Republican Tax Reform: Part 8–Average vs. Marginal Rates

This is the old conflict in decision-making: accounting is mostly backwards-looking, while economics and finance are mostly forward-looking. How much money did we make versus how much money will we make? Of course, the data we gather about the former is much more accurate than the forecasts we make about the latter.

So, accountants are pretty good at providing average values (from decisions made in the past), and the economic evidence is that people base decisions that they are making right now on marginal values.

It would be nice if we could measure those marginal values used to make decisions in the past, but typically our data isn’t measured that way. We can tease them out with econometrics, but it isn’t that easy (since expectations are ephemeral, yet they may critically affect marginal values).

In the case of taxes, what the government is setting is tax rates that are marginal. Then people make decisions about what to do (which we can observe) and what not to do (which we can’t observe) based on those. Lastly the accountants count up just the former, and provide averages for just that part of the whole picture.

N.B. This is not a knock on accountants or accounting, just one more statement of why social sciences are harder than natural sciences—our elements decide not to do stuff sometimes and theirs’ don’t.

What we need to pay attention to from a macroeconomic policy perspective is the marginal tax rates. This Republican reform reduced them a lot on corporations, and a little bit on individuals. You could also argue that some of the changes (like child care tax credits) changed marginal rates for some as well. So we should expect big changes in how firms behave, and not so big changes in how individuals behave.

But what we will get data on out in the future is average tax rates.

In an earlier post, I used the example of the marginal rate being 10% on your first thousand, and 20% on everything above that. Those are the two marginal rates.

Now, if you have $200 you pay $20, or $800 you pay $80, and the average tax rate is 10%. It’s the same as the marginal rate because those numbers all fall within one bracket.

But if you have income from both brackets, the average rate will fall between the two brackets.† So, if you have $1,100, you pay 10% on the first thousand, 20% for the remaining $100, for a total of $120. Divide that by $1,100 and you get an average rate of 10.91%.

A further complexity is added as income continues to rise: the average tax rate will go up and approach the higher marginal rate in the limit. So, if you have $2,000 you’d pay $300 in taxes (for a 15% rate), and if you have $10,000 you’d pay $1,900 for a 19% average rate.

FWIW: There’s really nothing new in that arithmetic. The average tax rate is a weighted average of marginal tax rates, and this is what weighted averages do as the weights change.

The result is things like Table 1 in the Summary of the Latest Federal Income Tax Data, 2016 Update from The Tax Foundation (yes, you need to click through and look at it). It shows that the top earners average rate was 27%, even though this page from yesterday’s post shows the top marginal rate for that year was 39.6%.

And yes, you do see demagogues noting that such and such a rich person only paid some percentage of their income in taxes even though they’re rich and should qualify for a higher rate. In the future, your response should be something like “Duh … do the math”. Arithmetically, it has to work this way, and we should know better than to complain about it.

Unfortunately, a lot of people want to use the tax system to punish people or behaviors they don’t like (this is called a Pigou tax after the economist that first described it). There’s nothing wrong with that. And the typical response is to raise what we can (those marginal tax rates) to get the average rate to go up.

The message here is that you have to raise those marginal rates quite a lot to get much movement out of the average rate. And the marginal rates are the ones that affect decisions. So what you’re really saying is let’s go straight after the decisions people make to move the needle on this indirectly connected gauge called an average rate.That’s a recipe for really clumsy and ham-handed government policy. <in a sarcastic voice> “Gee … that doesn’t ever happen, does it?”

And, the message is that if you really want to discourage some behavior, the brackets are not that critical, but cranking up the marginal rates very quickly is. Yet, it seems like this is also something that policymakers are disinclined to do. The evidence is the proliferation of rates, exemptions, and deductions at the low end of the tax code to get some people out of paying the tax.‡

† With more than two brackets, it will fall between the bottom one and the top one. But since exemptions and deductions create a 0% bracket, the average rate will just be less than the top marginal rate paid by that person.

‡ An interesting phenomenon in development economics is that poor countries often have ridiculously punishing marginal tax rates. The reason is that they design their rates and brackets to mimic some richer developed country’s, but they scale down the borderlines of those brackets to fit into the amounts of money the locals actually have. So you end up with us defining the rich who are deserving of high marginal rates at something like $200,000, and them setting their threshold at $2,000. Maybe that much does make you rich in a poor country, but what you’re really doing is excessively taxing a local, and undertaxing a potential foreign investor. I first saw this in Klitgaard’s book Tropical Gangsters over 30 years ago, so it’s not a new idea.

Republican Tax Reform: Part 7 - Brackets, Exemptions, Deductions, and Flat Taxes

Some of you are not accounting majors, or have yet to do a serious personal income tax return on your own. This is a primer on how tax rates work in practice.

In principal, taxes should be easy. You establish a tax rate. Say, 20%. You figure out a tax base, like $300 you have laying around, and you pay $60 of tax.

A tax like that is called flat: one rate applies to the entire base.

Keep in mind what you know from micro: even a flat tax creates distortions.

Except that there’s pretty much no tax that’s flat. If 2 or more rates apply, it’s not flat. And the number of separate distortions, if there are x different rates, is no smaller than 2x-1. This is because there’s a deadweight loss that’s different for each rate, plus behavioral responses that can get a little weird around each borderline. Legislators appear to have little clue about this as they install new gimmicks into the tax code.

With brackets, your tax base is divided up. At it’s simplest this is something like your first thousand, and then everything beyond that. For example, we might have two rates: 10% on the first thousand, and 20% on everything after that. In this case, you’d pay $60 on $600, but $220 on $1,600 ($100 on the first thousand, and 20% of the $600 after that).

Sounds simple, right? Except in the U.S. we have 7 brackets. Personally, my family has to pay in four of them. Here’s a history of the recent brackets. The Republican tax reform lowered rates in 5 of the 7 brackets. The 1986 reform, the gold standard for actually reforming, reduced the code from 15 to (eventually) 3 brackets. Then they started adding them back.

Except technically there’s an eighth bracket. An exemption is a certain amount you can claim for each person in your household. No tax is owed on this. (At low incomes, there’s also the earned income tax credit that creates a 9th bracket).

Then there are deductions. Exemptions are per person, while deductions are per household. Deductions don’t really create a new bracket, but they are distortionary (e.g., the mortgage interest deduction makes it easier for people to buy bigger houses than they might otherwise).

The real problem with all of this is that if the designers of the law can’t or won’t do the math, they could end up with some pretty dumb marginal tax rates (the marginal one is the one you have with your base right now, and that would apply if you changed your behavior). University of Chicago economist Casey Mulligan argued that the well-intentioned HAMP program (intended to keep people struggling with their mortgages both paying and in their homes) amounted to a marginal tax rate of 390% on someone exploring the alternative of getting a second job. That’s taking four times all the extra money you earned. Mulligan is well-known for opposing Obamacare because it amounted to an increase in marginal tax rates on the poor.

Nancy Folbre, an economist from the opposite end of the political spectrum from Mulligan noted that:

… Estimates from the Congressional Budget Office conclude that more than 20 percent of low- and moderate-income taxpayers face marginal tax rates of 40 percent or more …

That’s a rate only the rich people are supposed to pay in our country. She further noted that the overlay of federal with state systems can lead to situations where the poor face a less than 100% marginal rate in one state, and a rate over 100% in another.

Unfortunately, flat (income) tax rates have gotten a bad rap in the U.S., mostly because they were associated with unsuccessful Republican presidential candidates of a generation ago. The thing is, almost every tax we have, including FICA, most sales taxes, and corporate income tax are … already pretty flat.

The motivation for a non-flat income tax is a desire for progressivity: the rich should pay more and the poor should pay less. Fair enough, but a flat tax does that too. What we really mean is that the rich should pay a bigger percentage of their income. Again, fair enough, but you can get that with a flat rate and an exemption/deduction. For example, the bottom half of taxpayers only pay 3% of the total amount, and we could shift that down to 0% with a standard deduction of about $35K (which is not too far off where the Republicans just went with their increase to $24K). You could then match what we currently bring in with a single rate in the 30% range. Politically, what happens though, is that this is seen as too high on the lower part of the upper class, and then a special lower bracket is introduced for incomes that are not too high, but this loses revenue overall, so they need to raise the rate on the rich, and so on …

Brand New Top Level Research on Incidence of Corporate Tax Rate Cuts

This comes out in the February issue of the journal American Economic Review. AER is the top journal in our field. The February issue isn’t even out in print yet; if you’re a subscriber you get early access over the internet, so I got this in my email.

The article is entitled “Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany”, and it’s by Clemens Fuest, Andreas Peichl and Sebastian Siegloch. The final version is locked behind a paywall, but here’s a link to a recent pre-publication working paper. I am not recommending that you read it, but you might browse it a bit to see what top level work looks like.

Anyway, they use German data for a few reasons.

• It provides a lot of variety: corporate tax rates are set locally rather than nationally in Germany
• This also makes it a large sample: 45K observations, since each municipality is different from the next one.
• It also allows for a relatively pure test of policy changes that affect tax rates rather than the tax base. This is because the tax base (deciding which institutions have to pay, and which number gets taxed) is determined at the national level, but each municipality can decide whether they want to tax their corporations relatively more or less.

They conclude that a corporate tax (labeled as falling on corporations) is 51% incident on labor. The estimate is not very precise: the 95% confidence interval is 17 - 83%. These results are in column (1) of Table 1 on page 16.

This assertion I made in this blog (a few posts back) and in class the other day — that an incidence on labor of 2/3 is a good starting point — easily falls in their range.

So this confirms that the Republicans are right: their corporate tax rate cut will benefit workers.†

Reasonable people can quibble about where the truth lies in that range. But what one should not do is presume that the incidence is, say, 30%, because you prefer workers to owners. Instead, you need to be thinking, this could help workers a little (30%) or a lot (70%), but it’s definitely going to help workers.

Given where this was published, this is the new gold standard for evaluating corporate tax rate changes.

† In class, Jason used the phrase “trickle-down” to describe this process. Economists do not like that phrase: it has no firm definition. Republicans don’t like it either: it was invented by Democrats as a pejorative for policies in the 1980’s. Given the intention, it’s reasonable for them to view it as impolite at best (no knock on Jason, I’m just explaining). Anyway, the point of the lecture the other day is that it really isn’t something that trickles down, since that metaphor suggests that much of it is, or could be, prevented from trickling down in the first place. I think the metaphor of “baked in” that I used in class is better: labor and capital go into the firm, but once in there … their effects can’t be separated out again. We can only estimate what the split would be.

Republican Tax Reform: Part 6 —Keynesian Thinking (About the Demand Side) and Distortions (Mostly About the Supply Side)

To many Republicans, and to some voters in Utah, “Keynesian” is like a swear word. They associate it with big government, generous welfare policies, and so on.

Here’s the thing: Keynes’ ideas about macroeconomics underpin a lot of Republican policy ideas. They just won’t admit it.

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Any time we talk about taxes and macroeconomics, we have to think about two different dimensions of the issue: tax revenue and tax rates.

Governments plan for tax revenue, but they can’t control it very well. Why not? Mostly because the economy is hit by many shocks, and tax rate changes are just one of them. You might have a good forecast of what your tax rate change is going to do, but the other things going on might swamp that.

Governments control tax rates, but it’s often hard to connect those to how the economy behaves because they affect it through both tax revenue and tax distortions.

It’s hard to connect tax revenue to how the economy behaves too, but at least you can use your estimate of it to plan your spending budget as well.

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The public doesn’t always make that distinction very well. Republicans are expected to be more likely to “cut taxes”. But what exactly does that mean? (And there’s no reason you can’t insert some other political party, like Democrats wherever I write Republican).

What a Republican politician can do is cut tax rates. They could also eliminate a certain tax, but if you think about it, that’s just cutting the tax rate to zero percent. So any difference is one of scale.

Another thing a Republican can do is narrow the tax base. The tax base is the group of people or firms, or the portions of their income or wealth, that are subject to a tax. There’s really no difference between this and cutting tax rates either: there’s no difference between paying a 20% tax on 10% of your income and paying a 10% tax on 20% of your income.

It’s a little off-topic, but I’ve talked about how the reform of 1986 was a big one. A major thing that they did was eliminate loopholes and other forms of tax favoritism across a broad range of taxes. This allowed them to lower rates generally because they’d made the base so much broader.

Anyway, what voters want mostly is their tax bill to be cut. So this can be done by cutting rates, broadening the base (so everyone pays less), or exempting some income (creating a loophole). But however the Republicans choose to do this, what they’re hoping is that the forecasts they make of how much people will pay will go down.

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Keynes’ theory focused on spending. More spending and the economy boomed, less spending and it faltered.

Keynes worried about what we might today call consumer confidence or consumer sentiment, but which he called animal spirits, and which some books call herd behavior. Basically it means that a society as a whole can go through extended waves of optimism and pessimism. In the former, we spend more because some of it is on stupid stuff because we’re having such a good time of it. In the latter we spend less, and we may not spend enough on useful stuff because we feel lousy about the whole world. This is where he thought business cycles came from.

Macroeconomists have backed off both of those Keynesian stories. Some have eliminated them completely, but for most of us we think they’re still in the mix, although maybe not the biggest part. But politicians have not backed off those views much at all, so the Keynesian view is a great way to understand what politicians do, even if it leaves some parts of the macroeconomy unaddressed.

Keynes also asserted that government should pursue countercyclical policies. This means that when the public is optimistic and spending too much, the government should back off a little bit. And when the public is pessimistic, the government should step up its efforts.

For Keynes and Keynesians, changes in government spending were seen as more effective than changes in tax revenue. For example, if they needed to boost the economy the government could spend more and be certain that it happened. But if they tried to do the same by cutting tax revenue, people might just put it in the bank and spending wouldn’t change.

In the U.S., the Democrats were the majority party when Keynes’ theory was ascendant. So they adopted government spending as their primary tool, and tax changes as a secondary one. The Republicans reversed that: they claimed taxes as their baby, and spending as the afterthought.

Remember up above when I said that Republicans today view Keynesian as a sort of swear word? That’s dumb, because their position that they can manage the economy primarily through tax changes is Keynesian through and through. But … whatever … they’re just words and people will use them any way they like.

And when the Republican constituents clamor for a tax cut, what the Republicans attempt to give them is a cut in tax revenue, but they do this through cuts in tax rates.

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This brings us to distortions. A problem running behind all of this is that all taxes imposed as rates (instead of flat fees) are distortionary. This means they induce some people to do something they ordinarily would not.

All that stuff in your micro class about deadweight loss is about distortions. Without a tax, the market mechanism impersonally divides up potential buyers into two groups: those that choose to buy and those that don’t. It does the same to suppliers. What happens with a tax, and is behind the deadweight loss, is that the division is now into 3 groups: those that still buy, those that still won’t buy, and those that switched from buying to not buying because of the tax (3 groups for sellers too).

When we talk about the tax code getting more complex, what we’re really talking about is the number and scope of distortions increasing, creating additional problems when they overlap or interact with each other.

The Laffer Curve is an example of a really bad distortion. This is the idea that if a tax rate is high enough, it may distort behavior so badly that cutting it may actually raise revenue. Unfortunately for Republicans, there’s a much deeper belief in how common this effect is than is borne out by the data. Most of the time, you can safely dismiss this possibility as just a theoretical curiosity.

Generally, we tend to think of distortions as mainly a supply side problem. This is because, for all we complain about our personal income taxes, they are nothing compared to the hoops that we make businesses jump through.

So, when we talk about a supply side approach to tax reform (which the Reagan administration was known for, and whose crowning tax achievement was the reform of 1986) we mean a general reduction in the number of different rates, brackets, and exemptions, and a broadening of the tax base.

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Putting it all together, this tax reform is mostly a Keynesian demand side reform. It’s done some things to cut rates that are likely to lead to cuts in revenue, and more ultimately more private spending.

It’s widely perceived that this Republican tax reform, on net, did nothing to improve the supply side and may have made it a little worse. Everything that’s in it comes with a distortionary backside: cut the corporate tax rate but distort that with a one time repatriation tax, increase the standard deduction but add a distortion by creating brackets for SALT deductions, cut the Obamacare penalty (less distortionary by itself) because the conservative base wanted that along with an increase in childcare credits (more distortionary).

More Economists than Chefs

Bad news.

Washington D.C. is the only one of the 10 largest metropolitan areas in the U.S. with more economists than chefs.

It is also one of two with more economists than people who call the clergy their full-time job.

This looks really bad for us …

I think this may reflect that there is no serious professional threshold to calling yourself an economist. You don’t have to pass a test, like a CPA does.

Also, D.C. is full of people with master's degrees in economics from Maryland and other nearby schools. For better or worse, economics is one of the fields where an MA is closer to a BA than an MA is to a Ph.D. In my case, the single (true) MA class I took in economics was filled with bureaucrats trying to raise their pay grade. The material was drivel.

A good economics student needs to have a filter: when you here someone quoted who claims to be an economist, get on the internet and briefly check them out.

The Republican Tax Reform: Part 5–Tax Incidence vs. Tax Labeling

Microeconomics is one of the most common courses taken on college campuses around the world. It has been for decades.

One of the main topics towards the middle of that is that who a tax is incident upon (who actually pays it) has a lot more to do with the elasticity’s of demand and supply than who is labeled as being taxed.

Unfortunately, in politics, this insight is only used selectively.

Most people have no trouble recognizing that smokers are going to bear some of the burden of a tax on cigarette manufacturers. Politicians like it when that connection is recognized.

But when it comes to last year’s debates about the corporate income tax,† the incidence has been conveniently forgotten. Obviously, a lot of that has to do with grandstanding.

Even so, economists have even caved in the face of this moral hazard. There’s been a lot of calling out of Democratic-oriented economists over the past few months for finding reasons to object to the Republican plan (more on that in later posts).

Here’s a simple way to think about it. I’m envisioning this like a hull hypothesis in statistics: it’s not necessarily the truth, but it’s a good starting point for pinning down what the truth might be.

I start with the observation that national income and product accounts for all developed nations shows that compensation for peoples’ time is roughly 2/3 of GDP. Everywhere. All the time.

Now think of the revenue of the corporation, and note that it must equal costs plus profits. Since GDP is comprehensive, two thirds of that revenue is attributable to labor, as is 2/3 of costs, and 2/3 of profits. There might be small variations in that, but the bottom line (no pun intended) is it simply isn’t possible to attribute labor to one without attributing to the other too. The world just doesn’t split along lines that fine.

This means that if we cut a tax rate targeted at corporate profits, about 2/3 of the benefits of that are going to work back to the labor that helped produce the profit.

Reasonable people might quibble about how much that gets bumped up or down by the particulars of any particular tax bill, but the starting point for discussion by anyone should be that the corporate income tax is primarily incident on labor. It’s a sad testament that this should be a no-brainer.

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So, I think the Democrats have a problem on this one. I don’t think I’m alone in the perception that many Democratically-oriented people would assert that the incidence of the corporate income tax on labor is zero. That’s possible, but exceptionally unlikely, to the point of being inconceivable once you start to think about how production works and is measured in GDP.

I also think a lot of Democrats would assert that Republicans are in favor of the reducing the corporate income tax because 100% of the benefits will go to the owners who are more likely to vote Republican. I may have missed it, but I don’t recall any Republican ever making a claim that bald. If anything, they seem to be saying fairly consistently that a big chunk of the benefits of a  corporate income tax cut will go to workers. For that, they get pilloried as favoring “trickle down”. For my part, 2/3 doesn’t sound like anything that trickles; it sounds more like those big buckets at water parks that dump all the water at once on the squealing kiddies beneath.

I think ya’ score one for the Republicans on this one. Of course, that goes some way towards explaining why the Democrats of a few years back were in favor of cutting the corporate income tax when it seemed more likely that they’d be the ones getting credit for it.

† The income that is taxed in by a corporate income tax is the net income on the income statement, commonly thought of as profits.

The Republican Tax Reform: Part 4–Grandstanding

The Republicans passed a tax reform bill.

The Democrats hate it. Sort of.

Grandstanding is the name given to the political process of opposing something just because the other party is in favor of it.

I think it’s fair to say we’re seeing more grandstanding this year than in others. I also think it’s fair to say most of it is coming from Democrats this time around. Interestingly, there have also been intimations that some Democratic politicians would actually like the media and interest groups to back down on this a bit. Whatever.

I think different parts of the bill face different degrees of grandstanding.

The corporate tax rate reduction is getting the most grandstanding. This is move that the Obama White House wanted, and that both Obama and Romney campaigned in favor of in 2012. Reasonable should be able to disagree about the size of the reduction. Having said that, economists generally argue for a cut here that’s bigger than what the Republicans actually did. This has been a subject of some contention for the last 3 months, as many Democratically-oriented economists have publicly changed their tune, so there’s been a lot of WTF emails circulating amongst macroeconomists.

I do not think the Democrats are grandstanding about the removal of the Obamacare tax. This is a serious policy difference. On the other hand, the tax was a clumsy approach to partially addressing a still outstanding problem (that most people in the public have fooled themselves into thinking they pay for more than they get out of government healthcare programs — they don’t). The Republicans tried to come up with some alternatives for this, and they failed. Cutting this tax was a backhanded way to get part way there. I’m not saying that I disagree with the Republicans on that, but I think the Democrats are correct to point out that it’s dysfunctional.

On the increase in the standard deduction for personal income taxes, I think the grandstanding takes the form of silence. This is not something the Democrats have a principled opposition to, but very few of them are saying there are parts of the new law they actually like.

On the limits placed on deducting SALT from personal income taxes, I’m not sure the Democrats are grandstanding at all. Economically, the SALT deduction amounts to putting state and local government services on sale. It’s a distortion that leads to more expensive government, so it’s not really something anyone should support as a general proposition. But lots of people do support it because it benefits them personally, and no doubt they often ignore who’s paying the difference. And most of those supporters are in Democratically-oriented blue states. I view grandstanding as something that wouldn’t happen in other situations, and I would not call Democratic opposition to this grandstanding — instead I think the Republicans are picking on them, but the Republicans probably have the moral high ground on this issue.

The Republican Tax Reform: Part 3–How Major a Reform Is This, Actually?

In the big scheme of things, this is not a major reform.

Republicans should tone down their crowing about this.

Democrats should stop treating it like it’s the end of the world.

The biggest part of this reform is the reduction in the corporate tax rate. This was so “on the table” for so long that it was part of both Obama and Romney’s plan in 2012. So, at least for Democrats, their complaints about this deserve at least the contemplation of saying “How dare you complain about this?”

Turning the tables, the removal of the tax for not signing up for health insurance under Obamacare is something the Democrats have a legitimate beef about. Sure, it’s probably an unethical idea, but it’s a kinda’ sorta’ reasonable workaround to a problem neither party has solved. I think the Democrats (and the media) overstate the case with their everyone-loves-Obamacare mantra because many people clearly don’t. But I think they have a point in arguing that if the Republicans couldn’t modify Obamacare at all, then this is kind of a cheap shot rather than a fall back position.

As to the limit on SALT deductions, that idea has been around for a long time. The same with the increase in the standard deduction. Either party could have proposed those.

All in all, this is some reform, but it’s not big reform.

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Well then, what could have been in a big reform?

How about no corporate tax at all (economics students will recognize that all corporate profits are eventually paid out to people who pay income tax on them anyway)?

How about reducing the number of income tax brackets? How about getting the brackets down to just one (an income tax that’s flat, like just about all other taxes)?

How about taxing consumption instead of income? Europe moved in this direction a long time ago with their heavy use of VAT taxes.

How about reducing the indiscriminate use of means-testing in social programs, which amounts to imposing the highest tax rates on some of the poorest people?

How about eliminating almost all of the credits and write-offs on the individual an corporate tax forms? Most of these are just handouts to politically favored groups.

How about eliminating the mortgage interest deduction? This encourages over-investment in residential real estate. It also encourages overleveraging, which I seem to remember was a big problem they were going to fix because it had serious consequences when the real estate bubble collapsed in 2007.

How about putting corporate deductions and individual deductions on the same footing: businesses can deduct health insurance expenses but individuals can’t, and businesses have wider latitude to deduct interest expenses. I’m not even advocating picking one over the other, I’d just like them to match up so that we don’t push one type of expense towards one type of entity.

How about giving some credit for parents who pay for school outside of public systems? Currently, just about everywhere, if your kid does not go to public school you pay for it, and you still pay the full cost of public schools too. That’s just odd.

How about stop using the tax system to promote stupid stuff? Solar power may be cool, but it is not remotely cost effective even with subsidies, and we basically just lie about that. We’ve got really good figures on what the optimal carbon tax is, and in the worst case scenario solar is still a waste of money in most situations. Wind power is even worse.

When Social Security was enacted, the actuaries worked out a retirement age that provided a certain amount of coverage. If we matched that today, we’d have to raise the retirement age to about 80. We have to collect a ton of taxes just so we can divert money into making payments for seniors who didn’t pay enough in because they weren’t expected to live this long. And Medicare is a similar but far worse problem. All tax reforms are minor if they don’t address this.

All of these have been suggested over the last 30 years, and some of them have gotten fairly long and deep runs into the D.C. swamp.

Do note that there is some overlap in this list, so it might not make sense to do all of them.

The Republican Tax Reform: Part 2 —Why Tax Reform Only Occurs Occasionally

I’m not a political scientist, so I can’t tell you why they think this happens this way.

But I can 1) describe it, and 2) explain what economists think happens.

So, suppose we start at some point in time with a just-cleaned-up tax system. It’s sleek and efficient and makes people as happy as a tax system can.

What happens next? Politicians and bureaucrats find things they don’t like and try to fix them. Fair enough: we put them there to do something rather than do nothing.

Now, here’s the economics. There’s a subfield called public choice. One of its implications is that in representative government, these things get passed if they have concentrated benefits and diffused costs. You spread the cost over as big a group as possible, and it becomes so small that people don’t complain about it much. But you gather all those costs together and transfer that as a benefit to a smaller group. Now it’s concentrated, and those people can be very vocal.

Now … um … lather, rinse, repeat. A lot.

What you end up with over many years is a sleek and efficient tax system that has turned into a Frankenstein monster because you keep stitching new parts to it.

But now you run into a new problem, loss aversion, and the more complex form of that (brought into economics by psychologists) known as prospect theory. Basically, people don’t like perfectly even games like flipping coins because they worry more about losses than they feel good about gains.

So when we decide we need tax reform, the benefits are the part that is widely diffused, and the costs are often concentrated. Except because they are costs rather than benefits, those small group are going to be more vocal when undoing taxes than when they were being put together.

The result of this is a pattern of taxes getting incrementally worse for a long time, followed by a cathartic reform. It’s a very asymmetric process.

In the case of this tax reform, we really haven’t had a serious tax reform at the national level since 1986.

And it’s probably reasonable to not expect another one until you’re in middle age.

So this is a big deal.

The Republican Tax Reform: Part 1

This is the first of a multipart series on what macro students should make of the Republican tax reform that was passed at the end of 2017.

This post is kind of a table of contents for other posts, some of which are not written yet, and none of which are complete right now. So I may update this, and you should check it periodically.

Here are some of the issues I want to touch upon first:

• Why tax reform only occurs occasionally
• How major a reform is this, actually?
• Grandstanding
• Tax incidence vs. tax labeling
• Keynesian thinking (about the demand side) and distortions (mostly on the supply side)
• Brackets, exemptions, deductions, and flat taxes (I changed the order of these two)
• Average vs. marginal rates (I changed the order of these two)
• Progressive vs. regressive
• (New addition) Average/Mean vs. median outcomes

And then I want to get to the major features of tax law that were changed:

• Corporate income tax rate reduction
• Limits on SALT deductions
• Increase in the standard deduction
• Removal of the Obamacare penalty tax

Dolphin Production

Dolphins can be trained. In study centers, they train them to clean litter from their tanks: find litter, bring it to a trainer, get a fish. Simple, right?

The discussion below will fit in best with the last third of the semester and of the handbook. But, where I’m going with this is that economics is way more fundamental and basic to existence than most other fields you might study in college. As John Cochrane noted:

The sad paradox of free markets is that free markets do not need people to understand them to work.

The economics is there whether we want it to be, realize it, or sometime deny it. Hopefully, we recognize it and can explain it.

When we think about the economics of production, what we’re trying to do is formalize our thinking. At a very basic level, what production amounts to is combining things we’re willing to give up, to make something new, that we consume now (or sometimes save and invest, which ends up with consuming later).

At its most basic level, production combines labor and capital to produce output. Resources are a form of capital (but so are machines and tools … which we ultimately make out of labor and resources). And output is usually something we consume, right?

Back to the dolphins …

The dolphins combine their time and effort, with litter, and get fish to eat. Dolphins are the labor, litter is their capital, and fish are their output.

Big deal, right? Except that we study dolphins because they’re smart. So soon, they become not just labor, but skilled labor.

When we think about efficiently using our resources, what we are thinking about is combining fewer resources to get the same output, or the same resources to get more output.

And the dolphins … find litter, hide it, divide it into smaller pieces, and trade it for the same amount of fish. So they figured out a way to increase their marginal product of capital (MPK). Last time I checked what the generic social term “skilled labor” means when we formalize it is “able to get more production out of the same piece of capital than unskilled labor”.

In humans we’d note that we impart technological innovations to labor to make it more skilled. It’s not really that different than using some of the heat we used to lose from combustion in our engines to clean the exhaust further in a catalytic converter.

So dolphins are demonstrating technological growth. It gets better. Sea gulls are a nuisance to outdoor aquariums, and fortunately the dolphins view them as litter too. So instead of eating the gulls they catch, they trade them for fish (of course, big bird equals more fish). Then a dolphin invested: they saved some litter (instead of converting into fish), used it to bait the sea gulls, and then traded them for more fish … earning a rate of return.

Then then the dolphin who figured this out trained her calf and then others nearby. And now the technology is geographically correlated (within the dolphin culture of that tank), and temporally correlated (since dolphins today are better off than dolphins before).

Of course, not all of this was apparent to the journalist who wrote “Why Dolphins Are Deep Thinkers” for The Guardian. But George Mason University economist Alex Tabarrok picked up on some of the economics in “Dolphin Capital Theory”. And I’m telling you that there’s a growing macroeconomy at the Institute for Marine Mammal Studies inhabited by dolphins.

Go figure.