing the rate on reserves and discount window lending, controls inflation. An artificial interest spread between classes of Fed liabilities doesn’t matter. The Fiscal theory of the price level says that fiscal solvency gives price level control, not a scarcity of “liquid” vs. “illiquid” government debt. Monetarists thinks of reserves that pay full interest as bonds, not money, so arbitrary amounts are not inflationary. Milton Friedman himself called for interest on reserves.

Bottom line

As a policy priority, buying insurance against interest rate spikes at our current extremely low interest rates is the first priority. This has to be accomplished before long-term interest rates rise. The left-tail danger of a run on US Treasury debt, and an interest-cost death spiral, is real.

Providing abundant liquidity with floating-rate debt, which will discourage the reconstruction of a run-prone shadow banking system, is only a slightly longer term priority. An ideal maturity structure of government debt is perpetual. Long-term debt has a fixed $1 coupon, and a floating price. Short-term debt has a fixed $1 price debt and a floating coupon. Then there is never rollover risk, or rollover transactions cost. Making all Treasury debt even more liquid, by standardizing the long issues and allowing low-cost electronic transactions of the short issues, greases the financial system and lowers the rates the Treasury will pay.

By opening up to swap and other derivative transactions, the Treasury can dissociate the amount of interest-rate insurance it purchases or sells on behalf of taxpayers from the task of supplying the amount of these fundamental securities that private-sector “liquidity” demands require, and that provide the least-cost source of funding.

Obviously, these moves need to be coordinated with the Fed. There is no point in lengthening if the Fed just twists it away. I notice a tendency of the two institutions to follow parochial concerns and to forget that there is a single budget constraint uniting them!

Enjoy your cake.

Footnotes

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1 Professor of Finance, University of Chicago Booth School of Business, Research Associate, NBER, Senior Fellow, Hoover Institution, and Adjunct Scholar, Cato institution. John.cochrane@chicagobooth.edu, http://faculty.chicagobooth.edu/john.cochrane. These are comments prepared for the Second Annual Roundtable on Treasury Markets and Debt Management, Department of the Treasury, November 15, 2012. ^↩
2 Robin Greenwood, Samuel Hanson, and Jeremy Stein, 2012, “A Comparative-Advantage Approach to Government Debt Maturity” Manuscript, Harvard University. ^↩
3 Krishnamurthy, Arvind and Annette Vissing-Jorgensen, 2012, “The Aggregate Demand for Treasury Debt. Journal of Political Economy. (Aril 2012) ^↩
4 Actually, I’ve been screaming “go long” for a while now. In particular, see “Inflation and Debt,” National Affairs 9 (Fall 2011), and “Understanding fiscal and monetary policy in the great recession: Some unpleasant fiscal arithmetic,” European Economic Review 55 (2011), 2-30. ^↩
5 I got this from Hamilton, James D. and Cynthia Wu, 2011, “The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment,” Manuscript, UCSD and University of Chicago. They put all debt on a zero coupon equivalent basis. Beware the average maturity numbers, as this ignores coupons and weights long maturities too heavily. What we want of course is the duration of US debt – change in market value in response to interest rate changes – which I don’t have handy. ^↩
6 I use the total debt, including that held by government agencies, as these are the claims on the Federal income tax. Using debt held by the public does not generate a much prettier picture. ^↩
7 Daniel Beltran’s paper presented at the conference, said China alone is worth 2%! (Beltran, Daniel, Maxwell Kretchmer, Jaime Marquez, Charles P. Thomas (2012) “Foreign Holdings of U.S. Treasuries and U.S. Treasury Yields” Federal Reserve Board. ^↩