Tag Archives: American Economic Review

Does an income tax make people work less?

Harry Truman famously asked for a one-handed economist since all of his seemed reluctant to decisively answer anything: “on the one hand,” they’d tell him, but “on the other…”

When asked whether an income tax makes people work more or less, the typical economist gives the sort of answer that would have grated on Truman like a bad music critic.

If, however, we change the question slightly and make it more realistic, it’s possible to give a decisive answer to the question. Income taxes do reduce overall labor supply. This is something that economists James Gwartney and Richard Stroup explained in the pages of the American Economic Review some 30 years ago. And last week, the CBO’s much-discussed report on the ACA and labor-force participation illustrated their point nicely.

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Do Taxes Affect Economic Growth?

The CRS has a new report by Thomas Hungerford that has attracted some attention. It seems to suggest that taxes do not affect economic growth. To be precise, it seems to suggest that the top marginal tax rates of two taxes in particular—the personal income tax rate and the capital gains tax rate—have little statistically significant effect on economic growth.

A few comments:

First, as William McBride of the Tax Foundation notes in an excellent post, the study only examines two taxes.

The largest tax on investment is the corporate income tax, but the CRS report ignores corporate rates, even though other studies have found corporate taxes to be the most economically damaging.

Second, Will also rightly notes that the study focuses exclusively on the statutory rates of these two taxes, ignoring their actual incidence.

Because Congress has larded up the tax code with piles of credits, exemptions, and deductions, statutory rates often have little relationship to the rates people actually pay (just ask GE). For that, we need an estimate of effective marginal tax rates. As it turns out, many (most?) researchers who study taxes in the U.S. do attempt to get at this. Barro and Redlick’s piece is one example. It employs a tax model which accounts for the “complexity of the federal individual income tax due to the alternative minimum tax, the earned-income tax credit (EITC), phase-outs of exemptions and deductions, and so on.” Using this measure, Barro and Redlick find taxes do have “significantly negative effects on GDP.”

Third, the piece makes no attempt to account for reverse-causality (what economists call endogeneity).

Put simply, tax rates do not change randomly. If they did, that’d be great for researchers because randomization is the gold standard of the scientific method. But because policy makers are not so keen to let economists experiment with the national economy, tax rates don’t change randomly. Instead, governments tend to change rates in response to changing economic conditions; they cut taxes when the economy is weak and they raise taxes when the economy is strong. This makes disentangling cause and effect quite difficult.

Imagine we studied new drug treatments this way. Instead of large scale controlled experiments with randomized treatments and placebos, what if we only had one patient, and we only gave her a treatment when her condition worsened? If, after the treatment, her condition deteriorated further, would we conclude that the drug did her in? A simple statistical test would say so: drug applied, condition worsened. But such a test would ignore the fact that she only got the drug because she was sick to begin with! The point is that it’d be irresponsible to conclude anything from such a small sample and without trying to control for reverse-causality.

That’s why economists go to great lengths to mimic the conditions of a controlled, randomized experiment. In the case of tax studies, the best example of this is the study by Christina and David Romer. They painstakingly combed the archives of presidential speeches and government documents to identify tax changes that came about for reasons other than the condition of the economy. They found that these sorts of plausibly exogenous tax changes had quite significant macroeconomic effects. In their words:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Fourth, I also take issue with the way the report characterizes some of the existing literature. For example, Hungerford writes that:

There is substantial evidence…to suggest that labor supply responses to wages and tax changes are small for both men and women.

This is only true if the question is whether people who already have jobs change their labor supply in response to tax changes. Increasingly, however, the literature has identified another margin that matters: lifetime decisions about schooling, fertility, and work experience. If taxes affect these things, then they still affect labor supply, even if they don’t seem to affect short-term decisions about how much labor to supply. As Michael Keane’s recent piece illustrates, taxes have a very pronounced effect along this margin, especially among women.

The CRS report is interesting. And its results should be added to the body of literature on taxes. But it is hardly reason to throw out decades of other research which suggests taxes do harm growth:

 

Trickle-Down Economics: Does Anyone Actually Believe In It?

I have heard a lot about “trickle-down economics” lately. The President has taken to using it in speeches. And pundits have increasingly invoked the idea. Back in February, I was asked about the term when I testified before a House committee and had to confess that I have never met an economist who has advocated anything close to “trickle down” economics.

The words “trickle down” imply that if you redistribute money to the wealthy, they will spend it (say, by hiring workers or by buying products) and it will somehow find its way into the hands of the poor. To the extent that any economists endorse such a notion, they are emphatically not free market economists.

This is not to say that there is no case for low taxation. There is a strong theoretical case for low taxation (so long as it is accompanied by low spending!). And it is backed by good empirical evidence.

But the case for low taxation is not—as the phrase “trickle down” implies—based on the idea that we should give money to a wealthy person so she can spend it. Instead, it is based on the idea that if we take money away from either a rich or a poor person when they engage in some activity, they will tend to engage in less of that activity.

If we tax work, people will tend to work less. If we tax consumption, people will tend to consume less. If we tax saving, people will tend to save less. The idea is rooted in basic microeconomics. Taxing labor, for example, makes leisure less expensive. So people choose more leisure. This is called the substitution effect.*

All this theory is well and good, but is there any evidence to back it up? Yes. Michael Keane offers a nice survey of labor supply and taxation studies in the December issue of the Journal of Economic Literature. He identifies at least two major patterns in the evidence:

  1. Women are more responsive to taxes than men (most economists think men are relatively unresponsive to labor taxes, especially in the short run).
  2. People—particularly women—are more responsive to taxes when they consider whether to work than they are when they consider how much to work. In the average study, the long-run elasticity for female labor is 3.6. This means that if a tax hike reduces after tax wages by 10 percent, female labor force participation tends to fall by about 36 percent. As Keane puts it, this is a “very large” effect.

In my view, both of these patterns make sense. Historically, women have been more likely than men to work at home and so higher taxes seem more relevant for them than for men (as more women work outside the home and as more men stay home, I’d expect this gender difference to narrow). It also makes sense that taxes have a larger effect on the decision to work at all than on the decision to work a certain number of hours. Most of us can’t tell our employers that we want to work 30 hours a week rather than 40. But we can tell our employer that we don’t want to work at all. And evidently a lot of people—particularly women—do tell their employers this when taxes are high.

So far, I’ve only discussed how taxes affect labor supply. But they may also depress consumption and investment. What is the overall effect on the economy?

One of the best recent studies is that by President Obama’s former economic advisor, Christina Romer and her husband, macroeconomist David Romer. The Romers set out to understand the effect of taxation on an economy. But they knew that there was a major problem: taxes are not randomly increased or decreased. Instead, politicians tend to keep taxes low when the economy is in recession and raise them when the economy is booming. This makes it very difficult to disentangle cause and effect. So the Romers painstakingly analyzed decades of presidential speeches and government documents to identify exogenous tax changes (i.e., changes that were undertaken for reasons other than the condition of the economy). They then compared the performance of the economy following such exogenous changes. They concluded that exogenous tax increases are “highly contractionary.” As they put it in the conclusion:

Our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent.

Now here is the irony: As I note above, few if any economists advocate redistributing resources to the wealthy in the hopes that they will trickle down to the rest of us. But over the objection of economists—particularly free market economists—policy makers do this all the time. Think of President Bush’s TARP. Or President Obama’s decision to extend TARP to the auto companies. Or his excursions into venture capital. In each case, money was actually transferred from taxpayers to the (mostly) wealthy managers and shareholders of private firms.

If words mean anything, each of these policies—and not, say, an across the board reduction in marginal income tax rates—should be labeled “trickle-down economics.” But in politics, words often mean nothing.

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*  You might be thinking that the income effect offsets this: By taxing income, you not only make leisure less expensive, you also make people feel poorer. In response to feeling poorer, they may feel that they need to work harder to make up for the loss income. This works for an individual, but as economists James Gwartney and Richard Stroup long ago explained in the American Economic Review, it does not work for society as a whole. This is because governments do something with the money they collect in taxes. And the income effect of spending government revenue makes people work less. So at the economy-wide level, the income effect from spending offsets the income effect from taxing. All you have left is the substitution effect and that unambiguously reduces labor supply.

 

Does UK Double-Dip Prove that Austerity Doesn’t Work?

The U.K. has slipped back into recession and Paul Krugman thinks this is evidence that austerity doesn’t work. Is it?

There are three questions with austerity:

  1. Will it work? Will it actually cut the debt?
  2. Will it hurt? Will it harm the economy or might it actually be stimulative?
  3. What mix of spending cuts and tax increases yield the best answers to questions 1 and 2.

Here is what the data says (and there is a lot of it):

  1. Sadly, most austerity efforts fail. According to research by Alberto Alesina, about 84 percent of fiscal reforms fail to substantially reduce a nation’s debt-to-GDP level.
  2. We’ve known for a while that austerity can be stimulative. Even left-of-center economists such as David Romer have acknowledged this possibility. But the evidence on this is decidedly mixed. As Alesina put it in his Mercatus working paper, austerity is about as likely to be stimulative as…well…stimulus. And we know the economics profession is quite divided on stimulus. So you shouldn’t hold your breath hoping austerity will boost economic growth. But remember, that’s not why we should be pursing austerity. We should pursue austerity because we know that we are on an unsustainable fiscal path and that in the long run, too much debt is very bad for growth. Furthermore, we know that the longer we put off reforms, the more painful they will have to be.
  3. Lots and lots of papers* have now studied this question and the evidence is rather clear: the types of austerity that are most-likely to a) cut the debt and b) not kill the economy are those that are heavily weighted toward spending reductions and not tax increases. I am aware of not one study that found the opposite. In fact, we know more. The most successful reforms are those that go after the most politically sensitive items: government employment and entitlement programs. Lastly, there is evidence that markets react positively when politicians signal their seriousness by going against their partisan inclinations. In other words, the most credible spending reductions are those that are undertaken by left-of-center governments. So slash away, Mr. Obama!

photo by: 401K/Flickr

I summarized these issues in this summary and in this presentation.

Given what we know about austerity, my advice to the UK would be: tweak your austerity measures so that they are more spending-cut-focused and less revenue-increase-focused. And go after the most politically-sensitive items. I wish I knew more about what they actually did, but my knowledge of this is limited and I’ve frankly heard conflicting reports (apparently in the UK, there are just as many arguments over the proper baseline as there are here in the U.S.!).

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*Most of the following papers directly test the question of whether spending-cut-focused reforms or tax-cut-focused reforms are more successful and more expansionary. A few test related questions but provide corroborating evidence for this question. All of them suggest that spending-cut-focused reforms work better and are more likely to aid the economy. The papers are in chronological order, but I’d recommend starting with the latest:

Francesco Giavazzi and Marco Pagano, “Can Sever Fiscal Contractions Be Expansionary? Tales of Two Small European Countries,” NBER Macroeconomics Annual, (Cambridge, MA: MIT Press, 1990), 95-122.

Alberto Alesina and Roberto Perotti, “Reducing Budget Deficits,” 1994-95 Discussion Paper Series No. 759 (1995);

Alberto Alesina and Silvia Ardagna, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, No. 21, (1995): 207-47;

Francesco Giavazzi and Marco Pagano, “Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience,” Swedish Economic Policy Review, Vol. 3, No. 1 (1996): 67-112;

John McDermott and Robert Wescott, “An Empirical Analysis of Fiscal Adjustments,” International Monetary Fund Staff Papers, Vol. 43 (1996): 725-753;

Alberto Alesina and Roberto Perotti, “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” NBER Working Paper 5730 (1997);

Alberto Alesina, Roberto Perotti, and Jose Tavares, “The Political Economy of Fiscal Adjustments,” Brookings Papers on Economic Activity (1998);

Alberto Alesina and Silvia Ardagna, “Tales of Fiscal Adjustment,” Economic Policy, Vol. 13, No. 27 (1998): 489-545;

Roberto Perotti, “Fiscal Policy in Good Times and Bad,” The Quarterly Journal of Economics, Vol. 114 (1999): 1399-1436;

Juergen von Hagen and Rolf Strauch, “Fiscal Consolidations: Quality, Economic Conditions, and Success,” Public Choice, Vol. 109, No. 3-4 (2001): 327-46;

Alberto Alesina, Silvia Ardagna, Roberto Perotti, and Fabio Schiantarelli, “Fiscal Policy, Profits, and Investment,” American Economic Review, Vol. 92, No. 3 (2002): 571-589;

Juergen von Hagen, Hughes Halite, and Rolf Starch, “Budgetary Consolidation in Europe: Quality, Economic Conditions, and Persistence,” Journal of the Japanese and International Economics, Vol. 16 (2002): 512-35;

Silvia Adrian, “Fiscal Stabilizations: When Do They Work and Why?” European Economic Review, Vol. 48, No. 5 (2004): 1047-74;

Jose Tavares, “Does Right or Left Matter? Cabinets, Credibility and Fiscal Adjustments,” Journal of Public Economics, Vol. 88 (2004): 2447-2468;

Luisa Lambertini and Jose Tavares, “Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implicates for the EMU,” Contributions to Macroeconomics, Vol. 5, No. 11 (2005);

Boris Cournede and Frederic Gonand, “Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending?OECD Economics Department Working Papers, No. 520 (2006);

Stephanie Guichard, Mike Kennedy, Eckhard Wurzel, and Christophe Andre, “What Promotes Fiscal Consolidation: OECD Country Experiences,” OECD Economics Department Working Papers, No. 553 (2007);

OECD, “IV. Fiscal Consolidation: Lessons from Past Experience,” in OECD Economic Outlook, 2007;

Andrew Biggs, Kevin Hassett, and Matthew Jensen, “A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked,” AEI Economic Policy Working Paper No. 2010-04, (2010);

Ben Broadbent and Kevin Daly, “Limiting the Fallout from Fiscal Adjustment,” Goldman Sachs Global Economics Paper, No. 195 (2010);

David Leigh, Pete Devries, Charles Freedman, Jaime Guajardo, Douglas Laxton, and Andrea Pescatori, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” in World Economic Outlook: Recovery, Risk and Rebalancing (Washington, DC: International Monetary Fund, 2010);

 

 

Trust and the Long Shadow of Slavery

Back in October I wrote about trust, describing it as an important lubricant of commerce. I then talked about new research by Omar Al-Ubaydli, Daniel Houser, John V. Nye, Maria Pia Paganelli and Xiaofei Pan. In an experimental setting, they found that subjects primed to think about markets tend to be more trusting than those who are not primed to think about anything in particular.

In sum, I wrote:

Progress depends on the extent of the market, the extent of the market depends on trust, and trust can be facilitated with familiarity with markets.

Now, in the latest issue of the American Economic Review, Nathan Nunn and Leonard Wantchekon present some disturbing new results on trust and the long shadow of slavery:

We show that current differences in trust levels within Africa can be traced back to the transatlantic and Indian Ocean slave trades. Combining contemporary individual-level survey data with historical data on slave shipments by ethnic group, we find that individuals whose ancestors were heavily raided during the slave trade are less trusting today. Evidence from a variety of identification strategies suggests that the relationship is causal. Examining causal mechanisms, we show that most of the impact of the slave trade is through factors that are internal to the individual, such as cultural norms, beliefs, and values.

Great Myths of the Great Depression

The New Deal deficit spending helped boost the economy and bring the unemployment rate down to single-digit levels, but fear of deficits limited the scale of New Deal programs and caused Roosevelt to reverse course and cut back on spending in 1937, just as the economy was gaining momentum.

So writes Dean Baker in the New Republic. This is marginally better than the myth I learned in high school: FDR saved capitalism from itself by embracing the wisdom of Keynesian economics. He “primed the pump” with massive deficit spending and lifted the economy out of the Great Depression.

My high school story was a tad inconvenient for those who are fans of both Keynes and FDR: In 1940—7 years after the New Deal had begun—the unemployment rate still hovered at an astounding 14.6 percent.

But the high school myth turned out to be wrong: Keynesian economics didn’t end the Great Depression because Keynesian economics was never tried. Keynes, remember, called for deficit-financed spending during downturns (and surpluses during times of plenty to pay off the debt). The data show that FDR (and Congress) implemented half of the Keynesian stratagem: real spending dramatically increased throughout the Great Depression. 

The problem—from a Keynesian perspective—is that they also massively increased (already-high) taxes so that, even as the economy collapsed, revenue soared.  

 

 

A seminal piece in the American Economic Review by Cary Brown exploded the myth that Roosevelt was a Keynesian:

The primary failure of fiscal policy to be expansive in this period is attributable to the sharp increases in tax structures enacted at all levels of government.  Total government purchases of goods and services expanded virtually every year, with federal expansion especially marked in 1933 and 1934.  [But] the federal Revenue Act of 1932 virtually doubled full employment tax yields.

But notice, Brown doesn’t say that FDR failed to be Keynesian because he stopped spending; he failed to be Keynesian because he also raised taxes. But that doesn’t stop many in the punditry from claiming that, in his later years, FDR was converted into some sort of proto-Paul Ryan.

See this excellent post by Alex Tabarrok on the subject. See, also, these posts by Tyler Cowen.

What if Stimulus Works, But Government Can’t Get the Timing Right?

As of September 3, 2010, about $154.8 billion of the approximately $282 billion of total funds made available by the Recovery Act in 2009 for programs administered by states and localities had been paid out by the federal government.

That’s the conclusion of a new GAO report, out this week. Similarly, the Wall Street Journal reports this morning that:

[S]pending stimulus dollars fast has turned out to be surprisingly hard.

This reminds me of a point that Megan McArdle raised a few weeks back:

[W]hat if Keynesian stimulus works, but no one can ever actually afford to do it, short of something like World War II, where the government can tap into a patriotic outpouring of national savings by issuing bonds with negative real yields.

She was talking about the sheer size of the stimulus. But we could ask a similar question: What if Keynesian stimulus works, but the machinery of government is so slow and inept, that it is impossible to effectively implement it in time to be effective?

This, of course, was the (near) consensus view among macroeconomists just a little over a decade ago. Writing in the American Economic Review in 1997, Martin Eichenbaum wrote:

[T]here is now widespread agreement that counter cyclical discretionary fiscal policy is neither desirable nor politically feasible.

Perhaps the current struggles to effectively administer stimulus will one day cause that consensus to re-emerge.

Desperately Seeking Revenues

Dwindling revenues and budget deficits are leading lots of municipalities in search of revenue enhancements – i.e. tickets, fees and fines. California’s “fix-it” ticket has tripled: It will cost you $100 for a broken headlight.

Thomas Garrett and Gary Wagner, looking at North Carolina data, find that the number of citations issued go up in years following a drop in revenues. The bad news seems to be that governments get hooked: Garrett and Wagner find that the rate of ticket issuance does not decline when revenues rebound.

Elsewhere, my colleague Thomas Stratmann and Michael Makowsky of Towson University have a forthcoming paper in the American Economic Review that shows that when it comes to traffic tickets, the incentives faced by officers really matter:

The farther the residence of a driver from the municipality where the ticket could be contested, the higher is the likelihood of a fine and the larger its amount. The probability of a fine issued by a local officer is higher in towns when constraints on increasing property taxes are binding, the property tax base is lower, and the town is less dependent on revenues from tourism. For state troopers, who are not employed by the local, but rather the state government, we do not find evidence that the likelihood of traffic fines varies with town characteristics. Finally, personal characteristics, such as gender and race, are among the determinants of traffic fines.

Putting these two papers together suggests that states and municipalities will be looking to increase revenue collections from out-of-area motorists. Interestingly, this is the opposite approach taken by Virginia, which in 2007 enacted (and then rapidly backpeddaled on) an “abusive driver fee” that would increase the costs to in-state drivers for certain offenses but leave the cost for out-of-state drivers the same.