The mountain of disincentives

I recommend reading John Cochrane’s post about the job market and his thoughts regarding what a few other prominent economists believe are problems and solutions.

Here he addresses Alan Blinder’s prescription to give tax breaks to companies that expand payrolls (emphasis mine):

Is this really the right way to run a country? When “policy makers” want more employment, they slap on a complex, tax break on top of a mountain of disncentives. Presumably they then will remove this tax break, and pages 536,721 to 621,843 of the tax code describing it, despite the lobbying by large corporations who have figured out how to exploit it for billions of dollars, once the Brookings Institution decides that there is “enough” employment (!), and “policy-makers” no longer need to encourage it?
How are the existing hundreds of bits of social engineering in the tax code working out? Do we really need more of this?  Isn’t it time to return to a tax code that raises money for the government at minimal distortion?

Exactly.

And, great question, how are the existing hundreds of bits of social engineering in the tax code working out? 

Consider one of the most popular bits of social engineering: the mortgage interest deduction. How has that influenced home ownership rates? Does anybody know?

I read a lot of economics and I haven’t heard much about that.

Conventional wisdom is that it encourages home ownership by lowering its cost. But, this assumes home prices didn’t change because of the deduction or that renters don’t realize a similar benefit since their landlords deduct interest on their rental property loans.

Are we to believe that the stock market discounts future cash flows into stock prices, but the housing market doesn’t do the same for home prices?

Let me try are more concrete example. You want to purchase a certain new car and your choice is between two versions of the same model. They are exactly the same, except one thing: gas mileage. Version 1 gets 20 mpg and version 2 gets 30 mpg.

Would you be willing to pay more for version 2? Maybe. How much more? If you drive 10 thousand miles a year, version 2 will save you $500 a year. If you own the car for 5 years, that’s $2,500. You may not be willing to part with the full $2,500 of savings — after all, there’s some risk to that. Gas prices will fluctuate and your driving habits might change, but you would likely pay more.

That’s very similar thinking to how some, not all, home buyers factor in expected tax savings when buying a home.

God’s flat tax

Johns Hopkins neurosurgeon, Ben Carson, made a couple of interesting points at a White House prayer breakfast this week. Here’s one point about taxation (emphasis mine):

What we need to do is come up with something simple. And when I pick up my Bible, you know what I see? I see the fairest individual in the universe, God, and he’s given us a system. It’s called a tithe.

“We don’t necessarily have to do 10% but it’s the principle. He didn’t say if your crops fail, don’t give me any tithe or if you have a bumper crop, give me triple tithe. So there must be something inherently fair about proportionality. You make $10 billion, you put in a billion. You make $10 you put in one. Of course you’ve got to get rid of the loopholes. Some people say, ‘Well that’s not fair because it doesn’t hurt the guy who made $10 billion as much as the guy who made 10.’ Where does it say you’ve got to hurt the guy? He just put a billion dollars in the pot. We don’t need to hurt him. It’s that kind of thinking that has resulted in 602 banks in the Cayman Islands. That money needs to be back here building our infrastructure and creating jobs.”

Update: Grant Davies has posted the video of Carson’s speech on his blog, in case you are interested in watching it. Carson talks about much more than taxes. Thanks Grant!

And I highly recommend that you watch it. I’ll have more to post from it.

Should we raise the tax rate on wealthy people?

Here’s my attempt at using the Costco Connection format to look at this question from both sides.

Yes

What the experts say: Economists tell us that wealthier folks have lower utility for each marginal dollar than less wealthy folks, because they have more than met their basic needs.

Or, as most people believe, the wealthy can afford to pay more than the less wealthy.

The wealthy benefit more from government, so should pay more to support it.

Tax rates can help us remedy unfair income distributions.

No

The wealthy already pay more than the less wealthy.

It’s presumptuous of us to feel we have the right to demand more from the wealthy than we are willing to give ourselves.

Even if it’s true that the wealthy have less utility for each additional dollar than the less wealthy, that’s not the right comparison. Wealthy people have higher utility for each additional dollar than government bureaucrats have with other people’s money.

Diminishing marginal utility is not a good argument for taking stuff from people. If I stole all the stuff in your attic, would you accept my argument that what I did was right because you weren’t using it?

Everyone benefits from government and it’s fair to expect everyone to pay something for it.   In any situation where a minority pays for the majority of something that everyone benefits from (or thinks they benefit from), the tendency is for the majority to demand more and more, because it costs them nothing to do so.

Tax rates do not remedy envy. Higher tax rates on the wealthy can contribute to perceived income inequality, as wealthy folks respond to the incentives of their after-tax pay, not their before-tax income, while inequality is often based on gross income. In other words, if you raise taxes on the wealthy, they’ll seek to make even more income to make up for those higher taxes.

Higher tax rates also encourage the wealthy to make adjustments in their lives to avoid paying those taxes. Wealthy folks moved from England and France after those countries passed higher tax rates on the wealthy, for example.

My opinions

I think we spend too much time talking about tax rates and not nearly enough time talking about government spending.

I think everyone, no matter how rich or poor, should pay something.

I don’t begrudge the wealthy of their wealth, especially the wealth of those who have earned it fair and square. That means they’ve added value to society, something we fail to consider as we salivate over ways to take it from them.

Even with 20/20 hindsight, I’m appalled at how we fail to see that earned wealth often carried with it gut-wrenching risks, previous failures and an extraordinary amount of persistence against the odds. We act as if it was a given.

I don’t accept that wealthy people have less marginal utility for an additional dollar than the less wealthy. If that were true, I would expect to see more evidence of that in the financial behavior of less wealth people.

Good reporting from a store?

Despite my concern about a Costco founder publicly supporting tax increases, then making a special December Costco dividend to avoid these higher taxes, I’d like to commend Costco’s member magazine, the Costco Connection, for setting an example of good journalism.

Costco members receive this publication each month. It mostly has information on products available at Costco, but there is a smattering of other content. One recurring piece is the Yes/No page.

Each month, the Costco Connection asks an issue-related question to which they publish the response from two “experts,” one supporting the answer Yes and the other supporting No. The Connection also includes three short sound bites from customers on each side of the debate.

That’s a model other publications can learn from. I often stop reading news articles because of how poorly the facts and opposing arguments are presented. Often there is no attempt to present the opposing argument. Other times, when opposing arguments are included, they are token attempts that misrepresent the actual arguments.

Consider the recent reporting about the fiscal cliff. What arguments for Republican resistance to raising the top income tax rate did your news source present? I heard inaccurate and inept reporting on both sides.

Liberals seemed to think that Republicans wanted to protect their wealthy buddies, or just didn’t want to compromise with Democrats or were beholden to the power wielded by puppet-master Grover Norquist (who?).

Even when a fairer presentation of the Republican resistance was presented, it seemed to come with editorial gestures, like eye-rolls, that made it clear that such intentions should not be trusted and you’d be stupid to believe it.

Why didn’t we see more of the style of reporting that I can only seem to find in the Costco Connection?

Why not present the arguments in as fair and clear a light as possible and let people decide for themselves?

Maybe the Costco Connection will cover this issue before it all comes up again very soon.

Thoughts on taxes III: Social Engineering

In my original Thoughts on taxes post, I listed this as the second reason I prefer a simple tax system:

  • We don’t get the social engineering benefits that we think we do from the cleverly designed tax code that we have. We may only get bad outcomes.

I would prefer that we only think of taxes as a way to fund government, but many folks can’t resist the temptation to make the tax code serve double duty by also trying to use it for social engineering. That is, to encourage more behavior that we think of as good (like owning homes, earning income and going to college) and less behavior we think of as bad (like earning high income and making short-term investments:)).

Well, it’s not that we think earning a high income is bad. It’s that many people believe income inequality is bad and they think tax rates can balance that out, but as we’ll see shortly, progressive tax rates may contribute to income inequality.

I believe this desire to use the tax code for social engineering has two problems. First, and most important, we don’t actually realize the social engineering benefits. Those just get pushed to other margins through by distorting natural incentives. More on that in bit.

Second, it stands to reason that the natural rewards for good behavior (like buying homes, going to college and long-term investing) should be enough to encourage that behavior without any special tax treatment.

To think about how trying to reward good behavior in the tax code pushes the supposed benefits to other margins, consider the home mortgage interest deduction. We’ve been brainwashed to believe this is good because it encourages home ownership.

We’ve also been brainwashed to believe that home ownership is a good thing.

But, why exactly is home ownership something that we should encourage? Arnold Kling wonders this as well. What’s wrong with renting?

Home ownership isn’t for everyone. Home ownership doesn’t necessarily make one wealthier, wiser or more responsible, despite that conventional wisdom that fed the housing bubble.

Have you heard how much ownership the mortgage interest deduction has encouraged? I haven’t. If there is research on this topic, I haven’t seen it and a couple (admittedly quick) Google searches didn’t immediately turn up anything. If you can point me to any research on the topic, please do so in the comments.

But, even if there is research, I’m skeptical that it would thoroughly consider all the possible distortions to natural incentives the mortgage interest deduction could be causing and how those distortions have moved the benefits of home ownership to other margins.

Even I can’t know all the distortions caused by this part of the tax code, but I am willing to bet that the my following list of possibilities is something most folks haven’t ever considered. I know this because I bring it up to folks all the time and the response so far has always been “Wow, I never thought of that.”

I think, perhaps, the biggest distortion that may offset most of the social benefit of the deduction is higher home prices. Believe it or not, the value of the mortgage interest deduction benefit is accounted for in higher home prices.

Some folks I’ve discussed this with have a hard time believing it. They tell me that they didn’t explicitly consider that when making an offer on their home.

How market prices work is hard to understand. While my friends may not have explicitly considered it, the folks they were bidding against may have and they had to beat those bids to get the house. So, they did not have to explicitly consider this benefit for it to be built into the price.

If you still don’t believe me, you should also consider why the real estate brokers and home lenders actively lobby to keep the mortgage interest deduction. Do you think they are just looking after our best interests? No. Higher home prices means high transaction prices for real estate agents (7% commission x a higher number is a higher number).s.

The mortgage interest deduction also encourages folks to take out larger loans, keep that debt out longer and have less equity in their home than they might have otherwise.

These can weaken someone’s financial position and gives less incentive to be responsible home owners. As we found out in the housing bust, owners with no equity are no more responsible than renters who do not have to pay rent.

If I had not considered how taxes distort natural incentives before, this list of four possible distortions of the mortgage interest deduction would at least make me think more about the topic and possibly consider distortions driven by other socially engineered pieces of the tax code.

Could the most progressive income tax code of all developed countries actually be contributing to income inequality? In other words, does the higher marginal rates on higher income lead high income folks to seek higher rates of gross income to offset those higher tax rates?

Like home prices, this isn’t intuitive, but is the same thing. Labor is price, just like a home price is a price. If home prices adjust to include tax benefits, labor prices can adjust to cover tax costs.

Don’t think so? Imagine one of your favorite Hollywood stars. Even better if he happens to be vocal advocate for increasing taxes on the wealthy (e.g. Matt Damon).

Now, also consider the clout of your highly paid actor. Does he sell tickets? If so, he has some good earnings leverage over the studios that sign him to their projects.

Next, think about what happens in his next movie negotiation if he gets his wish and tax rates on high incomes are increased. Let’s say before he was banking $10 million per movie, or $6 million after tax.

If tax rates increase from 40% to 60%, for example, do you think he’ll settle for taking home $4 million on his next project? Probably not. Why should he? Do you think he would recognize the $2 million hit as a consequence of his advocacy? No.

His agent will ask for $15 million so his client can take home the same $6 million as he did before. And the actor will never connect the dots on how the tax rate actually made his gross income even more “inequal” ($15 million vs. $10 million) to the folks who didn’t see a 50% increase in tax rates.

But, we don’t need to guess how tax rates can distort a rich actor’s incentives. What if a neighbor, who you don’t know well, is planning an extended vacation next summer and offers to pay you to mow his lawn while he’s gone. He tells you it takes an hour to mow.

What price would get you to agree to his offer? $20? $40? $50? $100?

Which price raised your interest level?  I’d have tepid interest for $50 and be much more interested for $100. But, everyone is different because we all have different opportunity costs.

You agree to the offer at your desired price, but then find out that one of the Homeowner Association covenants, that you never read, states that the HOA gets 50% of any such neighbor-to-neighbor dealings. Now we’ve cut the fee your attention-getting-fee in half.

Are you still interested in mowing his lawn? No. Your opportunity costs are higher than that amount, else you would have picked that number the first time.

What would make it all better? If your neighbor doubled the fee to offset the HOA’s 50% tax.

See, our own behavior and incentive distortions are not much different from the rich Hollywood actor and it’s plausible that distortions caused by unequal tax rates winds up being priced into labor, which contributes to the ‘income inequality’ that so many folks get bellyaches over.

Writing this post has made me think about a new game to play on this blog: Guess the incentive distortions. Periodically, I’ll pick a policy and see if I can name a few possible distortions that might make the policy less desirable than it sounds.

Incentive distortions caused by tax rates are rarely discussed. When they are, they are often too quickly discounted. 

Simple changes for Social Security

Here are a couple of simple changes to SS.

First, make the tax compulsory only for those saving less than 7% of their income for retirement. For example, if you save 5% in a retirement account, then you pay a 2% SS tax.

Second, make it true to its name and make it insurance, not a for-sure benefit (at least, for-sure until there’s not enough folks to cover it). So, even if you find yourself penniless after having saved 7% in your 401k, you might be eligible for the safety net. But, there may be some conditions even to that to encourage folks to be prudent with their 401k investments.

Extra Credit Assignment

If I were an econ or math professor I might be inclined to assign an extra credit for a short explanation of Buffett’s tax rate comparison to his secretary’s.

Nobody seems to be able to get this much ballyhooed comparison — and inspiration for Obama’s “Buffett Rule” — correct.

Here’s what my answer to the assignment would look like:

The above table shows a comparison between the taxes and tax rates paid by Buffett and his secretary, Debbie.

The first comparison (1) is made by Buffett in the media and is composed of three parts:

  1. Payroll taxes (Social Security and Medicare) paid by each individual.
  2. Payroll taxes paid on behalf of each individual by their employer.
  3. Individual Federal income taxes paid.

Buffett includes the portion of payroll taxes paid by their employer on their behalves, but ignores the corporate income taxes paid on his behalf by the companies that paid him dividends, which make up nearly all of Warren Buffett’s taxable income.

Dividends are taxed twice, once when earned as income by the company and again when the company pays the dividend to its owners.

Buffett and other commentators treat the low dividend tax rate as if it were a random and unfair artifact of the tax code.

Rarely is it acknowledged that there is a rationale for a lower dividend tax rate and it’s not just to make the rich richer.

Part of the rationale is that the combined corporate and individual tax rates on dividends is high at around 45% -50%. As Congress evolved the tax code — with the input from economists — one of reason they set the dividend tax rate low was to help offset the effects of the double taxation.

When the total dividend tax rate was higher, companies avoided paying dividends because of the high tax rate.  Some managers used double dividend taxation as an excuse to hold on to shareholder money and blow it in bad investments.

Others used a more tax efficient method of distributing money to owners — share repurchases.  Since there is no good reasons for the tax code to favor one form of cash distribution (repurchases) over another (dividends), dividend taxes were lowered to make both methods more equal.

But, therein lies the danger of such clever and complex systems: The next set of folks forget or don’t understand the rationale.  Or, perhaps they understand it, but choose to exploit (and feed) the misperception of low tax rates for their own political purposes.

To get a more apples-to-apples comparison between the real tax rates Buffett and Debbie pay (comparison 2), I estimated that the companies that paid dividends to Buffett had already paid $14 million in taxes on his behalf.  Now, this isn’t wholly accurate.  They really paid more (the real number is probably closer to $20 million), but I’m simplifying for the sake of understanding.

When I add the corporate taxes paid in, I find that Buffett pays a substantially higher tax rate (50%) than Debbie (37%) and the “Buffett rule” has not been violated. Not even close.

One final note: In addition to underestimating the amount of corporate taxes paid, some could quibble that my analysis ignores taxes Buffett paid when we earned the dividend-paying holdings to begin with.  That’s true and that means his dividends are actually taxed three times.  But, I thought just adding in what the company pays on his behalf in the current period should make a strong enough case for casual observers that Buffett and Obama are deceiving the public for political purposes.

When is a tax cut not really a tax cut?

When it has the same incentives as a handout or ransom note.

One of the problems with American politics, or politics anywhere, is the politicians tendency to ingratiate their status with voters by appearing to give folks gifts of the voters own money.  Such things sound great on the campaign trail.  They all essentially boil down to:

I put more money in your wallet.  If you would like me to keep doing that, vote for me.

That’s what I thought when I heard about the ridiculous two-month extension of the payroll tax cut.  What politicians are really saying when they extend a tax cut for two months at a time is:

I will continue holding your wallet hostage.  The ransom is your vote for me.

Or…

I want you to feel dependent on me, vote for me.

While I’m usually for tax cuts, I don’t care much for tax cuts designed intently to increase politicians’ (real or perceived) power.

Government’s weakness: It doesn’t have to add value

In this previous post, I wrote about how government is overhead and that increasing overhead is probably not the way to improve a bad economy.

I compared the economy to a burrito-making business, with the private sector being the burrito-making and selling part of the business and the government being the overhead functions like accounting, legal and IT.

In this post, I’ll explore the limits of that overhead a bit more.

The value creation engine of our society is greatly under appreciated.  Without the burrito making part of the business, the overhead jobs for accountants, lawyers and IT folks at the burrito company would not exist.

The value creation engine in the economy is voluntary mutually beneficial trading.  When two parties trade voluntarily, they do so because they both come out ahead — otherwise, why would they trade?  Since they both come out ahead, value is created.

We each trade with others every day.  It’s hard not to.  We do it so naturally that we take it for granted.

Try this exercise.  The next time you buy something, ask yourself why you bought it.  What benefits did it provide you that made it more valuable than whatever it was that you gave up to buy it?

What was your next best use for your money?  Could you have spent it on something else? Save it? Why did you buy it instead of your next best use for the money?

Why do you show up to work to trade your time and skills for money?  Is that time or skill not worth as much to you as the time you give up?

The reasons you trade (or not) and the value you gain from the trade is Adam Smith’s Invisible Hand.   Your actions or inactions send signals through the price system on how much you value or don’t value things so that other individuals will respond and oblige to provide you more of what you do value.

In that sense, the price system was one of the earliest and best communication networks (although it doesn’t send information on why you value the things you buy, which befuddles many company managers).

Taxes paid to government, unlike voluntary trade, is compulsory trading forced by the government.

That’s not to say that some value isn’t created in that forced trade.  Government does create value for society, just as the overhead functions create value for the burrito business.  Governments provide citizens with security, law enforcement and justice systems, for example, that may benefit all of us.

But, since taxes and government are forced, it does mean that this trade does not have to create value for both sides of the trade.  That’s the important distinction that is glossed over by all sides of the debate on taxes and government.

When debating what government should or shouldn’t do, one side tends to provide examples of where they think government is worth the taxes paid.  The other side provides examples of where they think government is not worth it.

They never settle their dispute because they both can be right.  Neither side sees the full view that government can create value, but it’s not necessary that it does create value since government can force collect on taxes. Government gets money whether it creates value or not.

With voluntary transactions, it is more of a necessary condition that both sides come out ahead.   Voluntary trading that does not result in both sides coming out ahead usually dies out quickly because sooner or later the side that’s not coming out ahead voluntarily decides not to trade.  That’s a natural check on non-value added trades.

There’s not a natural check on what creates value with government and that’s why government can and does tend to grow far beyond where it adds value, which means it destroys value — or makes us poorer.

This also happens at successful companies.  Once a business finds a successful product and reaches a level of sustainable income, its overhead functions tend to grow faster than the value creation side of the business.

Some of this growth is good.  More overhead can make the business function more consistently.  But, it doesn’t have to all be good.  Just like with government, there’s not natural check (like the Invisible Hand) to limit the size of overhead and the “right” size of overhead is not clear cut.  Eventually bureaucrats feed off the flesh and muscle of the business and destroy value.

The overall limit on the size of overhead is the business’s income and many successful businesses have failed because management let overhead grow too large.

The overall limit on the size of governments (all of them — local and federal), is the value created by the private sector.  We are lucky that capitalism has created such a wealthy private sector.  It has allowed us to afford a good sized government.

But we are spending and destroying that wealth faster than the private sector is creating it.  Which means we are dipping far into our “rainy day” fund.  As Margaret Thatcher said,

The problem with socialism is that you eventually run out of other peoples’ money.

I’ll go a step further.  The problem with growing government so large is that you eventually run out of other people.

Don’t mistake this for an argument that essential government functions — especially those listed in the Constitution like defense — should be privatized.

Rather, we should be aware of this weakness of government and understand it has brought us to our current situation.  Further, we should keep this mind when evaluating what spending should be cut and consider private alternatives for the areas of government that are destroying value.

Would Buffett want to give politicians more of his money to spend if they ran his company?

President Barack Obama and Warren Buffett in t...

Would Buffett hire this guy to run Berkshire-Hathaway?

Warren Buffett makes another plea for government to take more from him and his net worth peers.

First, I’ll point Buffett to my advice for those who would like to raise taxes.  Thankfully, many others are calling for Buffett to lead by example and voluntarily cut a check as well.  Maybe Buffett will hear that message and respond.

I’ve also addressed Buffett’s analytical hypocrisy on this matter before.  That didn’t seem to work.

I’ll try another approach.

Carefully read Buffett’s words from this paragraph of his editorial:

They’ve [Twelve members of Congress] been instructed to devise a plan that reduces the 10-year deficit by at least $1.5 trillion. It’s vital, however, that they achieve far more than that. Americans are rapidly losing faith in the ability of Congress to deal with our country’s fiscal problems. Only action that is immediate, real and very substantial will prevent that doubt from morphing into hopelessness.

He never mentions spending — only deficit.  Buffett seems unwilling to hold our elected representatives accountable for spending way beyond our means.

I believe that’s partly due to an incentive effect.  If it were Buffett’s own pocketbook that representatives spent from he might think otherwise.

Buffett’s business, Berkshire Hathaway, is a holding company that owns lots of other companies.  He grew wealthy by buying good businesses run by good managers, keeping those managers and letting them do what they do best, run their businesses.

What do you think Warren would do if a business manager began spending much more than he was bringing in with no hope of closing that gap?

Do you think he would beg that manager to take even more of Buffett’s money so the manager could continue his spending spree?

I don’t think so either. I think he would fire him swiftly and find a replacement.

In my opinion, Buffett and his net worth peers, do much better for the economy by continuing to invest their wealth in productive ventures that make products and services that we value as consumers and provide jobs for millions of people, than by handing it over to politicians to help sustain the bureaucratic, rent-seeking behemoth we know as government.

I also think Buffett and his net worth peers could do much better by explaining this to folks and encouraging us to support and vote for politicians who would like to reduce the bureaucratic drain on society and double down on productivity.