What’s Europe’s Problem?

The NBER is pretty good about trumpeting what new papers they have. Sometimes you can find these on the author(s) websites. This one I found easily, but I gave up after a few minutes on the one in the post before this.

Obviously, Europe is prosperous, and has some pretty nice places (economically speaking).

BUT, top to bottom, even the best performing European countries (say Germany) have trouble keeping up with the U.S. across the board. Why is that so?

It turns out that there’s a lot more dispersion in firms’ marginal products in Europe. That’s an economists way of saying there’s too many little firms, and countries would be richer if they merged and got bigger. For example, perhaps Germany, France and Italy should not all have their own car companies, but rather just a few big European ones.

Unfortunately, diversity sounds nice in some social situations, but when your diversity is in performance … not so nice.

A lot of the reason for this is that while capital flows in Europe to where it’s needed, labor doesn’t move enough. Of course, that may also mean that the U.S. having a single language is a bigger advantage than we might guess.

They also decompose marginal products to examine whether dispersion seems to be from differences in resources (say, we’re a small country and it’s really hard to sell enough cars here to be viable) or differences in how political, social, and cultural institutions affect the utilization of those resources.

In an interesting counterfactual they actually put numbers on something everyone already suspects: if you ran Greek firms with German institutions, the Greek firms would have less dispersion in their productivity. But they also check out the opposite case: if you ran German firms with Greek institutions, you’d induce a lot of dispersion in productivity.

This research also shows that the dispersion problem appears to be getting worse, not better. Oops. Why they’re getting worse is not something the paper goes into deeply.

Opioids and Jobs

There’s this thing called the NBER. It’s short for National Bureau of Economic Research. A lot of economists who are from top schools are members (no one from SUU).

A lot of good research is made available first through the NBER, months or years before it appears in a journal.

BUT … the NBER puts those working papers behind a paywall.

So I have not read the new paper entitled “U.S. Employment and Opioids: Is there a Connection?” But I’ve read the abstract.

Causality could go both ways here. Opioids could change peoples’ employment. Alternatively, their employment situation could cause how many opioids they take.

Do note that the data is restricted to only prescriptions for opioids. Of course, a lot of abuse stems from prescriptions rather than underground markets, so this might not be a big deal.

Here’s the results:

• Opioid use makes it more likely for a woman to work. Neutral for men.
• The local job situation is unrelated to local prescription opioid abuse.

I would love to get my hands on this paper, just because Utah’s economy is strong, but our opioid problems are so heavily skewed towards prescriptions rather than drug dealers.

The Republican Tax Reform: Part 14 — Removal of the Obamacare Tax

Yeah … we made it to the last post on this subject!

For the last 8 years, the Republicans have been talking about undoing Obamacare. With more power in D.C. after the 2016 elections they took on that problem. And they failed twice.

Unfortunately, Democrats and Republicans both admit that there’s some parts of Obamacare that aren’t working and are badly in need of reform or removal. So the need is still there. But, given the political climate in D.C. this isn’t going to happen anytime soon.

After failing twice at healthcare reform, the Republicans in Congress moved on to tax reform. This they were able to pass. And they snuck in a dig at Obamacare along the way.

The American healthcare system has good and bad aspects to it. First, it is definitely unlike the healthcare system of any other country. Most of this is due to historical accidents. Second, Americans are typically in worse shape when they seek healthcare, but the prognoses once care is obtained are typically better. So it’s a high quality system. Unfortunately, third, it’s the most expensive healthcare system in the world. You get what you pay for. Fourth, and you probably have not heard this one before, the claims that American healthcare spending is too big a share of the economy are so groundless they probably qualify as fake news (I hate to use that term, and I’ll deny any Trumpiness, but there it is). The place to go for information on this is Random Critical Analysis. Basically, Americans are a lot richer than the easily available data shows, and healthcare demand is more income elastic than people recognize. Fifth, American healthcare is not distributed evenly and is probably not distributed equitably. Sixth, the financing of American healthcare is both complex and insufficient. There are other subproblems to these, and some other items I might add to the list.

Obamacare proponents pay lip service to all of these, but the actual act as written focuses mainly on the last two.

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I can’t make you believe that your professor is not a nut. But let me toss out some economics and finance for you to mull over. You don’t have to believe me, but facts have a way of coming back to bite us.

Private health insurers are a lousy investment if you have some money stashed away. They simply do not make profits with the ease that anyone thinks they do. They need help, not abuse.

Pharmaceutical companies are very dicey investment propositions too. They are playing Russian Roulette: if their next drug is a hit, they make money and get to try again, but if it’s a flop they typically lose their independence in a merger with a company that did get a hit. We can debate this, but there are solid arguments that all healthcare improvements for the last few generations are due to pharmaceuticals. Read that again: all. It’s debatable, but the data says it’s not out of the question that everything other than new pharmaceuticals has been a waste of time, money, and effort. So why are we making them play Russian Roulette?

Third, healthcare is not (for the most part) run by the federal government. They collect the money, but they farm it out to states, counties, and cities through programs like Medicaid. Those lower level governments are exceptionally cash-strapped due to underfunding. This is a huge problem, especially in the northeast and midwest: these governments are incapable of doing much else because they’re mandated to provide healthcare but not compensated enough to actually do so very well.

Fourth, it may be dumb that the U.S. doesn’t have one national single-payer system (I don’t agree, but that’s why I said “may”). But do not have any illusions: we have a few nationwide single-payer systems. The most prominent is the VA. This is also the system with the biggest scandal in our lifetimes for not actually providing the healthcare that they were paid to provide.

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OK. I’m done.

My point is that our healthcare problems have a lot to do with money, and not so much with access.

But Obamacare was painted as a policy to improve access.

I’m sorry (if you like Obamacare) but better access was the hook to reel you in. It was mostly about getting more money flowing through the parts of the healthcare system that are already run by the government. It’s a fever-dream to think it was about doing more of what they already can’t do. It was about fixing that stuff first. And this meant more money coming in, to help out health insurers (who were going broke), and pharmaceutical companies (who are at risk of going broke), and state governments that are paralyzed because there’s no money left over, and federal bureaucrats in the VA who claim underfunding as well.

Obamacare did 2 things to alleviate this. One was push for alternatives that would get uninsured people into the system. The other was the Obamacare penalty/tax for people who didn’t get into the system.

The thing is, most people who are uninsured choose to be that way. Yes, healthcare is often prohibitively expensive. But this doesn’t change the face that it’s a bad deal for most people who are adults, healthy, and young. A huge chunk of Obamacare is about getting those people to pay upfront for services they’re unlikely to collect upon. Yes, that gets them in the system, and provides security, and is arguably more equitable … but the big thing is that it gets extra cash into the system to fund the existing underfunded items.

This is where the tax comes in. This is sold as take the carrot (better plans under Obamacare) or get the stick (a tax penalty). No doubt there is some element of that. But look carefully at the economics: the choice is to either pay one way or pay the other way. In both situations, the government gets money out of the public. If you don’t think this is the primary goal of Obamacare, you haven’t been paying attention. (A big clue in favor of this is all the focus on the newly insured … note that there’s little talk about whether or not they’re actually healthier).

And along come the Republicans in 2017, and they can’t touch Obamacare, but they still want to fiddle with it, and they like cutting taxes, so they cut the Obamacare penalty/tax.

Again … choose the metaphor that works for you … keep your eye on the ball … don’t let the magician misdirect your attention … see through the smoke and mirrors.

The liberals/progressives/Democrats have tried to paint this as a reduction in healthcare. It isn’t. The people who were choosing to pay the penalty/tax were already committed to paying for their own healthcare (admittedly, they may not have been planning on paying very much for it, or as much as others might like). But consider this: is it conceivable that they’d pay less if they have more money? Probably not, particularly given the mountain of evidence on the income elasticity of healthcare demand. As much as some may hate to admit, any reasonable estimate a few years down the road is going to find that the Republicans tax reform increased spending on healthcare for many people in the economy.

But, this tax reform definitely funnels money in a direction that Obamacare did not intend. So it’s going to reduce healthcare spending for those segments of the economy whose bills are mostly paid for by deep pockets: private insurers, pharmaceutical companies, and the federal government. In a real sense, this is a “starve the beast” policy choice from Republicans.

From a Keynesian perspective, this tax reform is probably slightly expansionary since it will cut tax revenues. From a supply-side perspective, it is probably slightly expansionary since it reduces the incentives for tax avoidance.

Is it a smart move? Probably not. Obamacare was an attempt to improve the flow of funds, with a ridiculous amount of window-dressing about equitability. (Get this picture: no one wanted a tax increase, especially from Democrats, especially right after a huge recession … so it absolutely had to be covered up with warm fuzzy feelings). The flow of funds problem is still there, and the Republicans probably made it worse, and don’t seem to have the willpower to make another run at improving it. Unfortunately, the progressives/liberals/Democrats have spent so much time focused on the window-dressing that they’re not thinking clearly about the primary goal any more.

I’m not sure what the right metaphor for all this is. Maybe the Democrats brought home a stray dog and a stray cat, and the Republican ran the dog off so they don’t have to feed it, and the Democrats are claiming that this hurt the cat. On purpose! Except the Republicans didn’t hurt the cat, because they barely noticed it at all. But the dog is stray again and neither party is paying it much attention. It’s not a great metaphor, but it gets at the idea that neither party is acting well, or being honest about the realities.

P.S. And one last personal note on this. I don’t think the Democrats were very open and honest about the penalty back when this was passed, and they got help from conservatives on the Supreme Court to keep it in place. It’s hard not to say they all probably had this coming. It was kludgy from day one.

The Republican Tax Reform: Part 13 — The Increase In the Standard Deduction

The dynamic of tax systems is that they tend to get more complex slowly and continuously. Occasionally this is punctuated by widespread reforms.

On personal income taxes, a large source of complexity is Schedule A of Form 1040, which is used for itemizing deductions. Form 1040 is the main form for individuals and couples. It has several variations. About 30% of returns include Schedule A. So, any move towards personal income tax simplification probably needs to either reduce the complexity of Schedule A, or reduce the number of filers who use it.

We need one quick note on how taxes are filed. Filers are not the same as people. Filers are usually the only ones in an entire household filing personal income tax forms, so this is something like a third to half the overall population. Dependents are those who do not file.  Filers can be 1) singles, couples, or heads of household (who have dependents who may not be directly related to them). Couples have the choice of filing jointly (more common) or as individuals.

Increasing the size of exemptions and/or standard deductions has been a policy proposal floating around D.C. for a generation. Most flat tax proposals made by Republicans included this. Alternatively, guaranteed income proposals made by Democrats can be shown to be equivalent to a combination of a larger exemption and/or deduction combined with extending a subsidy if one's adjusted gross income is negative (we already sorta’ do that too, with the Earned Income Tax Credit).

In review, personal income is subject to adjustments, exemptions, and deductions prior to the calculation of tax. Adjustments are items that added or subtracted from income. Exemptions are amounts that are subtracted from income, usually per individual/dependent, to reduce taxes owed (and completely exempt those at very low incomes). Deductions are per filer, but otherwise work in a similar way.

Filers have two choices: take the standard deduction, or itemize deductions on Schedule A. Taking the standard deduction is similar to a large exemption that is the same for all filers. Alternatively, if one itemizes, you may be able to deduct more, at the expense of doing more paperwork (and a larger audit probability).

Expenses that can be itemized include SALT, out-of-pocket healthcare expenses, investment interest expenses (including mortgage interest and points), charitable contributions, and casualty and theft losses. A portion of the last major tax reform in 1986 was targeted at reducing the number of filers who itemized, by making it tougher to claims expenses (on your personal income tax) on business activity done in your home.

The idea of the standard deduction is twofold: 1) many filers have expenses that would be close to the standard amount if itemized, so why bother making them do the paperwork,  and 2) if they don't have that many itemizable expenses the standard deduction amounts to a tax break.

This gives us a clue about who those 30% of filers are. One group would be taxpayers in states with high income taxes, and/or localities with high property taxes. These filers are primarily rich and/or in the Northeast. Since the old and the poor have most healthcare expenses covered by Medicare or Medicaid, those who itemize due to healthcare expenses tend to be working, ill, and underinsured. These filers are most commonly found in the West where health insurance is both less common and more often seen as less economical. Mortgage expenses tend to be most heavily deducted by the young (with bigger payments), those with larger homes, or those in areas where real estate is more expensive (primarily the Northeast and Pacific Coast). Other investment interest is actually not that common a source of itemization, since many do this through corporate structures (with different forms) to limit their liability. Charitable contributions are quite common, but are often not terribly large because of the paperwork involved in documenting fair value. An exception to that is tithing, which is most common in the South and also Utah. In short, the 30% of filers who itemize is fairly diverse, with some lumpiness, across income, wealth, age, and geographic location.

Prior to this year, the standard deduction was around $12,000 for couples filing jointly. The Republican tax reform increased this to $24,000. It changed for other types of filers too, but I’ll stick to this most common case.

To understand the economic issues involved, recognize that this change divides the population of filers into three groups.

The largest group is those who did not itemize before the change. The change gives them no reason to change. Roughly, these are "the poor" even though this group also includes most of the middle class, so the increase in the deduction amounts to a tax cut equal to their marginal rate times the $12K difference. Also note that this reform effectively increases the width of the income bracket subject to a marginal rate of zero, increasing the number of the poor who go from paying a small amount of income tax to none at all.

So this reform should absolutely be regarded as a tax cut for the poor and middle class. However, as pointed out in other posts, many of the people don’t pay much tax to begin with, so the absolute size of the cut may not be very large.

The second group is those with deductions that are so large that they itemized before and will continue to after the change. Roughly, these are "the rich", and the increase in the standard deduction leaves their situation unchanged. They didn’t use it.

So, this particular reform should not be labeled as benefitting the rich at all.

The third group are those who did itemize before the change, but will claim the larger standard deduction after the change. (Personal note: my household is in this group during most years). For those near the lower end the change amounts to a tax cut, less so for those at the top end. For both groups the reform is a tax simplification.

In sum, from a Keynesian perspective, this reform is going to lead to a modest decline in revenue, since it largely affects those who don't pay much in taxes to begin with. From a supply side perspective, this is a simplification of the tax code, but not a terribly large one since it does not affect that may filers. Both are viewed as expansionary policies.

The Republican Tax Reform: Part 12–The New Limit On SALT Deductibility

Another feature of the Republican tax reform is the new limit on the deductibility of tax payments to state and local authorities (SALT). Previously, there was no limit on this. Now the limit is $10,000.

The U.S. has a more seriously federal system of government than most countries. "Federal" is the word that means layers of government that have some ability to operate independently of each other. Just to confuse things, we also use the word federal to denote the top level of government at the national level.

So, in the U.S., the Federal government's big roles are defense and collecting tax revenue. A lot of that tax revenue is paid out as transfer payments to individuals (like social security), but some is transfer payments sent out to states to provide services to individuals (like Medicaid). States actually provide a lot of healthcare, as well as funding transportation projects and universities. Cities and counties to a lot of healthcare too, while school districts provide K-12 education.

Not all states have an income tax, but most do. Localities, mostly cities, towns, and school districts, also levy property taxes.

In most places, people file two income tax returns: a federal one and a state one. Then most people make a third payment, often included in their mortgage payment, for property taxes.

On income taxes, there are adjustments, exemptions, and deductions. Adjustments are for items that are or are not counted in income. For example, alimony payments from a working divorcee to their (often non-working) former partner lead to a downward adjustment if you are paying (because you don’t benefit from that income) and an upward adjustment if you are receiving (because you do benefit from that income). Exemptions are for everyone: they are a certain amount taken out of your income on which no tax is owed. Exemptions are the same for everyone: for example, rich or poor, if you have a child, they knock about $4K off your taxable income. No one asks what you spent that money on. Deductions are a little more complex. These are specific stipulations that some things that you spend money on also may be subtracted out of your income before taxes are calculated. The big categories for deductions are interest paid on investments, charitable contributions, out-of-pocket healthcare expenses, job expenses, monetary losses to casualty (for example, uninsured storm damage) and theft, and state and local taxes.

The rough idea behind deductions is that these are expenses that induce changes in someone else's income (that will also be taxed). Someone else could be another person, but it could also be the future you. So, interest on investments is deducted because you are giving up some income now to make more income later on (mortgage interest and points fall in this category). Charitable contributions often provide income directly to someone else (like supporting an artist with cash), or indirectly (like tithing being used to pay the income of church employees), or substitute for someone earning income (like food donations). The intention is always that if the government can track where that income went, they'll tax it there: more on that later. Healthcare expenses are deductible because getting healthier now may help you earn more income later. And casualty and theft losses are claims on things that have to be replaced, often out of current income, to earn more income in the future.

Donations to charity are worth a deeper look. Hypothetically, you could do something like this. Set up a charity to which you donate. Use the charity to buy things that are difficult to tax. Then donate those items back to yourself. This avoids the income tax on those items: if you bought them directly, you'd be spending income that had already been taxed. For obvious reasons, this sort of behavior is defined as (illegal) tax fraud rather than (legal) tax avoidance. What is legal is to make a donation and receive back something of value, as long as you subtract that value off your donation. More on this later. Also note how different this is from the deductibility of interest income: with charity you may be able to deduct the whole expense, whereas with investments you can only deduct interest if you borrowed, and not the value of the asset you invested in and will sell later on.

I do not know the history, but somehow tax payments made to state and local authorities were added to the list of deductible expenses. This is not completely dubious. For example, you pay taxes that support education, which in turn may help your kids earn higher incomes (which will be taxed later on). Fair enough. But do note that you're getting an indirect benefit here. So this case is fairly close to that of charitable contributions, in that the best justification for this deduction is if it is on the net rather than gross amount.

Of course, there is also the counterargument that while the rich pay more taxes, it isn't clear that they get back in benefits what they put in. This is a cornerstone of the progressive principles that underlie most social policy.

But, now we're on to something. Taxes that pay for things that make you or someone else more productive probably shouldn't be deductible, but taxes that go to certain social programs probably should be.

The big question would be how to divide those two. It's not clear there's a decent answer for that. The precedent is that it's all been deductible.

In this case, the Republican tax reform at the national level can be seen as a slap at the states and localities with more progressive government policies. These tend to be in the northeast and on the west coast. And those are mostly blue states that have voted against Republicans for a couple of decades, and urban areas that have voted against Republicans for almost a century. Politically, the limit on SALT deductions is absolutely a slap in the face of these areas.

All of the above is prologue. What I'm really interested in here is the macroeconomics.

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Macroeconomically, we think of government as a pass-through. It produces little or no income from productive efforts on its own. But it does draw off income from productive sources. That's bad. But it also passes through that money and spends it on stuff produced in the private sector. The question is if that stuff is good enough to make the taxation worthwhile.

Microeconomically, we think there are some good things to spend money on, primarily public goods. The tough question is drawing the borderline between a public good that would not be available without the government, and a private good that might be.

Macroeconomically, Keynes asserted that there was a multiplier process that amplified some government spending. A multiplier larger than one indicates that government spending is beneficial (after netting out the negatives of taxes). Currently, a point estimate of 1.5 for the multiplier is widely accepted. What is not clear is how why the confidence interval is on that.

However, there's an important caveat on that multiplier process. It only works on spending that is autonomous. That's defined as spending that's unrelated to the income of individuals who might benefit from the policy. For example, Warren Buffet can afford steak, but is known for eating hamburgers. Roughly, if he would not buy a steak on his own (even though he can afford it), if the government buys him a steak rather than a hamburger, the difference in the price is autonomous. That's a frivolous example, but it extends readily to things like bridges or military equipment. The big questions come with stuff like education and healthcare spending. Is that autonomous too, even if someone would pay for it on their own if the government didn’t provide it for them?

Do note that a problem of political discourse over the last few decades is that politicians of all stripes have lost sight of that autonomous spending argument. It's widely asserted that all government spending is beneficial because it is subject to the multiplier process. This is self-serving: if your job is to spend other peoples' money, who wouldn't assert that all your choices are positive ones? Keynes never claimed his theory supported all spending. A reflection of this is the interest of most politicians in infrastructure spending: everyone agrees that ought to be helpful as long as it's not stupid or extravagant. BTW: a useful way to think about contemporary China is as a big experiment in textbook Keynesian economics — heavily tilted towards infrastructure at the expense of social programs.

This is useful for contrasting the U.S. with western Europe. It's often decried that the U.S. is less progressive because out government does not spend as much. (Do note that there's a huge pitfall here if you count only the national government, since the U.S. system is more federal than most European ones). This difference is often attributed to social programs. To the extent that is correct, the extra social programs are doing nothing to promote growth. This goes some way towards addressing the inability of most western European country's economies to grow as fast as the U.S. over the last generation or two.

Also, note that none of this is to say that social programs are not beneficial or desirable. I'm just making the point that there is little macroeconomic theory suggesting that they do much to alleviate business cycles or promote growth.

All of this leads up to a rather mind-blowing insight about the SALT deduction. To see this, consider archetypes of extreme conservative/Republican and liberal/progressive/Democratic positions.

In the extreme conservative/Republican view, government spending does no good at all. SALT is collected, but the money is completely wasted. In this case, the tax that was paid never helped the individual in the way that other income does. Yet income that doesn't benefit the individual is usually not taxed at all: like alimony paid. It's still hard to justify a deduction for SALT, but if you think government spending does little good it's easy to justify subtracting all SALT to adjust income. This is the opposite of what is in the Republican tax reform.

In the extreme liberal/progressive/Democratic position, government spending is better than private spending at providing benefits to society. But, if you pay SALT and receive benefits, this a reason to net out those benefits to reduce the SALT deduction (as in the case of some charitable contributions). Yet it is blue state Democrats who are complaining the most about the limits on SALT deductions. In fact, they are going so far as to propose special charities that taxpayers can donate to in order to get around the new deductibility SALT limits.

Through this lens, these two observations suggest that the SALT deductibility limits were a purely political move, with little economic meaning.

Personally, I come down on the liberal/progressive/Democratic side that quite a bit of government spending is actually helpful to the economy. Unlike those groups, my principles tell me it is a good thing to cap or even eliminate the SALT deduction. It's basically a way to get extra government services for your locality, while you pay a discounted price and others pick up the difference.

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The Republican Tax Reform: Part 11—The Corporate Income Tax Rate Reduction

This post is now done.

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I think control issues are a general problem with politicians and bureaucrats. I’m speculating, but I think that jobs where you can conceivably control some things attract people who believe controlling things is important.

A problem with that is if controllers believe they can control something that they can’t.

This comes up a lot in tax policy. There’s a real economic problem with tax labeling and tax incidence that no one should ignore. But political processes often focus on labeling exclusively, or as a matter of convenience. There’s also an issue that you can target a certain tax base, but you always need some element of buy-in from the parties being taxed. It’s perfectly legal for people to avoid being included in the tax base, and if buy-in is weak you may get some tax cheating on top of the avoidance.

Which brings us to the problem of multinational corporations. These don’t face one corporate tax rate. They face a bunch. And it’s reasonable and legal to expect them to pick and choose where to place the tax base they create.†

Here’s how that might work out. Country A has a corporate income tax rate of 10% and country B has a corporate income tax rate of 20%. Multinational firms from both countries then do everything they can to shift costs to country B (as a practical matter of tax planning, if not so much an ethical one, costs you measure internally are easier to move around than revenues that others might be able to measure externally to the firm) . Income is revenue minus costs, so the goal is to cancel out all the revenue from country B with costs from country B but also costs from country A that have been shifted over. If they do this perfectly, they end up with their income all taxed at 10%. This makes good financial sense, and going further, it is the fiduciary duty of corporate officers to make sure this happens. Now suppose the politicians in country B want to increase taxes. They raise their rate to 21%, and still collect nothing. Even worse, they may not be able to admit how it is possible for country A to raise their rates even more, say to 12%, and have their tax revenue go up by 20%.

Part of me does not believe that politicians can be that dumb.

But a different part of me is certain that sometimes they are that dumb. Here’s why. If country B really wants to increase tax revenues (instead of just labeling themselves as tough on business) they should undercut country A’s rate. Perhaps country B should try 9%. But if they do, country A should try 8%. That game ends with both of them charging a 0% rate. At first glance, this outcome might seem implausible, but governments do this all the time when they compete with each other to offer tax breaks to get firms to locate within their jurisdiction. In public finance there’s actually evidence of governments going past zero and offering packages that amount to negative tax rates on net. That’s what can happen if governments are not that dumb. If they are dumb, they might not go that far, and end up with a positive rate, but one that is different from other countries. This is actually what we observe in the real world, which makes me think there are a lot of politicians who really don’t get the economics involved in their job.

Which brings us to the U.S. corporate tax rate. The OECD says that, yes, the U.S. did have the highest statutory corporate tax rate (the right column at this site). Those are marginal rates, so there will be some weirdness to judging our system when all we’ll have is average rates from the data. Also, when we talk about the statutory rate, this is before deductions, exemptions, credits and so on. The effective tax rate might be much lower. The Congressional Budget Office (CBO) researched that for G-20 countries, and found that in 2012 … our marginal corporate rate was the highest, our average corporate tax rates were still the third highest, and our effective corporate rate was the fourth highest (see Table I here). That’s better, but not good. The change in positions also indicates that our system has a lot of complexity to it.

So yes, it is reasonable to think that high U.S. corporate tax rates were causing multinational firms to shift their costs around the world. How recent a phenomenon is that? Well, historical panel data sets on that are both complex and sketchy, but the OECD data for earlier periods shows the U.S. did not used to be at the top of the list. What’s happened is that many other large and/or rich countries have reduced their corporate tax rates over the last generation or so. This is because the wave towards lower tax rates that hit the U.S. starting in the 1980’s was a global phenomenon. It just did not hit our corporate income tax rate.

After all this, the U.S. was doing one more dumb thing. Well, smart from the perspective of collecting revenue, but dumb from the perspective of reducing tax distortions. The U.S. had been running a non-territorial tax system. In a territorial tax system, a U.S. multinational would pay tax on its income in each country that it operates, at the tax rate for that country … and then you were done. But this is not the system the U.S. had. Instead, if the tax owed in the foreign country was lower than what would have been paid if that operation was in the U.S., the firm owed the different too. Except that a U.S. firm could claim that the foreign income on which that extra tax was owed was still needed or active in that foreign country, say for future investments. In this case, that tax liability could be deferred indefinitely. And obviously, it could be invested in financial investments from the foreign country and earn even more income that could also be deferred.

But wait! There’s one more big distortion. The “Americanness” of a firm was judged on the basis of its headquarters’ location. And some countries had territorial tax systems in place. This led to inversions: move the headquarters to a lower tax country with a territorial tax system and completely avoid rather than defer some U.S. corporate taxes.

This was considered a big problem under the Obama administration, and a motivation for tax reform for both countries.

So what we have are some symptoms: too much corporate profit parked overseas, and too many inversions. The causes are a corporate tax rate that's relatively high, and double taxation from a non-territorial tax system.

The Republican tax reform addresses this with three different measures. First is the reduction in the corporate income tax from 35% to 21%. Second is the conversion of U.S. corporate tax collection to a territorial system.

The third deals with the issue that corporations should not be (especially) rewarded for tax avoidance. This is exactly what would happen if old profits that were never taxed at the U.S. rate under the old system could be brought back to the U.S. and taxed at the new low rate. So, there's also a surcharge on repatriating the accumulation of past profits. It's set at about 15%; a little more than the decline in the main rate.

Of course, we’ve seen in the news over the last 2 months how many firms have already started repatriating those past profits parked overseas.

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All of this motivated a lot of angry discussion amongst macroeconomists last autumn. For someone like me, this was extraordinary: if economists ever bitch-slapped each other, this would be the occasion. On one side were non-political economists and conservative economists noting that a cut in the corporate tax rate theoretically should increase wages (this is how we know to go out and actually look for that sort of thing in the German data I posted about last month). On the other side were progressive/liberal economists saying something along the lines of "but not this time". Their arguments were pretty weak and everyone knew it.

John Cochrane might have summed it up the best:

[Cutting the corporate tax rate and having it help labor] is not the same as the Laffer curve [cutting tax rates and having tax revenue go up], which I think causes some of the confusion. The question is not whether one dollar of static tax cut produces more than a dollar of revenue. [I don't really see that as a confusion, but Cochrane must have run across people who made that argument). The question is whether it raises capital enough to produce more than a dollar of wages.

This is also a lovely little example for people who decry math in economics. At a verbal level, who knows? It seems plausible that a $1 tax cut could never raise wages by more than $1. Your head swims. A few lines of algebra later, and the argument is clear. You could never do this verbally.

​Yep. This is why we do the math.​

I also think, and it makes me a little sad to say this, but in this particular case the progressive/liberal argument was made strongly and verbally to audiences that don't do the math. And it showed. :(

This all started with Trump's Council of Economic Advisors releasing a position paper arguing for a lower corporate income tax. (This is not required, but is very readable for undergraduates). But, it's a serious economic summary, not a political hack's job, which harks back to Harberger's seminal 1962 paper showing that the corporate tax hit workers pretty hard.

First out of the gate was Paul Krugman, the Nobel-Prize winning economist from Princeton who now mostly writes progressive opinion pieces for the The New York Times, with a column with the subtle title "Lies, Lies, Lies, Lies, Lies, Lies, Lies, Lies, Lies, Lies" In it, he literally goes through 10 lies that he sees in the Republican position. Some of it's good stuff, but some of it is ... hmmm ... things I wouldn't be proud of. Most relevant to this post is his 4th one. It’s my job to help you filter these things, and I suggest you be very suspicious of an argument that starts out with the tax rate cut won’t help workers and ends by reasoning that this is because it will make the trade deficit go up. If that sounds like a dodge, it’s because it probably is. Next up was Larry Summers (Harvard economist, former Clinton Treasury secretary, and Obama advisor), who remarked more than once that he was in favor of cutting corporate tax rates, but that he didn’t agree with the forecasts. Then there was Jason Furman (a Harvard economist, and one of Obama’s economic advisors) who tweeted that he would not disagree with reducing the corporate tax rate to zero … but that he just didn’t like Trump’s numbers that didn’t reduce it that far. ‡ Sheesh. In the same thread, Brad DeLong got to the heart of the misgivings on the political left: none of the conservative/Republican justifications hold water if output per worker isn’t flexible. This is absolutely true, but of dubious import since the whole point of economic growth is that output per worker has been going up for about three centuries. That really is the heart of the matter: progressives/liberals/Democrats think there’s something stagnating worker productivity that can only be addressed by pursuing their policy agenda, and conservative/Republicans think that it’s that progressive/liberal/Democratic policy agenda itself that is what’s standing in the way. For my part, I think a lot of the “wages have stagnated over the last generation” argument is that compensation has not stagnated, but we’re just getting paid with a lot more coupons good for the healthcare of some lucky senior citizen chosen by some bureaucrat we don’t know.

Back to Cochrane: we do the math because it sorts through these things in a way that’s actually easier to dissect in the long-run (yeah … if you think about it, all math is tough in the short-run, and then you figure out how a technique works and use it repeatedly in the long-run because it seems so easy now).

The math was originally put out in a blog post by Greg Mankiw (another Harvard macroeconomist, who started out by founding the neo-Keynesian branch of macro and then ended up working in the Bush II White House). There was nothing new here. Most economists could have kicked this out,  but Mankiw reminded everyone of it. Go read it, at least through the bold text. The simple math is in the Mankiw post. Something more formal, with a great discussion is in Cochrane. Mulligan chimes in too. An alternative way of thinking about it with graphs and Harberger triangles is offered by Landsberg. Browse the comments too: they are filled with chip-ins from top notch people.

Before we jump into the math, take a step back and think about how the world works. It’s a complex place, and everyone thinks about the world in simpler terms than the reality around them. The thing is, that’s a model. Even if you don’t write it down. Even if it isn’t mathematical, it’s still a model. We might call it naïve, or informal, or ocular to get the point across that it’s just our mental model and shouldn’t be taken too seriously. I think it’s fair to say that a conclusion from the mental model of most people is that the incidence of the corporate income tax on labor is zero.

What economists try to do is formalize some that. This means assigning some plausible functions to describe behavior, and then seeing how they interact. You may not find the math simple, but it is probably as simple as we can make it.

Mankiw’s model is algebraic. It uses the basic principle from algebra that you need an equation for every variable you want to solve for. There are three variables the wage, the capital-to-labor ratio, and the amount of tax revenue collected: w, k, and x. We can have extra variables in the equations, but we don’t solve for these … in the sense that we make statements about why they go up or down. Instead, with these extra variables, we presume that they go up or down as a reflection of outside forces or policies. Because they are coming from outside the 3 equations of the model, we call them exogenous variables. These are the tax rate, and the rate of return on capital: t and r. If these are exogenous, then the variables we solve for are called endogenous.

Mankiw starts with a production function, f(k). The notation f just means function. The k is the capital-to-labor ratio; basically tools per person. Economists presume that production functions share some features: they’re curved, they slope up,  and they get flatter as k gets bigger. Because we’re not making a lot of assumptions, a production function is exceptionally flexible. All we’re assuming is that more tools always help you be more productive (that’s the upward slope), but that the initial tools are more important than the ones you added later (this is the getting flatter part, which economists call diminishing marginal productivity). We need a function, with a curve, to have our slope change. In terms of calculus, f’>0, and f’’<0. The first one says the slope is positive, and the second one is that the slope is getting smaller (or the curve is getting flatter).

Next up is the marginal product of capital (MPK). This is how much is produced by one additional unit of capital, and it is the slope of the production function, f’. (That’s a tiny bit of calculus: the first derivative of a function is another function which tells you its slope everywhere). For simplicity, we think of firms renting capital, in the same way that they hire labor. The MPK is then the very most we can afford to pay for capital: if you pay more than that you’ll lose money on every tool you rent. In sum, we produce f and we rent capital for f’.

Without taxes, this means that r=f’. Here r is the rental rate of capital: it functions that say way as w being the rate at which labor is paid.

But with taxes, part of that productivity of capital is skimmed off the top by taxes. So the rental rate is what’s left after you pay taxes, as in: r=(1-t)f’.

Hold that thought while we build a second equation. In its simplest form, with only two factors of production, all the value of production is paid out workers or to capital. So f=wl+rk (that’s an “el”, although it might look like an “eye” with this font). We can make things even simpler by assuming that there’s only one worker, and they use the k pieces of capital to produce f. In this case we get f=w+rk. Keep in mind that this equation is at the production stage, before the tax is paid. If I substitute in r=f’, and rearrange, we get w=f-kf’.

Lastly, we put together an equation to describe how tax revenue, x, is related to tax rate, t. Now, we’re not talking about rates of return, but rather amounts paid out. The revenue reduction is then dx = –kf’dt. Starting on the right of that, dt is the change in the tax rate. In this case that’s negative. That tax cut is applied to the amount that’s paid out to the owners of capital, kf’. The negative sign in front is there so that we can talk about a tax cut as a positive number, like we cut taxes by $100. We don’t say we changed taxed by –100$, even though that would mean the same thing. If we described tax cuts as a negative number, we wouldn’t need the minus sign in the equation, but since we describe them as positive numbers we do need the minus in there to change the sign.

So the question is, what’s dw/dx? That is the change in wages for a certain change in tax revenue no longer paid by owners of capital?

Before we go there, we have to think about the whole algebra problem. And we ought to make it match up with what we know about the real world. So we’ve got 3 equations:

r=(1-t)f’

w=f-kf’

dx=-kf’dt

Three equations means we can solve for three unknowns. Recall that f is a function of the variable k, and not a variable in and of itself; d is the same way, it’s shorthand for a Greek letter delta denoting change in a number. The three unknowns that we solve for are k, w, and x. The thing coming from the outside that makes those 3 change is the tax rate t.

But if you look, there’s one variable we haven’t accounted for: the rate of return on capital, r. We have two choices: 1) make it endogenous by adding another equation so we can solve for it, or 2) assume that it’s also exogenous. The first one sounds like more work, so we want to avoid that. The cool thing is, making that assumption is good economics too!

How can that be? Well, which is more different across countries: r or w? We’ve discussed in class how differences in incomes often differ by 50:1 around the world. Do rates of return? No; you don’t hear about people investing in, say, China, because they can earn a rate of return of 100% per year rather than 10 % per year … but you do hear them say they’re investing in China because the labor is a tenth the cost there.

There’s good reason for that. Capital moves much more readily from place to place than labor does. In fact, a defining feature of the financial world over the last generation has been rapid movement of capital around the world for very small differences in rates of return.

OK. Don’t lose sight of the big picture here. We’re trying to make a little, formal, model to tell us how a corporate tax rate cut affects workers. It doesn’t have to be perfect. All it has to be is a step forward from the presumption from the mental model that the incidence of the corporate tax on labor just has to be zero. So, we’re going to assume that r is exogenous too. It can move, but it doesn’t move because of what we described in the model, but rather because we might want to see how it changes other stuff.

Now, back to the three equations. Solving a three equation system is something most students do in 9th grade algebra. This is a doable thing if the equations are all lines. We have a problem here that they are not lines. So we need to linearize the (first two) equations, because of the f, and f’. In mathematics, you linearize by taking total differentials. And we’ll have to use the chain rule because we have multiplication. This is one of the few instances in this course where we’ll have to use calculus. Here are the three equations, with the first two now linearized:

dr = (1-t)f’’dk – f’dt

dw = f’dk – f’dk – kf’’dk

dx = –kf’dt

Saying the r and t are exogenous means they won’t change unless we’re exploring what happens when they do change. So dr = 0, and:

0 = (1-t)f’’dk – f’dt

dw = f’dk – f’dk – kf’’dk

dx = –kf’dt

Also note that we can cancel in the RHS of the second equation, so:

0 = (1-t)f’’dk – f’dt

dw = – kf’’dk

dx = –kf’dt

Rearrange the last equation to get:

-f’dt = dx/k

Substitute that into the first equation to get:

0 = (1-t)f’dk +dx/k

Solve that one for dk to get:

dk = –dx/[(1-t)kf’]

Lastly, substitute that into the middle equation to get:

dw = kf’dx/[(1-t)kf’]

We can cancel the k’s to get:

dw = f’dx/[(1-t)f’]

And now, this is really cool from an economic perspective. Recall that f is a production function. But it's a generic one: anything that slopes up and gets flatter, right? We have f’ in both the numerator and denominator, so we can cancel them. What’s so cool is this means no matter what details or complexity we want in our model of production to make it more realistic, it will not affect the final conclusion about dw and dx:

dw = dx/(1-t)

We’re interested in dw/dx, the response of wages to a change in tax revenue. We get this by division, so:

dw/dx = -1/(1-t)

If the corporate tax rate is about 1/3 (which is roughly what it was in the U.S.) we get dw/dx = 1.5. Thus, if we increase corporate income tax revenue by 2 dollars, wages go down by 3. The works out to an incidence of 60% on workers (3 is 60% of the total 2+3 lost by the owners of capital and the owners of labor).

This is why we do the math: a naïve view is that the incidence is zero, but a little math shows that 60% is a much better second guess. (Do keep in mind that this may seem like a lot of math to a student doing it the first time, but it is mostly just me laying out every single step in detail). Don’t believe me: here’s where I worked it out originally:

Yeah. Read it on my phone while sitting on the bed waiting for my family to get ready to go out, and knocked out the math on one of those cheap pads they leave by the phone. I am not saying you should be able to do this right now, but I am saying that you should be learning that a minute or two of math can help you readily dismiss naïve viewpoints.

An additional point to keep in mind is how marginal behavior works. This model made an initial inclusion of economics and math into a mental model. The marginal returns to that (in terms of changing what we thought the answer would be) were huge. We can add a lot of bells and whistles onto this model: more equations, more variables, more complex behaviors … but they’re unlikely to change that 60% answer too much because we’ve already made the biggest marginal contribution to our thinking.

The way that theory and econometrics work is that you assume away as much as you can in the theory to get to the heart of the matter. This gives you an idea of what to look for in the econometrics. Then you go get as much good data as you can, and hopefully you find something that confirms the theory. That is why I posted about that paper with the German data in January: it’s an empirical confirmation that 60% is a good starting point.

How could this possibly be so? It just seems like it can’t be right. To see why, go back to the three equations.

0 = (1-t)f’’dk – f’dt

dw = – kf’’dk

dx = –kf’dt

Suppose we cut the corporate tax rate, so dt < 0. The first equation still has to hold. But the only thing in there that can change in response is k. So if dt < 0, that whole last term on the RHS is negative. We’re subtracting that, so it means the term on the left must be positive too. But if 0 < t < 1, and f’ > 0, then dk must be positive. Not surprisingly, a tax cut increases the amount of capital in the worker’s hands.

But in the second equation, an increase in capital, times the negative f’’ gets us a positive value for dw. Not surprisingly, more capital increase the MPL of workers and they get paid more.

It’s worth discussing how both the casual and more formal complaints from liberal/progressive/Democrats fits into this.

The casual response is that firms just won’t invest the extra money they have after the tax cut back into capital. That would be the case if capital didn’t flow around the world to where returns are the highest. But this is one of the major international macroeconomic problems of the last 50 years: capital does exactly that. S it might be OK to surmise that your employer wouldn’t be that smart, but somebody else must be or we wouldn’t have all that capital movement in the first place.

The formal complaint, stated most clearly by DeLong, is the dw is just zero. Wages are stagnant. End of story. As an assumption, that’s OK. But that assumption would mean the w is the exogenous variable in the model, and not r. I’ll leave it to you to resolve. But, in short, if all the economic pressure from the tax cut goes into rates instead of wages, then rates would go up instead of wages. That’s possible, but not plausible: everything we know about the data for the last several decades is that rates are far more equal around the world than wages are. Because capital movements are so elastic with respect to rates, capital would pour into the U.S. in even huger amounts than envisioned in the model as set out by Mankiw. And that would put pressure on wages to go up. But if you’re going to assume that wages are fixed, then the high rates will remain, and capital will pour in even faster. The reductio ad absurdum is that all capital from everywhere flows into the U.S. That just does not seem realistic.

† Thomas Piketty’s Capital in the 21st Century made a big splash a few years ago. There’s evidence that many non-economists didn’t read much past the first chapter. But economists did (Piketty is a big name guy on our field’s political left). Piketty wants big government. He doesn’t hide that. But big government requires big taxes. Multi-national corporations can short-circuit that by moving their income around to lower tax jurisdictions. Not surprisingly, Piketty suggested that we need a single global tax system and rate to apply to corporations, with a bureaucracy to distribute the proceeds down to individual countries.

‡ Furman should watch out, since Casey Mulligan snarkily dubbed the first pass result showing that the wages paid to labor are elastic with respect to corporate tax rate cuts a “Furman ratio”. It gets worse: Furman made a fairly common initial dodge, assertingd that the result was from a simpler static model, and that a more complex dynamic would be different. Except that Erlingsson called his bluff and found that a “dynamic Furman ratio” supports the conservative/Republican position more strongly. Mulligan also pointed out that Summers argued for corporate tax rates cuts in one of his most heavily cited papers using a model very much like presented here.